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. Q DX =f(P X,P Y,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.

Demand Suppose that the consumers in this market are willing and able to purchase Q 1 units per period of time when the price of each unit is P 1. P/unit Q P1P1P1P1 Q1Q1Q1Q1

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 P1P1P1P1 Q1Q1Q1Q1 Q2Q2Q2Q2 P2P2P2P2 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 P1P1P1P1 Q1Q1Q1Q1 Q2Q2Q2Q2 P2P2P2P2 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. Q SX =f(P X,P input,P Other,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 DefinitionFormula

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 Demand Usually a negative number  As price increases, quantity decreases  As price decreases, quantity increases Definition |E P | > 1 |E P | < 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 Quantity P/unit

Example: Price Elasticities of Demand for Automobile Makes (1990)  Source: Berry, Levinsohn and Pakes, "Automobile Price in Market Equilibrium," Econometrica 63 (July 1995),

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 Inelastic Elastic

Look at the Extremes P Q P Q   0 D D   infinite Perfectly Elastic DPerfectly Inelastic D

Relatively Elastic vs. Relatively Inelastic Demand Curves Q1Q1 Q2Q2 Q2’Q2’ P1P1 P2P2 D’D’ D D’ is relatively more elastic than D P Q

Price Elasticities of Demand  Price elasticity of market demand for automobiles is between -1 and  Price elasticity of demand for ready-to-eat breakfast cereal in the U.S. is on the order of to  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 LevelFirm 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, |E P | > 1 so %  Q>%  P Thus, when P increases, Q decreases by more! Revenues = P*Q falls For inelastic response, |E P | < 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 Q DX = P X + 10P Y +2.5*I Derive demand curve by holding P Y and I constant (e.g., at P Y =100, and I=1000) giving: Q DX = P X Derive  Q/  P)* P 1 /Q 1 What is P 1 and Q 1 ? What is  Q/  P? Quick Example: mathematical demand function

Elasticity calculation   Q/  P)* P 1 /Q 1   -25*190/13750 =  What is the interpretation?

Look at an Example Suppose the price elasticity of demand is  -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  -3.6, and you expect a 5% price increase next year. What should happen to the quantity demanded? Answer:    Q/  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.