AEM 4550:Economics of Advertising

Prof. Jura Liaukonyte

LECTURE 2:REVIEW OF MICROECONOMIC

TOOLS

The Demand Function A demand function is a causal relationship:

Relationship between a dependent variable (i.e., quantity demanded) and various independent variables (i.e., factors which are believed to influence quantity demanded).

Remember, this is just a behavior function.

Let’s consider a market demand function, and list the factors.

Independent Variables in the Demand Function Quantity demand is a function of:

Price of good Income (normal goods, inferior goods) Price related goods (substitutes, complements) #Buyers

Note: Can depend on ADVERTISING Tastes

Note: Can depend on ADVERTISING Expectations (price changes, income changes)

As always, we have to abstract.

General Function Form

is a random term.• Human beings have random element to behavior.• There are random events (disasters, etc.) which influence

demand.

QDX=f(PX,PY,I,Tastes(A),Expect.,Buyers(A), )

Red Variables are constant for a given

demand curve

Lets Systematically Derive the Demand Curve Graphically

The demand curve holds all the factors that shift demand curves constant.

Only the own price changes.

DemandSuppose that the consumers in this market are willing and able to purchase Q1 units per period of time when the price of each unit is P1.

P/unit

Q

P1

Q1

A Change in Demand The demand curve

shows consumers’ willingness and ability to purchase these alternative units at alternative prices when everything else remains constant.

Suppose something else does change!

P/unit

Q

P1

Q1 Q2

P2

D

A Change in Demand• If one of the ceteris

paribus assumptions changes, this shifts the entire demand curve.

• Suppose advertising affects tastes positively, or increases number of buyers.• Demand increases or

shifts right!• Q increases at every

price.

P/unit

Q

P1

Q1 Q2

P2

D

D’

Q’1

Q’2

The Supply Function A supply function is a causal relationship between a

dependent variable (i.e., quantity supplied) and various independent variables (i.e., factors which are believed to influence quantity supplied)

Again, this is just a behavior function.

Lets consider a market supply function, and list the factors.

Factors which you believe influence quantity supplied Your list:

Price of good Technology Price of inputs Price related goods

Other goods which could be produced Number of suppliers Expectations Government through excise taxes or subsidies,

regulation

General Function Form

is a random term. Suppliers may behave randomly. There are random events (disasters, etc.) which influence

supply.

QSX=f(PX,Pinput,POther,Tech.,Expect.,#Sellers,Govt,)

Red Variables are constant for a given

supply curve

Elasticity of Supply and Demand

Not only are we concerned with what direction price and quantity will move when the market changes, but we are concerned about how much they change.

Elasticity gives a way to measure by how much a variable will change with the change in another variable.

Specifically, it gives the percentage change in one variable resulting from a one percent change in another.

Price Elasticity of Demand

Measures the sensitivity of quantity demanded to price changes The percentage change in

the quantity demanded of a good that results from a one percent change in price

P

QE DDP

%

%

Definition Formula

P

Q

Q

P

PP

QQEDP

Price Elasticity of Demand

The percentage change in a variable is the absolute change in the variable divided by the original level of the variable.

Therefore, elasticity can also be written as:

Price Elasticity of DemandUsually a negative number

As price increases, quantity decreases As price decreases, quantity increases

Definition

|EP| > 1

|EP| < 1

The good is price elastic |%Q| > |%P|

The good is price inelastic |%Q| < |% P|

Determinants of Price Elasticity of Demand

The primary determinant of price elasticity of demand is the availability of substitutes

Many substitutes, demand is price elastic Can easily move to another good with price

increases Few substitutes, demand is price inelastic

Price Elasticity of Demand

Price elasticity of demand must be measured at a particular point on the demand curve

Looking at a linear demand curve, as we move along the curve Q/P is constant, but P and Q will change

Elasticity will change along the demand curve in a particular way

1 2 3 4 5 6 7 8 9 10 110

10

20

30

40

50

60

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

QD Elasticity

Quantity

P/unit

Model Price Estimated Q,P

Mazda 323 $5,039 -6.358

Nissan Sentra

$5,661 -6.528

Ford Escort

$5,663 -6.031

Lexus LS400

$27,544 -3.085

BMW 735i $37,490 -3.515

Example: Price Elasticities of Demand for Automobile Makes (1990)

Source: Berry, Levinsohn and Pakes, "Automobile Price in Market Equilibrium," Econometrica 63 (July 1995), 841-890.

Price Elasticity of Demand

The steeper the demand curve, the more inelastic the demand for the good becomes

The flatter the demand curve, the more elastic the demand for the good becomes

1 2 3 4 5 6 7 8 9 10 110

10

20

30

40

50

60

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

QD QDElasticity Elasticity

Inelastic

Elastic

Look at the Extremes

P

Q

P

Q

e 0

D

D

e -infinite

Perfectly Elastic D Perfectly Inelastic D

Relatively Elastic vs. Relatively Inelastic Demand Curves

Q1 Q2 Q2’

P1

P2

D’D

D’ is relatively more elasticthan D

P

Q

Price Elasticities of Demand

Price elasticity of market demand for automobiles is between -1 and -1.5.

Price elasticity of demand for ready-to-eat breakfast cereal in the U.S. is on the order of -0.25 to -0.5.

Price elasticity of demand for BMW 325 is on the order of -4 to -6.

Price elasticity of demand for individual brands, such as Captain Crunch, is on the order -2 to -4.

Market Level Firm Level

Price Elasticity and Revenues• Suppose we look at P increase along D curve.• Revenues = P*Q

• Impact on expenditure (revenue) depends on which effect is greater.

• For elastic responses, |EP| > 1 so %Q>%P• Thus, when P increases, Q decreases by more!• Revenues = P*Q falls

• For inelastic response, |EP| < 1 so %Q<%P• Thus, when P increases, Q decreases by less!• Revenues = P*Q rises

• Assume equilibrium P and Q:• Q=13,750 and P=190

• Demand function• QDX=15000 - 25PX + 10PY+2.5*I• Derive demand curve by holding PY and I constant

(e.g., at PY=100, and I=1000) giving: QDX=18500-25PX

• Derive eQ/P)* P1 /Q1

• What is P1 and Q1?• What is Q/P?

Quick Example: mathematical demand function

Elasticity calculation eQ/P)* P1 /Q1

e-25*190/13750 = -0.34

What is the interpretation?

Look at an Example• Suppose the price elasticity of demand is e-3.6,

and you expect a 5% price increase next year. What should happen to the quantity demanded?

Look at an Example• Suppose the price elasticity of demand is e-3.6,

and you expect a 5% price increase next year.• What should happen to the quantity demanded?

• Answer: eQ/P

Q/(+) • Solving for Q=5*(-3.6)=-18%

Comments Don’t forget the economics behind your

calculations. Know how to calculate these, and how to

manipulate them.