CHAPTER 3

Quantitative
Demand Analysis

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter Outline

Chapter
Overview

The elasticity concept

Own price elasticity of demand
Elasticity and total revenue
Factors affecting the own price elasticity of demand
Marginal revenue and the own price elasticity of demand

Cross-price elasticity
Revenue changes with multiple products

Income elasticity
Other Elasticities
Linear demand functions
Nonlinear demand functions

Obtaining elasticities from demand functions

Elasticities for linear demand functions
Elasticities for nonlinear demand functions

Regression Analysis
Statistical significance of estimated coefficients
Overall fit of regression line
Regression for nonlinear functions and multiple regression
3-2

Introduction

Chapter
Overview

Chapter 2 focused on interpreting

demand functions in qualitative terms:
An increase in the price of a good leads
quantity demanded for that good to
decline.
A decrease in income leads demand for a
normal good to decline.

This chapter examines the magnitude of

changes using the elasticity concept,
and introduces regression analysis to
measure different elasticities.
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The Elasticity Concept

The Elasticity Concept

Elasticity

Measures the responsiveness of a

percentage change in one variable
resulting from a percentage change in
another variable.

3-4

The Elasticity Concept

The Elasticity Formula

The elasticity between two variables,

and , is mathematically expressed
as:
When a functional relationship exists,
like , the elasticity is:

3-5

The Elasticity Concept

Measurement Aspects of
Elasticity

Important aspects of the elasticity:

Sign of the relationship:
Positive.
Negative.

Absolute value of elasticity magnitude

relative to unity:

is highly responsive to changes in .

is slightly responsive to changes in .

3-6

Own Price Elasticity of Demand

Own Price Elasticity

price elasticity of demand
Own

Measures the responsiveness of a percentage

change in the quantity demanded of good X
to a percentage change in its price.
Sign: negative by law of demand.
Magnitude of absolute value relative to unity:
: Elastic.
: Inelastic.
: Unitary elastic.

3-7

Own Price Elasticity of Demand

Linear Demand, Elasticity, and

Revenue
Price

Linear Inverse Demand:

Demand:
Revenue

=$
Elasticity:
Conclusion: Demand is elastic.

$40
$35
$30
$25

Observation:
Elasticity varies
along a linear
(inverse) demand
curve

$20
$15
$10
$5
0 10 20 30 40

Demand
50

60 70

80

Quantity

3-8

Own Price Elasticity of Demand

Total Revenue Test

When demand is elastic:

A price increase (decrease) leads to a

decrease (increase) in total revenue.

When demand is inelastic:

A price increase (decrease) leads to an
increase (decrease) in total revenue.

When demand is unitary elastic:

Total revenue is maximized.

3-9

Own Price Elasticity of Demand

Extreme Elasticities
Price
Demand

Perfectly
elastic

Demand

Perfectly Inelastic

Quantity

3-10

Own Price Elasticity of Demand

Factors Affecting the Own Price Elasticity

Three factors can impact the own

price elasticity of demand:
Availability of consumption substitutes.
Time/Duration of purchase horizon.
Expenditure share of consumers
budgets.

3-11

Own Price Elasticity of Demand

Elasticity and Marginal Revenue

marginal revenue can be derived
The

from a market demand curve.

Marginal revenue measures the additional

revenue due to a change in output.

This link relates marginal revenue to the

own price elasticity of demand as follows:
When then, .
When then, .
When then, .

3-12

Own Price Elasticity of Demand

Demand and Marginal Revenue

Price
6

El

as
ti c

Unitary

MR

In
ela
st
ic

Demand
0

6 Quantity
Marginal Revenue (MR)
3-13

Cross-Price Elasticity

Cross-Price Elasticity
Cross-price elasticity

Measures responsiveness of a percent

change in demand for good X due to a
percent change in the price of good Y.
If , then and are substitutes.
If , then and are complements.

3-14

Cross-Price Elasticity

Cross-Price Elasticity in Action

Suppose it is estimated that the
cross-price elasticity of demand
between clothing and food is -0.18. If
the price of food is projected to
increase by 10 percent, by how much
will demand for clothing change?
That is, demand for clothing is expected
to decline by 1.8 percent when the price
of food increases 10 percent.

3-15

Cross-Price Elasticity

Cross-Price Elasticity

Cross-price elasticity is important for

firms selling multiple products.
Price changes for one product impact
demand for other products.

Assessing the overall change in

revenue from a price change for one
good when a firm sells two goods is:

3-16

Cross-Price Elasticity

Cross-Price Elasticity in Action

Suppose
a restaurant earns $4,000 per week

in revenues from hamburger sales (X) and

$2,000 per week from soda sales (Y). If the
own price elasticity for burgers is and the
cross-price elasticity of demand between
sodas and hamburgers is , what would
happen to the firms total revenues if it
reduced the price of hamburgers by 1
percent?
That is, lowering the price of hamburgers 1
percent increases total revenue by $100.
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Income Elasticity

Income Elasticity
Income elasticity

Measures responsiveness of a percent

change in demand for good X due to a
percent change in income.
If , then is a normal good.
If , then is an inferior good.

3-18

Income Elasticity

Income Elasticity in Action

Suppose
that the income elasticity of demand

for transportation is estimated to be 1.80. If

income is projected to decrease by 15
percent,
what is the impact on the demand for
transportation?
Demand for transportation will decline by 27
percent.

is transportation a normal or inferior good?

Since demand decreases as income declines,
transportation is a normal good.
3-19

Other Elasticities

Other Elasticities
Own advertising elasticity of demand
for good X is the ratio of the
percentage change in the consumption
of X to the percentage change in
advertising spent on X.
Cross-advertising elasticity between
goods X and Y would measure the
percentage change in the consumption
of X that results from a 1 percent
change in advertising toward Y.
3-20

Obtaining Elasticities From Demand Functions

Elasticities for Linear Demand

Functions

From a linear demand function, we

can easily compute various
elasticities.
Given a linear demand function:
Own price elasticity: .
Cross price elasticity: .
Income elasticity: .

3-21

Obtaining Elasticities From Demand Functions

Elasticities for Linear Demand

Functions In Action

The
daily demand for Invigorated PED shoes is
estimated to be
Suppose good X sells at $25 a pair, good Y
sells at $35, the company utilizes 50 units of
advertising, and average consumer income is
$20,000. Calculate the own price, cross-price
and income elasticities of demand.
units.
Own price elasticity: .
Cross-price elasticity: .
Income elasticity: .
3-22

Obtaining Elasticities From Demand Functions

Elasticities for Nonlinear

Demand Functions

One non-linear demand function is

the log-linear demand function:

Own price elasticity: .

Cross price elasticity: .
Income elasticity: .

3-23

Elasticities for Nonlinear Demand

Functions
In
Action
An
analyst for a major apparel company estimates

Obtaining Elasticities From Demand Functions

that the demand for its raincoats is given by

where denotes the daily amount of rainfall and

the level of advertising on good Y. What would be
the impact on demand of a 10 percent increase in
the daily amount of rainfall?
. So, .
A 10 percent increase in rainfall will lead to a 30
percent increase in the demand for raincoats.

3-24

Regression Analysis

Regression Analysis
How does one obtain information on
the demand function?
Published studies.
Hire consultant.
Statistical technique called regression
analysis using data on quantity, price,
income and other important variables.

3-25

Regression Analysis

Regression Line and Least Squares

Regression
True
(or population) regression model
unknown population intercept parameter.
unknown population slope parameter.
random error term with mean zero and standard
deviation .

Least squares regression line

least squares estimate of the unknown parameter .
least squares estimate of the unknown parameter.

The parameter estimates and , represent the

values of and that result in the smallest sum of
squared errors between a line and the actual data.
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Excel and Least Squares

Estimates

Regression Analysis

SUMMARY
OUTPUT

Estimated Demand:

Regression Statistics
Multiple R

0.87

R Square
Adjusted R
Square

0.75

Standard Error
Observations

0.72
112.22
10.00

ANOVA

Df

SS

Regression

MS
F
301470.8
301470.89
9 23.94

Residual

100751.61 12593.95

Total

402222.50

Significanc
eF
0.0012

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Evaluating Statistical
Significance

Regression Analysis

Standard
error

Measure of how much each estimated

coefficient varies in regressions based on the
same true demand model using different
data.

Confidence interval rule of thumb

t-statistics rule of thumb

When , we are 95 percent confident the true
parameter is in the regression is not zero.
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Excel and Least Squares

Estimates

Regression Analysis

SUMMARY
OUTPUT

Regression Statistics
Multiple R

0.87

R Square
Adjusted R
Square

0.75

Standard Error
Observations

0.72

, the intercept is different

from zero.
, the intercept is different
from zero.

112.22
10.00

ANOVA

Df

SS

Regression

MS
F
301470.8
301470.89
9 23.94

Residual

100751.61 12593.95

Total

402222.50

Significanc
eF
0.0012

3-29

Regression Analysis

Evaluating Overall Regression Line

Fit: R- Square
R-Square

Also called the coefficient of determination.

Fraction of the total variation in the
dependent variable that is explained by the
regression.

Ranges between 0 and 1.

Values closer to 1 indicate better fit.

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Regression Analysis
Evaluating Overall Regression
Line
Fit:
Adjusted R-Square
Adjusted R-Square

A version of the R-Square that penalize

researchers for having few degrees of
freedom.
is total observations.
is the number of estimated coefficients.
is the degrees of freedom for the
regression.

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Regression Analysis

Evaluating Overall Regression Line

Fit: F-Statistic
A measure of the total variation
explained by the regression relative to
the total unexplained variation.
The greater the F-statistic, the better the
overall regression fit.
Equivalently, the P-value is another
measure of the F-statistic.
Lower p-values are associated with better
overall regression fit.

3-32

Excel and Least Squares

Estimates

Regression Analysis

SUMMARY
OUTPUT

Regression Statistics
Multiple R

0.87

R Square
Adjusted R
Square

0.75

Standard Error
Observations

0.72
112.22
10.00

ANOVA

Df

SS

Regression

MS
F
301470.8
301470.89
9 23.94

Residual

100751.61 12593.95

Total

402222.50

Significanc
eF
0.0012

3-33

Regression Analysis

Regression for Nonlinear Functions

and Multiple Regression
Regression techniques can also be
applied to the following settings:
Nonlinear functional relationships:
Nonlinear regression example:

Functional relationships with multiple

variables:
Multiple regression example:
or

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Excel and Least Squares

Estimates

Regression Analysis

SUMMARY
OUTPUT

Regression Statistics
Multiple R

0.89

R Square
Adjusted R
Square

0.79

Standard Error

9.18

Observations

0.69
10.00

ANOVA

Df

SS

MS

F
7.59

Regression

1920.99

640.33

Residual

505.91

84.32

Total

2426.90

Coefficie

Standard

Significanc
eF
0.182

Upper

3-35

Conclusion
Elasticities are tools you can use to quantify
the impact of changes in prices, income, and
advertising on sales and revenues.
Given market or survey data, regression
analysis can be used to estimate:
Demand functions.
Elasticities.
A host of other things, including cost functions.

Managers can quantify the impact of

changes in prices, income, advertising, etc.

3-36