Economics

Principles &
Applications
Dr. Manoj Mishra
Consumer
Behavior and
Demand Theory
CNLU PATNA
Chapter 2
Demand

Managerial Economics,
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 Chapter 3:
Demand Theory
Law of Demand

• Holding all other things constant (ceteris

paribus), there is an inverse relationship
between the price of a good and the
quantity of the good demanded per time
period.
• Substitution Effect
• Income Effect
Components of Demand:
The Substitution Effect

• Assuming that real income is constant:

• If the relative price of a good rises, then
consumers will try to substitute away from the
good. Less will be purchased.
• If the relative price of a good falls, then
consumers will try to substitute away from
other goods. More will be purchased.
• The substitution effect is consistent with
the law of demand.
Components of Demand:
The Income Effect
• The real value of income is inversely related to the prices
of goods.
• A change in the real value of income:
• will have a direct effect on quantity demanded if a good is
normal.
• will have an inverse effect on quantity demanded if a good is
inferior.

• The income effect is consistent with the law of demand

only if a good is normal.
 Individual Consumer’s Demand
QdX = f(PX, I, PY, T)
QdX = quantity demanded of commodity X
by an individual per time period
PX = price per unit of commodity X
I = consumer’s income
PY = price of related (substitute or
complementary) commodity
tastes of the consumer
T=
 QdX = f(PX, I, PY, T)

QdX/PX < 0
QdX/I > 0 if a good is normal
QdX/I < 0 if a good is inferior
QdX/PY > 0 if X and Y are substitutes
QdX/PY < 0 if X and Y are complements
 Market Demand Curve
• Horizontal summation of demand curves of individual
consumers
• Exceptions to the summation rules
• Bandwagon Effect
• collective demand causes individual demand
• Snob (Veblen) Effect
• conspicuous consumption
• a product that is expensive, elite, or in short supply is more desirable
 Market Demand Function
QDX = f(PX, N, I, PY, T)
QDX = quantity demanded of commodity X
PX = price per unit of commodity X
N = number of consumers on the market
I = consumer income
PY = price of related (substitute or complementary)
commodity

T = consumer tastes
Demand Curve Faced by a Firm
Depends on Market Structure
• Market demand curve
• Imperfect competition
• Firm’s demand curve has a negative slope
• Monopoly - same as market demand
• Oligopoly
• Monopolistic Competition

• Perfect Competition
• Firm is a price taker
• Firm’s demand curve is horizontal
Demand Curve Faced by a Firm Depends on the Type of
Product
• Durable Goods
• Provide a stream of services over time
• Demand is volatile

• Nondurable Goods and Services

• Producers’ Goods
• Used in the production of other goods
• Demand is derived from demand for final goods or services
 Linear Demand Function
QX = a0 + a1PX + a2N + a3I + a4PY + a5T

PX Intercept:
a0 + a2N + a3I + a4PY + a5T

Slope:
QX/PX = a1

QX
Linear Demand Function Example
Part 1
Demand Function for Good X
QX = 160 - 10PX + 2N + 0.5I + 2PY + T

Demand Curve for Good X

Given N = 58, I = 36, PY = 12, T = 112
Q = 430 - 10P
Linear Demand Function Example Part 2

Inverse Demand Curve

P = 43 – 0.1Q
Total and Marginal Revenue Functions
TR = 43Q – 0.1Q2
MR = 43 – 0.2Q
Elasticity of
Demand
CNLU PATNA
Definition
• Elasticity = %age change in demand for product A/%age change in
price of product A
• =100* Δd/D / 100 * Δp/P
• = Δd/D * P/ Δp
Price Elasticity of Demand

Q / Q Q P
Point Definition EP   
P / P P Q

P
Linear Function EP  a1 
Q
Price Elasticity of Demand

Q2  Q1 P2  P1
Arc Definition EP  
P2  P1 Q2  Q1
Marginal Revenue and Price Elasticity of Demand

 1 
MR  P  1  
 EP 
Marginal Revenue and Price Elasticity of Demand

PX
EP  1
EP  1

EP  1

QX
MRX
Marginal Revenue, Total Revenue, and
Price Elasticity

TR MR>0 MR<0
EP  1 EP  1

QX
EP  1 MR=0
Determinants of Price Elasticity of Demand

The demand for a commodity will be more price elastic

if:
• It has more close substitutes
• It is more narrowly defined
• More time is available for buyers to adjust to a price
change
Determinants of Price Elasticity of Demand

The demand for a commodity will be less price elastic if:

• It has fewer substitutes
• It is more broadly defined
• Less time is available for buyers to adjust to a price
change
Income Elasticity of Demand

Q / Q Q I
Point Definition EI   
I / I I Q

I
Linear Function EI  a3 
Q
Income Elasticity of Demand

Q2  Q1 I 2  I1
Arc Definition EI  
I 2  I1 Q2  Q1

Normal Good Inferior Good

EI  0 EI  0
Cross-Price Elasticity of Demand

QX / QX QX PY
Point Definition E XY   
PY / PY PY QX

Linear Function PY
E XY  a4 
QX
Cross-Price Elasticity of Demand

QX 2  QX 1 PY 2  PY 1
Arc Definition E XY  
PY 2  PY 1 QX 2  QX 1

Substitutes Complements
E XY  0 E XY  0
Example: Using Elasticities in
Managerial Decision Making
A firm with the demand function defined below expects a 5% increase in income
(M) during the coming year. If the firm cannot change its rate of production, what
price should it charge?

• Demand: Q = – 3P + 100M
• P = Current Real Price = 1,000
• M = Current Income = 40
Solution
• Elasticities
• Q = Current rate of production = 1,000
• P = Price = - 3(1,000/1,000) = - 3
• I = Income = 100(40/1,000) = 4

• Price
• %ΔQ = - 3%ΔP + 4%ΔI
• 0 = -3%ΔP+ (4)(5) so %ΔP = 20/3 = 6.67%
• P = (1 + 0.0667)(1,000) = 1,066.67
Other Factors Related to Demand Theory
• International Convergence of Tastes
• Globalization of Markets
• Influence of International Preferences on Market Demand

• Growth of Electronic Commerce

• Cost of Sales
• Supply Chains and Logistics
• Customer Relationship Management
Chapter 3

Appendix
Indifference Curves
• Utility Function: U = U(QX,QY)
• Marginal Utility > 0
• MUX = ∂U/∂QX and MUY = ∂U/∂QY

• Second Derivatives
• ∂MUX/∂QX < 0 and ∂MUY/∂QY < 0
• ∂MUX/∂QY and ∂MUY/∂QX
• Positive for complements
• Negative for substitutes
Marginal Rate of Substitution
• Rate at which one good can be substituted for another while holding
utility constant
• Slope of an indifference curve
• dQY/dQX = -MUX/MUY
 Indifference Curves:
Complements and Substitutes

Perfect Perfect
Complements Substitutes
QY QY

QX QX
The Budget Line
• Budget = M = PXQX + PYQY
• Slope of the budget line
• QY = M/PY - (PX/PY)QX
• dQY/dQX = - PX/PY
Budget Lines: Change in Price
GF: M = $6, PX = PY = $1
GF’: PX = $2
GF’’: PX = $0.67
Budget Lines: Change in Income

GF: M = $6, PX = PY = $1
GF’: M = $3, PX = PY = $1
Consumer Equilibrium
• Combination of goods that maximizes utility for a given set of prices and
a given level of income
• Represented graphically by the point of tangency between an
indifference curve and the budget line
• MUX/MUY = PX/PY
• MUX/PX = MUY/PY
Mathematical Derivation
• Maximize Utility: U = f(QX, QY)
• Subject to: M = PXQX + PYQY
• Set up Lagrangian function
• L = f(QX, QY) + (M - PXQX - PYQY)

• First-order conditions imply

•  = MUX/PX = MUY/PY
Demand

• Demand is---

Willingness

Ability to pay

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Demand
• Demand is a function of:
- own price
- Prices of related commodities
- income
- tastes and preferences
- others

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Law of Demand
• - Ceteris Paribus conditions
- “ all other factors remaining constant”

- inverse relationship between own price and

quantity demanded

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Why negative slope?

• - Substitution effect of a price change

• - income effect of a price change

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Exceptions

• - negative income effect greater than

substitution effect

• Giffen good

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Shifts in Demand
• When ceteris paribus assumption is relaxed

• When income/ tastes change

or

simply when ‘time’ changes’

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Shifts in and movements along a Demand
Curve

• Effect on demand of changes in its own price

results in movement along the demand curve.

• Effect on demand of changes in other factors

results in shifts in demand curve

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Market Demand

• Horizontal summation of individual demand curves

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Elasticity
• Price Elasticity: Proportionate change in quantity
demanded due to a proportionate change in price
- ∆Qx/ ∆Px * Px/Qx
- negative for normal goods
- negative sign is ignored while making
comparisons among normal goods

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Price Elasticity
• Pe Greater than1 (ignoring – sign): Elastic
• Pe Equal to 1 (ignoring – sign) : Unit Elastic
• Pe Less than 1 ( ignoring – sign): Inelastic
• Price Elasticity and Expenditure:
- Pe less than 1 a fall in price lower exp
- Pe equal to 1 a fall in price exp constant
- Pe greater than 1 a fall in price higher exp
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Price elasticity

• Special cases:

Infinitely elastic

Zero elasticity

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Price elasticity
• Along a linear demand curve:

P
Pe > 1

Pe < 1

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Price elasticity
• Price elasticity and MR:
• TR = P (Q) *Q
• MR = dTR/dQ = P + Q dP/dQ
= P(1+ (Q/P * dP/dQ)
= P (1 + 1/Pe)
With Pe being –ve, it becomes
P ( 1- 1/Pe) (and Pe is without the –ve sign)
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Price elasticity
• Price elasticity and AR:
Since Ar =P,
We have MR = AR (1 – 1/Pe)
MR = AR – AR/ Pe
…….
……
Pe = AR / (AR – MR)

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Income Elasticity
• Income Elasticity
∆Qx/∆I * I/Qx

• Could be negative or positive:

Negative for Inferior goods
Positive for Superior goods
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Elasticity of
Demand
4
Market demand (for a firm and for the economy),
Determinants of Price Elasticity
• Factors affecting price elasticity of demand
• The number of close substitutes – the more close substitutes there are in the market, the
more elastic is demand because consumers find it easy to switch. E.g. Air travel and train travel
are weak substitutes for inter-continental flights but closer substitutes for journeys of around
200-400km e.g. between major cities in a large country.
• The cost of switching between products – there may be costs involved in switching. In this
case, demand tends to be inelastic. For example, mobile phone service providers may insist on
a12 month contract which has the effect of locking-in some consumers once a choice has been
made
• The degree of necessity or whether the good is a luxury – necessities tend to have an
inelastic demand whereas luxuries tend to have a more elastic demand. An example of a
necessity is rare-earth metals which are an essential raw material in the manufacture of solar
cells, batteries. China produces 97% of total output of rare-earth metals – giving them
monopoly power in this market
Determinants of Price Elasticity
• The proportion of a consumer's income allocated to spending on the good – products
that take up a high % of income will have a more elastic demand
• The time period allowed following a price change – demand is more price elastic, the
longer that consumers have to respond to a price change. They have more time to search for
cheaper substitutes and switch their spending.
• Whether the good is subject to habitual consumption – consumers become less sensitive
to the price of the good of they buy something out of habit (it has become the default
choice).
• Peak and off-peak demand - demand is price inelastic at peak times and more elastic at
off-peak times – this is particularly the case for transport services.
• The breadth of definition of a good or service – if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef
are likely to be more elastic following a price change.
Cross Elasticity
• Cross elasticity of demand is the ratio of percentage change in quantity
demanded of a product to percentage change in price of another product.
It is used to measure how responsive the quantity demanded of one
product is to a change in price of another product.
• Cross elasticity of demand indicates whether any two products are
substitute goods, complementary goods or independent goods. A positive
cross elasticity of demand means that the products are substitute goods.
A negative cross elasticity of demand means that the products are
complementary goods. A near zero cross elasticity of demand means that
the products are independent goods i.e. quantity demanded of product A
is not affected by any movement in price of product B.
 Cross Elasticity
Formula
Percentage changes in the above formula are calculated using the mid-point formula which
divides actual change by average of initial and final values.
The formula to calculate cross elasticity thus becomes:
Where,
Qf and Qi are the final and initial quantities demanded of product A, respectively; and
Pf and Pi are the final and initial prices of product B.

% increase in quantity demanded of A

Cross Elasticity of Demand EA, B =
% increase in price of product B

Qf − Qi Pf − Pi
EA, B = ÷
(Qf + Qi) ÷ 2 (Pf + Pi) ÷ 2
Income Elasticity

Income elasticity of demand measures the

responsiveness of demand to a change in income.

For example, if your income increase by 5% and your

demand for mobile phones increased 20% then the YED
of mobile phones = 20/5  = 4.0
Income Elasticity

Income elasticity of demand measures the

responsiveness of demand to a change in income.

For example, if your income increase by 5% and your

demand for mobile phones increased 20% then the YED
of mobile phones = 20/5  = 4.0
Income Elasticity
Promotional Elasticity
Thanks