1 university of technology managerial economics riad sultan applied economics lecture in demand and...

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University of TechnologyUniversity of Technology

Managerial EconomicsManagerial Economics

Riad SultanRiad SultanApplied EconomicsApplied Economics

Lecture in demand and consumer theoryLecture in demand and consumer theoryContact: +2307677377, +2304037882Contact: +2307677377, +2304037882

r.sultan@uom.ac.muakthar_rs@yahoo.comakthar_rs@yahoo.com

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Managerial Economics: Analysis of demand Managerial Economics: Analysis of demand Readings:Readings: Dwivedi, D. N (2008) Managerial Economics, Dwivedi, D. N (2008) Managerial Economics,

Chapter 6,7,8Chapter 6,7,8

The manager’s playing field: the marketThe manager’s playing field: the market

The market for a product works on certain The market for a product works on certain market principles, the laws that govern the market principles, the laws that govern the working of the market systemworking of the market system

Fundamental laws of the market: the laws of Fundamental laws of the market: the laws of demand and supply demand and supply

Conclusion: determine the price of the productConclusion: determine the price of the product

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Market systemMarket system

Two forces of the market: demand and supplyTwo forces of the market: demand and supply

Market: goods and services are exchanged, Market: goods and services are exchanged, bought and soldbought and sold

: where buyers and sellers interact to : where buyers and sellers interact to determine the price of a good and quantitydetermine the price of a good and quantity

Sellers and buyers: individuals, firms, factories, Sellers and buyers: individuals, firms, factories, dealers and agentsdealers and agents

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The Demand side of the marketThe Demand side of the market

Demand: refers to all Demand: refers to all consumers and the price that consumers and the price that they are they are willing to paywilling to pay and and able able to payto pay for buying a certain for buying a certain quantity of the product during a quantity of the product during a period of timeperiod of time

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The Law of DemandThe Law of Demand

When price goes up, quantity demanded When price goes up, quantity demanded fallsfalls

Price is the most important determinant of Price is the most important determinant of demanddemand

Demand schedule: presentation of Demand schedule: presentation of quantity demanded at different pricesquantity demanded at different prices

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The Law of DemandThe Law of Demand

Price (Rs)Price (Rs) Quantity (unitsQuantity (units

88 88

66 1515

44 3030

33 4040

22 5555

11 8080

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The Demand Schedule (Curve)The Demand Schedule (Curve)

0

1

2

3

4

5

6

7

8

9

0 20 40 60 80 100

Quantity

Pri

ce

88

Factors affecting demandFactors affecting demand

Consumer’s incomeConsumer’s income

Price of the substitutes and Price of the substitutes and complementary goodscomplementary goods

Consumer’s taste and preferencesConsumer’s taste and preferences

AdvertisementAdvertisement

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Shift in the demand scheduleShift in the demand schedule

0

1

2

3

4

5

6

7

8

9

0 50 100 150

Qold

Qnew

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The supple side of the marketThe supple side of the market

Supply Supply means the quantity of a commodity that means the quantity of a commodity that its producers or sellers offer for sale at a its producers or sellers offer for sale at a given pricegiven price

The law of supply: as price increases, supply The law of supply: as price increases, supply will also risewill also rise

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Supply scheduleSupply schedule

Price (Rs)Price (Rs) Quantity (unitsQuantity (units

88 9595

66 8080

44 5555

33 4040

22 2525

11 55

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The supply scheduleThe supply schedule

0

1

2

3

4

5

6

7

8

9

0 20 40 60 80 100

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The Market The Market

Price (Rs)Price (Rs) DemandDemand SupplySupply CalculateCalculate

88 88 9595

66 1515 8080

44 3030 5555

33 4040 4040

22 5555 2525

11 8080 55

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Consumer theory and the Consumer theory and the

Individual DemandIndividual Demand • Three crucial features of demand: Three crucial features of demand:

1.1. Desire to have the good;Desire to have the good;• The good confers utility to the consumerThe good confers utility to the consumer

2.2. Willingness to pay; Willingness to pay; • There is a willingness to pay to acquire the There is a willingness to pay to acquire the

right to consume the good;right to consume the good;

3.3. Ability to pay for that good;Ability to pay for that good;• The consumer has the resource to purchase The consumer has the resource to purchase

the good.the good.

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Individual Demand and PriceIndividual Demand and Price

What is the relationship between the What is the relationship between the individual’s demand for a product and the individual’s demand for a product and the price of that product?price of that product?

To answer this question, scholars in To answer this question, scholars in economics have constructed a theoryeconomics have constructed a theory

‘‘Consumer Theory’Consumer Theory’

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Consumer TheoryConsumer Theory

Starting point of the theory: what are the Starting point of the theory: what are the characteristics of a humancharacteristics of a human

For the economist, human refers to For the economist, human refers to economic agenteconomic agent

What is an economic agent?What is an economic agent?

Someone who is rational!!Someone who is rational!!

What is rationality? The means –ends What is rationality? The means –ends relationshiprelationship

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Economic AgentsEconomic AgentsAssume rationalAssume rational

Assume to be self-interestAssume to be self-interest

Maximise utilityMaximise utility

Choices are transitiveChoices are transitive

Non-satiation pointNon-satiation point

Ability to compare between different Ability to compare between different bundle of goods (completeness)bundle of goods (completeness)

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Building a theory of individual Building a theory of individual demand -Consumer theorydemand -Consumer theory

Two requirements: Two requirements: – study constraint: ability to paystudy constraint: ability to pay– Study preference: willingness to payStudy preference: willingness to pay

A budget constraintA budget constraint– Income=mIncome=m– Price of good X = PxPrice of good X = Px– Price of good Y = PyPrice of good Y = Py– Quantity of X = QxQuantity of X = Qx– Quantity of Y = QyQuantity of Y = Qy

The budget constraint: PxQx + PyQy = mThe budget constraint: PxQx + PyQy = m

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Budget constraint: graphical Budget constraint: graphical illustrationillustration

Good X, Qx

Good Y, Qy

Ability to buy

Inability to buy

When price of X falls

When price of X rises

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Desire and willingness to buy: Desire and willingness to buy: Consumer PreferenceConsumer Preference

Better off

Worst off

The Consumer is indifferent

Good X, Qx

Good Y, Qy

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Desire and willingness to buy: Desire and willingness to buy: Consumer PreferenceConsumer Preference

Good Y, Qy

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Ability to pay + Desire + willingness Ability to pay + Desire + willingness to payto pay

Good Y, Qy Equilibrium

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Good Y, Qy

Good X, Qx

B

A

A

BP0

P1

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Conclusion: Take away pointConclusion: Take away point

Movement from A to B derives the Movement from A to B derives the demand curvedemand curveThe movement means a reallocation of The movement means a reallocation of resource and choiceresource and choice

– It is made up of two effects: It is made up of two effects: 1.1. income effect: when price falls, the consumer income effect: when price falls, the consumer

has more purchasing power has more purchasing power 2.2. Substitution effect: when price falls, the product Substitution effect: when price falls, the product

becomes cheaper, the consumer consumes becomes cheaper, the consumer consumes more of it and less of the othermore of it and less of the other

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Demand for a productDemand for a product

When price falls:When price falls:– Substitution effect: the consumer consumes Substitution effect: the consumer consumes

moremore– Income effect: Income effect:

if the good is a normal good, consumer will if the good is a normal good, consumer will consume moreconsume more

If the good is inferior good, the consumer will If the good is inferior good, the consumer will consume lessconsume less

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Analysis of Market DemandAnalysis of Market Demand

Market demand can be defined as the sum Market demand can be defined as the sum of individuals demands for a product at a of individuals demands for a product at a price per unit of time.price per unit of time.

The aggregate of individuals demands for The aggregate of individuals demands for a product is called market demand for the a product is called market demand for the productproduct

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The derivation of market demandThe derivation of market demand

Adding up individual demand at different Adding up individual demand at different pricesprices

Summing up individual demand functions Summing up individual demand functions

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Market demand curveMarket demand curve

Price of X A B C Market demand 25 0 0 0 020 5 0 0 515 10 5 0 1510 15 10 5 305 20 15 10 450 25 20 15 60

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The derivation of market demandThe derivation of market demand

Market demand curve

0

5

10

15

20

25

30

0 20 40 60 80

Quantity

Pri

ce

A

B

C

Market

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Mathematical approach Mathematical approach

A’s demand: Da = 100 – 10PxA’s demand: Da = 100 – 10Px

B’s demand: Db = 75 – 7.5PxB’s demand: Db = 75 – 7.5Px

C’s demand: Dc = 50 – 5PxC’s demand: Dc = 50 – 5Px

Market demand curve: D = (100-10Px)Market demand curve: D = (100-10Px)+(75-7.5Px)+(50-5Px)= 225-22.5Px+(75-7.5Px)+(50-5Px)= 225-22.5Px

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Kinds of demandKinds of demand

Individual demand Individual demand

Market demandMarket demand

What is more important for the businessWhat is more important for the business– Demand for firm’s productDemand for firm’s product– Demand for the industry’s productDemand for the industry’s product

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Industry’s and firm’s demandIndustry’s and firm’s demand

Aggregate demand of all firms is called the Aggregate demand of all firms is called the industry demand functionindustry demand function

firm’s demand: how the industry demand firm’s demand: how the industry demand is shared??is shared??– One leader and many followersOne leader and many followers– Equal sharing and many firmsEqual sharing and many firms– Equal sharing but few firmsEqual sharing but few firms– One firmOne firm

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Autonomous or direct demand function Autonomous or direct demand function

Derived demand Derived demand

Durable goods demand: create Durable goods demand: create replacement demand, due to depreciationreplacement demand, due to depreciation

Non-durable goods demand: satisfaction is Non-durable goods demand: satisfaction is exhausted from a single useexhausted from a single use– all food items all food items

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Short run demand: fashion, seasonal, Short run demand: fashion, seasonal, inferior, inferior,

Long run demand: consumer and producer Long run demand: consumer and producer goods goods

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Take away pointsTake away pointsDeterminants of market demandDeterminants of market demand– Price of the productPrice of the product– Price of the related goodsPrice of the related goods

SubstituteSubstituteComplementsComplements

– Consumer’s incomeConsumer’s income– Essential consumer goodsEssential consumer goods– Inferior goodsInferior goods– Normal goodsNormal goods– Luxury and prestige goodsLuxury and prestige goods– Consumer’s taste and preferenceConsumer’s taste and preference– Advertisement expenditure Advertisement expenditure – Consumers’ expectationsConsumers’ expectations– Demonstration effectsDemonstration effects– Consumer-credit facility Consumer-credit facility – Population of the CountryPopulation of the Country– Distribution of National income Distribution of National income

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Analysis of demandAnalysis of demand

Linear demand functionLinear demand function

Non-linear demand functionNon-linear demand function

Elasticities of demand Elasticities of demand Arc elasticities Arc elasticities

Point elasticities Point elasticities

Price elasticity and marginal revenuePrice elasticity and marginal revenue

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Demand function Demand function

Dx = 100 – 5PxDx = 100 – 5Px– When price = 0, Dx = 100When price = 0, Dx = 100– When price =10, Dx = 50When price =10, Dx = 50– When price =20, Dx = 0When price =20, Dx = 0

– Such demand function is called LINEAR Such demand function is called LINEAR DEMAND FUNCTIONDEMAND FUNCTION

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Non Linear: Dx = 10(Px)-3Non Linear: Dx = 10(Px)-3

Dynamic or long run demand function Dynamic or long run demand function : Qx = 1.0 - 2.0 Px +1.5 I + 0.8 Py – 3.0 Pm + 1.0 : Qx = 1.0 - 2.0 Px +1.5 I + 0.8 Py – 3.0 Pm + 1.0

AA

Qx = Sales of corn flakes, in millions of 10 ouces boxesQx = Sales of corn flakes, in millions of 10 ouces boxes

Px = the price of cornflakes, in rupeesPx = the price of cornflakes, in rupees

I = personal disposal incomeI = personal disposal income

Py = price of competitive brand of cornflakesPy = price of competitive brand of cornflakes

Pm = price of milkPm = price of milk

A = advertising expenditures A = advertising expenditures

d10(Px) Dx

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ExerciseExercise

think of a product think of a product

Identify the determinants of demand for Identify the determinants of demand for the your productthe your product– E.g. tomatoes, restaurants meals, glassware, E.g. tomatoes, restaurants meals, glassware,

taxi service, furniture, housing, alcohol, taxi service, furniture, housing, alcohol, movies, foreign air travel, shoes, auto repair, movies, foreign air travel, shoes, auto repair, medical insurance, gasoline, owner occupied medical insurance, gasoline, owner occupied housinghousing

Application Application

An economic consultant for X Corp. recently provided the firm’s An economic consultant for X Corp. recently provided the firm’s marketing manager with this estimate of the demand function marketing manager with this estimate of the demand function for the firm’s product:for the firm’s product:

  QQxx = 12,000 – 3P = 12,000 – 3Pxx + 4P + 4Pyy – 1M +2A – 1M +2Axx

  where Qwhere Qxx represents the amount consumed of good X, P represents the amount consumed of good X, Pxx is the is the

price of good X, Pprice of good X, Pyy is the price of good Y, M is income, and A is the price of good Y, M is income, and Axx represents the amount of advertising spent on good X. represents the amount of advertising spent on good X. Suppose good X sells for Rs200 per unit, good Y sells for Suppose good X sells for Rs200 per unit, good Y sells for Rs15 per unit, the company utilises 2,000 units of advertising, Rs15 per unit, the company utilises 2,000 units of advertising, and consumer income is Rs10,000. How much of good X do and consumer income is Rs10,000. How much of good X do consumers purchase? Are goods X and Y substitutes or consumers purchase? Are goods X and Y substitutes or complements? Is good X a normal or an inferior good?complements? Is good X a normal or an inferior good?

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ApplicationApplication

You are the manager of a chain of computer You are the manager of a chain of computer stores. The state has recently passed a two-stores. The state has recently passed a two-tier program designed to further enhance the tier program designed to further enhance the computer industry position. The legislation computer industry position. The legislation provides increased funding for computer provides increased funding for computer education in primary and secondary schools, education in primary and secondary schools, as well as tax breaks for firms that develop as well as tax breaks for firms that develop computer software. As a result, what do you computer software. As a result, what do you predict will happen to the equilibrium price predict will happen to the equilibrium price and quantity of software?and quantity of software?

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Review QuestionReview QuestionDistinguish between individual and market demand for Distinguish between individual and market demand for a product. Market demand is the main concern of a product. Market demand is the main concern of business managers. Why should business managers business managers. Why should business managers then study individual demand curve?then study individual demand curve?What are main determinants of market demand for a What are main determinants of market demand for a commodity?commodity?How do the changes in the following factors affect the How do the changes in the following factors affect the demand for a commodity?demand for a commodity?

1.1. Price, Price, 2.2. IncomeIncome3.3. Price of substitutePrice of substitute4.4. advertisementadvertisement5.5. PopulationPopulation