Demand Theory andIts Implications In

Managerial Economics

Group Members

Omer ShahzadMB-12-08

Anam ArifMB-12-03

What is Demand ?

Demand is the basis of all productive activities. Demand theory is an economic theory that concerns the relationship between the demand for goods and their prices; it forms the core of microeconomics. The generation of demand can be pictorically shown as below,

NEED WANT DEMAND

Desire to buy

Willingness to pay

Ability to pay

Want Demand

Concept of Effective Demand

Individual Consumer’s DemandQdX = 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

T = Tastes of the consumer

Consumer Demand Theory

Consumer Demand Theory

GoodsNormal GoodsGoods for which demand increases when income increases, and falls when income decreases but price remains constant.

Inferior GoodsA good that decreases in demand when consumer income rises.

SubstitutesA product or service that satisfies the need of a consumer that another product or service fulfills.

Individual Demand Curve

Price of a Commodity (PX)

Quantity Demanded (QdX)

$2 1

$1 3

$0.50 4.5

Law of Demand

The law of demand states that the quantity demanded and the price of a commodity are inversely related, other things remaining constant. If the income of the consumer, prices of the related goods, and preferences of the consumer remain unchanged, then the change in quantity of good demanded by the consumer will be negatively correlated to the change in the price of the good.

Law of Demand

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

Law of Demand

Income Effect

When price of a commodity falls then the individual can purchase more units of that commodity, thus quantity demanded for that commodity increases.

Substitution Effect

When price of a commodity falls, the quantity demanded for that product increases because the individual substitutes in consumption the product with its substitutes.

Horizontal summation of demand curves of individual consumers

Market Demand Curve

Individual to Market Demand

Market Demand FunctionQDX = 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

Individual to Market Demand

Individual to Market Demand

Bandwagon EffectPeople tend to purchase a commodity which others are using or in order to follow the fashion.

Snob EffectSituation where the demand for a product by a high income segment varies inversely with its demand by the lower income segment.

Market Structure Monopoly

Perfect Competition

Oligopoly

Monopolistic Competition

Demand Faced by a Firm

Demand Faced by a Firm

Monopoly

Firm is sole producer of commodity

No substitutes

Total control on price

A rare case bound with government regulations

Examples are local telephone, electricity, public transport.

Perfect Competition

Large number of firms

Identical products

No control on price

A rare case

Examples are farmers selling wheat or rice or sugar-cane

Demand Faced by a Firm

Oligopoly

Firms producing homogeneous or standardized products like cement

Firms producing heterogeneous or differentiated products like soft drinks

Examples are firms in production sector of the economy

Monopolistic Competition

Involves elements of monopoly and perfect competition

Firm has somehow control over price

Examples are firms in service sector like gasoline stations or barber shops

Type of Good Durable Goods

Nondurable Goods

Producers’ Goods - Derived Demand

Demand Faced by a Firm

Demand Faced by a Firm

Durable Goods

Goods that provide services not only during the year when they are purchased but also in following years

Firm faces a more volatile or unstable demand

Examples are automobiles, electric appliances

Non-Durable Goods

Goods that cannot be stored and can be used within a year

Firm faces a stable demand

Examples are food, cosmetics and cleaning products

Demand Faced by a Firm

Non-Durable Goods

Goods that cannot be stored and can be used within a year

Firm faces a stable demand

Examples are food, cosmetics and cleaning products

Producer’s Goods

Goods, such as raw materials and tools, used to make consumer goods

The demand for such goods is derived demand because it depends upon the demand for goods and services it sells

Firm’s demand for producers goods is also more volatile and unstable

QX = a0 + a1PX + a2N + a3I + a4PY + a5T + …….

Linear Demand Function

QX = Quantity demanded of commodity X faced by the firm

PX = Price of commodity X

I = Consumer’s income

PY = Price of related (substitute or complementary) commodity

T = Tastes of the consumer

a = Co-efficient estimated by the regression analysis

An Insight into a new era of Demand Theory

Price Elasticity of Demand

A measure of the relationship between a change in the quantity demanded of a particular good and a change in its price. Price elasticity of demand is a term in economics often used when discussing price sensitivity. The formula for calculating price elasticity of demand is:

𝑃𝑟𝑖𝑐𝑒𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑=%𝑎𝑔𝑒 h𝑐 𝑎𝑛𝑔𝑒𝑖𝑛𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑%𝑎𝑔𝑒 h𝑐 𝑎𝑛𝑔𝑒𝑖𝑛𝑝𝑟𝑖𝑐𝑒

Price Elasticity of Demand

Price Elasticity of Demand

Point Price Elasticity of Demand

Arc Price Elasticity of Demand

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 Definition2 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, Total Revenue, and Price Elasticity

TR

QX

1PE MR<0MR>0

1PE

1PE MR=0

PX

QX

MRX

1PE

1PE

1PE

Marginal Revenue, Total Revenue, and Price Elasticity

Determinants of Price Elasticity of Demand

Demand for a commodity will be more elastic if:

It has many close substitutes

It is narrowly defined

More time is available to adjust to a price change

Demand for a commodity will be less elastic if:

It has few substitutes

It is broadly defined

Less time is available to adjust to a price change

Determinants of Price Elasticity of Demand