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Applied Microeconomics

Demand
Outline
• Demand functions and inverse demand
functions
• Elasticity
• Total revenue and marginal revenue
• Marginal revenue and elasticity
• Aggregating demand and elasticity

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Readings
• Perloff: Chapter 2-3
• Kreps: Chapter 4
• Zandt: Chapter 3

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Approximation
• More buyers or
divisible goods
smoothens the jagged
demand curve we
derived in the last
lecture
• This enables us to
treat the demand
curve as a continuous
function
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Demand functions
• Consider the market for a divisible good
• The demand function D(p) says how much of
a given product would be purchased at each
price p per unit, holding other variables fixed
• The inverse demand function P(x) gives the
price at which q units of the product would be
sold, holding other variables fixed
• Example: D(p)=10-2p gives P(x)=(10-x)/2

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Demand and Inverse
Demand Functions

5 P(x)=(10-x)/2

D(p)=10-2p

10 x
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Do Demand Functions
Slope Downward?
• It is common to assume that demand functions
are downward sloping
• Convenient since this makes the demand
function invertible
• Generally true
• Exist examples of demand functions that slope
upwards for some range of prices (Giffen
goods) when buyers are unsure about product
quality and believes price signals something
about quality
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Demand Facing Firm and
Demand Facing Industry
• Important to distinguish between the demand
facing an entire industry or the demand facing
a single firm within the industry
• The demand facing an entire industry is usually
less responsive to changes in prices than
demand facing a single firm
• Example: A 10% price increase on all laptops
vs. 10% increase on Dell laptops

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Price Taking Firms and
Firms with Market Power
• In the case of a competitive market, such as
that of crude oil carriers, the demand facing a
firm is zero if it sets its price above the market
price - the firm is a price taker
• When, on the other hand, the firm can choose
its output, selling an amount determined by its
demand function, it is said to have market
power

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Other Variables Affecting
Demand
• A demand function records how the quantity of
a certain good changes as a function of the own
price of the good
• This means that all other variables affecting
demand are held fixed or “ceteris paribus”
• What is held fixed?
– Prices of other goods
– Income
– Advertisement expenditure etc.
• Sometimes complicated in practice
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Example: Demand for Coke
• Estimated 1992 demand for Coke
D(pcoke )=26.17-3.98pcoke +2.25ppepsi
+2.60acoke -0.62apepsi +9.58s+0.99y
• Where:
– aj is advertising expenses
– s=1 if summer, s=0 otherwise
– y is real income

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Example: Demand for Coke
• The following factors
each causes an p
outward shift in the
demand for Coke
– Pepsi price …crease
– Pepsi ad. exp. …crease
– Coke ad. exp. …crease
– Real income …crease
x

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Classification of Goods
• If demand increases as the price of another
good increases, the goods are substitutes
• If demand decreases as the price of another
good increases, the goods are complements
• If demand increases as income increases, the
good is a normal good
• If demand decreases as income increases,
the good is an inferior good

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Do Firms Know Their
Demand Functions?
• We will generally assume that firms know their
own demand functions perfectly
• This is not entirely true, but firms do find out
about the shape of the demand functions in a
neighborhood of current price using various
techniques
• Made easier by technologies such as
supermarket scanners and internet

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Estimating Demand
Functions
• Procedure:
– Write down model (equation) for product demand with
unknown coefficients.
– Fit line or curve to data points using statistical
techniques (regression).
• Some sources of data:
– Consumer surveys
– Consumer focus groups
– Market experiments
– Historical (real) data: cross-section, time-series, or
both (panel)
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Estimating Demand
Functions
• Commonly estimated equations:
– Linear: D(p)=A-Bp+Cy
– Log: ln(D(p))=A-Bln(p)+Cln(y)
• You can try this out by doing problem
4.15 in Kreps (data on the web and
answer in Student Companion)

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2 Price Sensitivity
1.5

Price 1
• Which is the most
price sensitive of the
0.5
demand functions in
01 2 3
Quantity
4 5 each diagram?
• For which market
2

1.5
would you set the
Price 1 higher price?
0.5

01 2 3 4 5
Quantity

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Price Sensitivity
• Suppose we want to know what
happens to demand as we increase the
price slightly
• Crucial for profit maximization to find
out how sensitive demand is to changes
in price
• The tool for this is elasticity

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Elasticity
• The (own-price) elasticity of demand at a particular
price p0 and quantity x0 is the % change in quantity
demanded per 1% change in price: (∆x/x0)/(∆p/p0)
• Example: Price increase from 100 to 102 causes
demand decrease from 10 to 9, giving elasticity of
-10%/2%=-5 at p0=100
• We can also calculate the midpoint Arc Elasticity which
is given by
vA(p0,p1)=(x1-x0)/0.5(x1+x0)/(p1-p0)/0.5(p1+p0))
• Example gives (1/9.5)/(2/101)=-5.32
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Elasticity
• With a differentiable demand, this can be
expressed as
v(p0)= ∂D(p0)/∂p·p0/D(p0)=D´(p0)·p0/D(p0)
• We may also express the elasticity using the
inverse demand function: v*(x0)=1/P´(x0)·P(x0)/x0
• Note the difference between the functions v(p0)
and v*(x0)

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Two Extreme Cases

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Calculating Elasticity
• If we estimate a demand function of the
form D(p)=A-Bp+Cy,
the own-price elasticity is
v(p)=?
• If we estimate a demand function of the
form ln(D(p))=A-Bln(p)+Cln(y),
the own-price elasticity is v(p)=?

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Demand and Elasticity
5
4
3
2
1
P(x)=5-x
0
v*(x)=-(5-x)/x
-1 0 1 2 3 4 5

-2
-3
-4
-5

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Why Elasticity and Not the
Derivative?
• Example: Suppose a consumer has monthly
demand for gasoline given by DM(p)=50(3-p) and
annual demand given by DA(p)=12*DM(p)
• Suppose we want to find the effect on his demand
of a small change in the price:
– The price derivative of the monthly demand is –50 and of
the annual demand is -12*50=-600
– However, the elasticity of demand is v(p0)=-p0/3-p0 for
both demand functions!

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Other Elasticities
• Income elasticity measures demand
sensitivity to changes in income:
vy(y)= ∂D/∂y·y/D
• Cross-price elasticity measures demand
sensitivity to changes in the price of
another good: vC1(p2)= ∂D1/∂p2·p2/D1

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Marginal Revenue
• The firm’s total revenue from selling x units of
a good is given by the function TR(x)=xP(x)
• If we take the derivative of this with respect to
quantity, we obtain the marginal revenue
function MR(x)=TR’(x)
• It tells us how much more revenue we get
from adjusting price so that we sell one more
unit of the good

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Total Revenue and Marginal
Revenue
7

3
P(x)=5-x
1 MR(x)=5-2x
TR(x)=x(5-x)
-1 0 1 2 3 4 5

-3

-5

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Elasticity and Marginal
Revenue
• MR(x)=P(x)+xP’(x)=P(x)(1+xP’(x)/P(x))
• But recall that xP’(x)/P(x)=1/v*(x)
• This gives, MR(x)=P(x)(1+1/v*(x))
• Hence, marginal revenue is a
function of price and elasticity!

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Elasticity and Marginal
Revenue
V*(x0) MR(x0) Demand

<-1 >0 Elastic

=-1 =0 Unit elastic

>-1 <0 Inelastic

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Demand, Elasticity, and
Marginal Revenue
5
4
3
2
1 P(x)=5-x
0 MR(x)=5-2x
-1 0 1 2 3 4 5 v*(x)=-(5-x)/x
-2
-3
-4
-5

MR(x)=0 30
Aggregating Demand
Functions
• The individual demand function Di(p) is the
demand from a single consumer
• The aggregate or market demand is the
demand from a group of I consumers D(p)
• The relationship between the two is
D(p)=D1(p)+ D2(p)+ …+DI(p)

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Aggregating Demand
Functions: Example
• 2 consumers with individual demand
functions D1(p)=10-2p and D2(p)=4-p…
• …gives aggregate demand D(p)={14-3p
for p<4, 10-2p for 4≤p<5, and 0 for 5≤p}
p p p
5
4 5

+ =

10 qq 4 qq 14q q

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Aggregating Elasticity
• Suppose we know the demand functions for three
segments of the market (Austria, Belgium and Cyprus):
DTotal (p)=DA(p)+DB(p)+DC(p)
• The elasticities of the segments are given by:
– vA(p)=pD’A(p)/DA(p)
– vB(p)=pD’B(p)/DB(p)
– vC(p)=pD’C(p)/DC(p)

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Aggregating Elasticity
• Then we have that:
vA(p)DA(p)+vB(p)DB(p)+vC(p)DC(p)=pD’total(p)
• Hence: vTotal(p)=pD’total(p)/Dtotal(p)
=(vA(p)DA(p)+vB(p)DB(p)+vC(p)DC(p))/Dtotal(p)
• In other words: the total elasticity is the
weighted average of the segments’
elasticities, weighted by their shares of
total demand

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Disaggregating Demand
Functions
• Firms often tries to break down total
demand into segments, charging
different segments different prices
• Example: Student discounts, vouchers,
air fares
• This is known as price discrimination
• You will learn more about this in a
couple of weeks…
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Conclusions
• Demand functions measure quantity that can be sold at each
price, inverse demand functions price that can be charged for
each quantity sold
• Elasticity is the % change in demand per 1% change in price
• Aggregate demand is the horizontal sum of individual
demand
• Aggregate elasticity is the weighted average of individual
elasticities
• MR(x)=P(x)(1+1/v*(x))

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