Principles and Worldwide Applications, 7th Edition Managerial Economics Principles and Worldwide Applications, 7th Edition Dominick Salvatore & Ravikesh Srivastava

Chapter 3: Demand Theory

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 Demand QdX = 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 = 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 Function QDX = 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

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 Intercept: a0 + a2N + a3I + a4PY + a5T Slope: QX/PX = a1 QX

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 Point Definition Linear Function

Price Elasticity of Demand Arc Definition

Marginal Revenue and Price Elasticity of Demand

Marginal Revenue and Price Elasticity of Demand PX QX MRX

Marginal Revenue, Total Revenue, and Price Elasticity TR MR>0 MR<0 QX 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 Point Definition Linear Function

Income Elasticity of Demand Arc Definition Normal Good Inferior Good

Cross-Price Elasticity of Demand Point Definition Linear Function

Cross-Price Elasticity of Demand Arc Definition Substitutes Complements

Example: Using Elasticities in Managerial 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 Price 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 Perfect Complements Perfect Substitutes QY QX QY QX

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