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Chapter 3: Demand Theory
Instructor: Maharouf Oyolola
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Outline of the lecture
- Determinants of Demand
-graph of the demand function
-Demand schedule
-Law of Demand
-Difference etween change in Demandand Change in !uantity Demanded
-"rom indi#idual to mar$et demand
-
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Outline of the lecture
-%rice elasticity of Demand &%oint and 'rc(
-Income )lasticity of Demand &%oint and
'rc( -Cross-%rice elasticity of demand
- )-commerce
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Demand Theory
In this chapter* we egin our analysis ofconsumer demand+ Demand is one of themost important aspects of managerialeconomics* since a firm would not eestalished or sur#i#e if a sufficientdemand for its product did not e,ist or
could not e created+
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The fundamental oecti#e of demand theory isto identify and analy.e the asic determinants ofconsumer needs and wants+
Therefore* an understanding of the forcesehind demand is a powerful tools for managers+/uch $nowledge pro#ides the ac$groundneeded to ma$e pricing decisions* forecast
sales* and formulate mar$eting strategies+
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Demand analysis was introduced as a toolfor managerial economics+
"or e,ample* a $nowledge of price andcross elasticities can assist managers inpricing and that income elasticities pro#ideuseful insights into how demand for a
product will respond to differentmacroeconomic conditions+
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Determinants of Demand
0e egin this section y e,amining thedeterminants of indi#idual1s demand of a
commodity+In managerial economics* we are primarilyinterested in the demand for a commodity
faced y the firm+
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Determinants of Demand
In determining what to purchase*indi#idual consumers face a constrainedoptimi.ation prolem+ That is* gi#en their
income &the constraint(* they select thatcomination of goods and ser#ices thatma,imi.es their personal satisfaction+
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Determinants of Demand
The consumer demand theory postulatesthat the 2uantity demanded of acommodity is a function of* or depends on:
- the price of the commodity
-the consumer1s income
-the price of related commodities&complements and sustitutes(
-tastes of the consumer
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raph of the demand function
4owe#er* when we graph the relationshipetween the price and the demand* weassume other #ariales& income* tastes
and preferences( are constant* meaningtheir #alues do not change+
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The Demand ScheduleThe Demand Schedule
Demand Schedule:Demand Schedule: a list showinga list showingquantities of a good thatquantities of a good that
consumers would choose toconsumers would choose to
purchase at different prices, withpurchase at different prices, with
all other variables held constant.all other variables held constant.
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DEMAND CURVE FOR milkDEMAND CURVE FOR milk
Copyright 888 y 4arcourt* Inc+ 'll rights reser#ed+
$1.50
1.40
1.30
1.20
1.10
1.00
.90
0 45 50 55 60 65 70 75
Quani! "# milk
$%i&'
AB
D
C
E
F
G
H
D
p
rice
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Law of DemandLaw of Demand
TheThe law of demandlaw of demandstatesstates
that when the price of athat when the price of a
good rises and everythinggood rises and everything
else remains the same, theelse remains the same, thequantity of the goodquantity of the good
demanded will fall.demanded will fall.
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In functional form
!d,A "& %,* I* %y* T(
0here
!d,A 2uantity demanded of commodity B %,A %rice per unit of commodity B
IA consumer1s income
%yA %rice of related commodities TA tastes of the consumer
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Difference etween change in 2uantitydemanded and change in demand
!A" &%,* I* %r* T*(
To study the relationship etween theprice and 2uantity demanded* we assumethat income* price of related goods andtastes are constant+
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MOVEMEN( A)ON* A DEMAND CURVEMOVEMEN( A)ON* A DEMAND CURVE
VER+U+ +,-F( "# ' /'man/ &u%'VER+U+ +,-F( "# ' /'man/ &u%'
D0
D0
D1
D1
$1.30
1.10
C
F
Quani! D'man/'/
$%i&'
Copyright 888 y 4arcourt* Inc+ 'll rights reser#ed+
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Demand vs. QuantityDemand vs. Quantity
DemandedDemandedChange in QuantityChange in Quantity
Demanded =Demanded = movementmovement
alongalongthe demand curvethe demand curve
Change in Demand =Change in Demand =
movementmovement of the entireof the entire
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"rom indi#idual to mar$et demand
The mar$et demand cur#e is simply thehori.ontal summation of the demandcur#es of all the consumers in the mar$et+
&include the 3 graphs on page
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The andwagon effect
0hen people sometimes demandcommodity ecause others are purchasingit and in order to e fashionale
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The /no effect
Occurs when many consumers who see$to e different and e,clusi#e ydemanding less of a commodity as more
people consume it
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Durale goods
oods that pro#ide ser#ices not onlyduring the year when they are purchasedut also in suse2uent years+
),ample:washing machines* automoiles
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%rice )lasticity of Demand
' price change can either increase ordecrease total re#enue* depending on thenature of the demand function+
The uncertainty in#ol#ed could e reducedif managers had a method of measuringthe proale effect of price changes on
total re#enue+
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%rice )lasticity of Demand
One such measure is the price elasticity ofdemand* which is defined as thepercentage change in 2uantity demanded
di#ided y the percentage change in price+
Measure the responsi#eness of theconsumer to a change in price+
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0hy is the concept of elasticity ofdemand to the firm
"rom a decision-ma$ing perspecti#e* the firmneeds to $now the effect of changes in any of
the independent #ariales in the demandfunction on the 2uantity demanded+ /ome ofthese #ariales are under the control ofmanagement* such as price* ad#ertising*product 2uality* and customer ser#ice+
Ey affecting sales* the pricing policies of thefirm also affect its production costs* and thus itsprofitaility+
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4ow to find the percentagechange
),ample 7: %7A F788 %A F768
),ample : !7A
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%oint Gersus 'rc )lasticity
There are two approaches to computingprice elasticities:
&( The point price elasticity
&3( The arc price elasticity
The choice etween the two depends on thea#ailale data and the intended use+
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'rc elasticity
They are appropriate for analy.ing theeffect of discrete changes in price+
"or e,ample* a price increase from F7 toF could e e#aluated y computing thearc elasticity+
In actual practice* most elasticitycomputations in#ol#e the arc method+
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%oint )lasticity
This approach can e used to e#aluate theeffect of a #ery small price changes or tocompute the price elasticity at a particular
price+ %oint elasticities are important in
theoretical economics+
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%rice )lasticity of Demand
Eecause of the in#erse relationshipetween % and !* )p is negati#e+4owe#er* for simplicity* we use the
asolute #alue of )p or I)pI to interpretthe result
Q
P
P
Q
P
PQ
Q
Ep
=
=
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If I)pIH7 The demand is elastic
Meaning: If the price of the productincreases y 7* the consumers respondy decreasing their demand of the producty more than 7+
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If I)pIJ7 the demand is inelastic
Meaning: if the price of the productincreases y 7* the consumers respondy decreasing their demand of the producty less than 7
),ample: a necessary good
gas* electricity* water
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If I)pIA7 the demand is unit elastic
Meaning: if the price of the productincreases y 7* the consumer respondsy decreasing its demand of the producty e,actly the same percent+
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/'man/ &u%0'
8
:5
9
K
8 :88 588 988 K88
Quani! /'man/'/
$%
i&'
!
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't E
>=
=
=
==
==
15
100
5
165
1000100
IEpI
Q
P
P
Q
The demand is elastic
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'rc %rice )lasticity of Demand
Measures the price elasticity of demandetween two prices
2/)(
2/)(
21
21
PP
P
Q
Ep+
+
=
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),ample
=sing the point elasticity of demand* let1scompute )p:
C to D )pA-
D to C )pA-7
To a#oid this* we use the a#erage of thetwo prices and the a#erage of the two2uantities
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Eetween C and D
%7%A53A ;
!7!A88388A688
)pA-7+5
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),ample
Consider the >E' corporation* which hadmonthly as$etall shoe sales of 78*888 pairs&at F788 per pair( efore a price cut y its maorcompetitor+ 'fter this competitor1s price
reduction* >E'1s sales declined to K*888 pairs amonth+ "rom the past e,perience >E' hasestimated the price elasticity of demand to eaout -+8 in this price-2uantity range+ If the >E'
wishes to restore its sales to 78*888 pairs amonth* determine the price that must echarged+
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/olution
Letting !A78*888 !7AK*888 %7AF788 and
)DA-+8* the re2uired price* %* may e
computed:
50.89$
100$100$
000,8000,10
000,8000,10
0.2
2
2
2
=
+
+
=
P
PP
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%rice )lasticity* Total @e#enue andMarginal @e#enue
T@A%+!
M@ANT@N!
If % increases I)pIJ7 T@ increases
),ample: as &necessary good( there is noclose sustitute for gas+
It can e an answer to many who wonder why
oil companies are ma$ing huge profits whengas prices are increasing+
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%rice )lasticity* Total @e#enue andMarginal @e#enue
If % increases I)pIH7 T@ falls
'#ailaility of close sustitutes led theconsumer to sustitute the product withthe closest sustitute
M@A%& 7 7)p(
Discuss this formula in detail
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"actors affecting the price elasticityof demand
The price elasticity of demand dependsprimarily on:
- the e,istence of close sustitutes for thecommodity
-the length of time o#er which the 2uantityresponse to the price change is measured
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The price elasticity of demand is larger thecloser and the greater is the numer ofa#ailale sustitutes for the commodity
Intuiti#ely* the price elasticity of sugar ishigher than the price elasticity of salt
),ample: /ugar has more sustitutes than
salt
/ustitutes for sugar: honey* saccharine
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The price elasticity of demand is alsolarger the longer is the time period allowedfor consumers to respond to the change in
the commodity price+ 's time goes y* consumers learn aout
the e,istence of sustitutes and adust
their purchases to the price change
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),ample
During the period following the sharp increase ingasoline price in 7
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%rice elasticity and DecisionMa$ing
Information aout price elasticities can ee,tremely useful to managers as theycontemplate price decisions+
If demand is inelastic at the current price*a price decrease will result in a decreasein total re#enue+
'lternati#ely* reducing the price of aproduct with elastic demand would causere#enue to increase+
% i l ti it d D i i
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%rice elasticity and DecisionMa$ing
The relationship etween elasticity andtotal re#enue can e shown using simplecalculus+
M@A%&77)p(
If )pA-7 M@A8 Q interpretation: if thedemand is unitary elastic* prices will notchange total re#enues+
% i l ti it d D i i
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%rice elasticity and DecisionMa$ing
If )pJ-7 Q the demand is elastic QM@H8Q ' price reduction would increase the2uantity demanded+ Therefore* total
re#enue would increase+
If )pH-7 Q the demand is inelastic
QM@J8 Q ' price reduction woulddecrease total re#enue+
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Income )lasticity of Demand
Measures the responsi#eness of thedemand for a commodity to a change inconsumer1s income
0h th i l ti it f
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0hy the income elasticity ofdemand is important to the firm
-Income is one of the determinant ofdemand+
"or instance* consumers tend to changetheir uying hait during a recession ore,pansion+ Therefore* the firm needs tota$e that factor into consideration while
choosing the amount of output to produce
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%oint Income elasticity of Demand
Q
I
I
Q
I
I
Q
Q
EI
=
=
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'rc Income )lasticity of Demand
21
21
21
21
2/)(
2/)(
II
I
QE
II
I
QE
I
I
+
+
=
+
+
=
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Definitions
' >ormal good:a good whose 2uantitydemanded rises as the income of theconsumer increases+
),amples: automoiles* education* tra#el*mo#ies* housing
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Inferior good: ' good whose 2uantitydemanded increases as the income of theconsumer falls+
),ample:Elac$ and 0hite TG* hot dogshamurgers
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If )IH8 >ormal goods
If )IJ8 Inferior goods
),ample of normal goods: lu,ury itemsuch as #acations in the Cariean* which
will increase when the economy isooming
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>ormal goods
"ood* clothing and housing )IH8 ut low
necessities
4ealthcare and education )I
H7
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Inferior goods
)IJ8
Elac$ and 0hite TG
"lour
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Cross-price elasticity of demand
The demand of a commodity alsodepends on the price of related &i+e+sustitutes and complements(
commodities+ ),ample: If the price of tea rises* thedemand for coffee increases Consumerssustitute coffee for tea in consumption
On the other hand* if the price of sugar &acomplement of coffee( rises* the demandfor coffee declines
The point cross price elasticity of
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The point cross-price elasticity ofdemand
Measures the responsi#eness in thedemand for commodity B to a change inthe price of commodity ?+
x
y
y
x
y
y
x
x
XY Q
P
P
Q
P
P
Q
Q
E
=
=
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If ),yH8 commodities B and ? are
sustitutes
),amples:coffee and tea
utter and margarine
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If ),yJ8 commodities B and ? are
complements
),amples:sugar and coffee
cars and gasoline
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If )B?A8 B and ? are independentcommodities
),amples: oo$s and eer
cars and candy
pencils and potatoes
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The cross-price elasticity of demand is a#ery important concept in managerialdecision-ma$ing+
"irms often use this concept to measurethe effect of changing the price of aproduct they sell on the demand of other
related products that the firms also sell+
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),ample
eneral motors corporation can use thecross-price elasticity of demand tomeasure the effects of changing the price
of Che#rolets on the demand for %ontiacs+ Che#rolets and %ontiacs are sustitutes+
Therefore* lowering the price of Che#rolets
will reduce the demand for %ontiacs
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)-Commerce
It refers to the production* ad#ertising* sale* anddistriution of products and ser#ices fromusiness to usiness and from usiness toconsumers through the internet+
In e-commerce* there is no tra#eling to atraditional store* no salesperson* and no cash-register+
The e-commerce has tremendously change theway in which uyers and sellers interact in themar$etplace+
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'd#antages of )-commerce
- reduction of time and distance arriersetween uyers and sellers+
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/ustitution effect
0hen the price of a good such as stea$ declines* it ecomes less e,pensi#e inrelation to other goods for e,ample*
chic$en+ 's a result of the price decline*the rational consumer may e ale toincrease his or her satisfaction &or utility(y purchasing more of the good whose
price has declined and less of the othergoods+ This is $nown as the sustitutioneffect+
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),ample
/uppose that the prices of stea$ and chic$en are F6 andF per pound* respecti#ely+
'ssume that an indi#idual purchases two pounds ofstea$ and two pounds of chic$en per wee$ for totale,penditure of F75+
/uppose that the price of stea$ declines to F5 perpound+ 's a result of this price decrease* an indi#idualwho has a preference for stea$ may decide to increasehis or her consumption of stea$ to three pounds perwee$- which re2uires the same total e,penditure of F75
per wee$+ Thus we see that a decrease in the price of stea$&relati#e to chic$en( has led to an increase in the demandfor stea$+
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Income effect
0hen the price of a good for e,ample* stea$ declines* the effect of this decline is that the real incomeof the consumer has increased+ This is $nown as theincome effect+
If an indi#idual normally purchases two pounds of stea$per wee$ at F6 per pound* a price decline to F5 perpound would enale the consumer to purchase the sameamount of stea$ for F less per wee$
This sa#ings of F represents an increase in real income
of F* which may e used to purchase greater 2uantitiesof stea$ &as well as other goods( each wee$
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%rolems
In class prolems
%rolem R7 page 7K
%rolem R page 7K
0ritten assignment
%rolem R3 page 7K
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