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Copyright 2007 by Oxford University Press, Inc.PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Slide 3

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 DemandQdX = f(PX, I, PY, T)

quantity demanded of commodity X by an individual per time period

price per unit of commodity X

consumer’s income

price of related (substitute or complementary) commodity

tastes of the consumer

QdX =

PX =

I =

PY =

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 FunctionQDX = f(PX, N, I, PY, T)

quantity demanded of commodity X

price per unit of commodity X

number of consumers on the market

consumer income

price of related (substitute or complementary) commodity

consumer tastes

QDX =

PX =

N =

I =

PY =

T =


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

QX

Intercept:a0 + a2N + a3I + a4PY + a5T

Slope:QX/PX = a1


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


Price Elasticity of Demand

/

/P

Q Q Q PE

P P P Q

Linear Function

Point Definition

1P

PE a

Q


Price Elasticity of Demand

Arc Definition 2 1 2 1

2 1 2 1P

Q Q P PE

P P Q Q


Marginal Revenue and Price Elasticity of Demand

11

P

MR PE


Marginal Revenue and Price Elasticity of Demand

PX

QX

MRX

1PE

1PE

1PE


Marginal Revenue, Total Revenue, and Price Elasticity

TR

QX

1PE MR<0MR>0

1PE

1PE 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

Linear Function

Point Definition/

/I

Q Q Q IE

I I I Q

3I

IE a

Q


Income Elasticity of Demand

Arc Definition 2 1 2 1

2 1 2 1I

Q Q I IE

I I Q Q

Normal Good Inferior Good

0IE 0IE


Cross-Price Elasticity of Demand

Linear Function

Point Definition/

/X X X Y

XYY Y Y X

Q Q Q PE

P P P Q

4Y

XYX

PE a

Q


Cross-Price Elasticity of Demand

Arc Definition

Substitutes Complements

2 1 2 1

2 1 2 1

X X Y YXY

Y Y X X

Q Q P PE

P P Q Q

0XYE 0XYE


Example: Using Elasticities inManagerial 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

QY

QX

QY

QX

Perfect Complements

Perfect Substitutes


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

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