1 University of Technology Managerial Economics Riad Sultan Applied Economics Lecture in demand and consumer theory Contact: ,

2 Managerial Economics: Analysis of demand Readings: Dwivedi, D. N (2008) Managerial Economics, Chapter 6,7,8 The manager’s playing field: the market The market for a product works on certain market principles, the laws that govern the working of the market system Fundamental laws of the market: the laws of demand and supply Conclusion: determine the price of the product

3 Market system Two forces of the market: demand and supply Market: goods and services are exchanged, bought and sold : where buyers and sellers interact to determine the price of a good and quantity Sellers and buyers: individuals, firms, factories, dealers and agents

4 The Demand side of the market Demand: refers to all consumers and the price that they are willing to pay and able to pay for buying a certain quantity of the product during a period of time

5 The Law of Demand When price goes up, quantity demanded falls Price is the most important determinant of demand Demand schedule: presentation of quantity demanded at different prices

6 The Law of Demand Price (Rs) Quantity (units Quantity (units

7 The Demand Schedule (Curve)

8 Factors affecting demand Consumer’s income Price of the substitutes and complementary goods Consumer’s taste and preferences Advertisement

9 Shift in the demand schedule

10 The supple side of the market Supply means the quantity of a commodity that its producers or sellers offer for sale at a given price The law of supply: as price increases, supply will also rise

11 Supply schedule Price (Rs) Quantity (units Quantity (units

12 The supply schedule

13 The Market Price (Rs) DemandSupplyCalculate

14 Consumer theory and the Individual Demand Three crucial features of demand: Three crucial features of demand: 1.Desire to have the good; The good confers utility to the consumer The good confers utility to the consumer 2.Willingness to pay; There is a willingness to pay to acquire the right to consume the good; There is a willingness to pay to acquire the right to consume the good; 3.Ability to pay for that good; The consumer has the resource to purchase the good. The consumer has the resource to purchase the good.

15 Individual Demand and Price What is the relationship between the individual’s demand for a product and the price of that product? To answer this question, scholars in economics have constructed a theory ‘Consumer Theory’

16 Consumer Theory Starting point of the theory: what are the characteristics of a human For the economist, human refers to economic agent What is an economic agent? Someone who is rational!! What is rationality? The means –ends relationship

17 Economic Agents Assume rational Assume to be self-interest Maximise utility Choices are transitive Non-satiation point Ability to compare between different bundle of goods (completeness)

18 Building a theory of individual demand -Consumer theory Two requirements: –study constraint: ability to pay –Study preference: willingness to pay A budget constraint –Income=m –Price of good X = Px –Price of good Y = Py –Quantity of X = Qx –Quantity of Y = Qy The budget constraint: PxQx + PyQy = m

19 Budget constraint: graphical illustration Good X, Qx Good Y, Qy Ability to buy Inability to buy When price of X falls When price of X rises

20 Desire and willingness to buy: Consumer Preference Better off Worst off The Consumer is indifferent Good X, Qx Good Y, Qy

21 Desire and willingness to buy: Consumer Preference Good Y, Qy

22 Ability to pay + Desire + willingness to pay Good Y, Qy Equilibrium

23 Good Y, Qy Good X, Qx B A A B P0 P1

24 Conclusion: Take away point Movement from A to B derives the demand curve The movement means a reallocation of resource and choice –It is made up of two effects: 1. income effect: when price falls, the consumer has more purchasing power 2. Substitution effect: when price falls, the product becomes cheaper, the consumer consumes more of it and less of the other

25 Demand for a product When price falls: –Substitution effect: the consumer consumes more –Income effect: if the good is a normal good, consumer will consume more If the good is inferior good, the consumer will consume less

26 Analysis of Market Demand Market demand can be defined as the sum of individuals demands for a product at a price per unit of time. The aggregate of individuals demands for a product is called market demand for the product

27 The derivation of market demand Adding up individual demand at different prices Summing up individual demand functions

28 Market demand curve

29 The derivation of market demand

30 Mathematical approach A’s demand: Da = 100 – 10Px B’s demand: Db = 75 – 7.5Px C’s demand: Dc = 50 – 5Px Market demand curve: D = ( Px)+(75-7.5Px)+(50-5Px)= Px

31 Kinds of demand Individual demand Market demand What is more important for the business –Demand for firm’s product –Demand for the industry’s product

32 Industry’s and firm’s demand Aggregate demand of all firms is called the industry demand function firm’s demand: how the industry demand is shared?? firm’s demand: how the industry demand is shared?? –One leader and many followers –Equal sharing and many firms –Equal sharing but few firms –One firm

33 Autonomous or direct demand function Derived demand Durable goods demand: create replacement demand, due to depreciation Non-durable goods demand: satisfaction is exhausted from a single use –all food items

34 Short run demand: fashion, seasonal, inferior, Long run demand: consumer and producer goods

35 Take away points Determinants of market demand –Price of the product –Price of the related goods SubstituteComplements –Consumer’s income –Essential consumer goods –Inferior goods –Normal goods –Luxury and prestige goods –Consumer’s taste and preference –Advertisement expenditure –Consumers’ expectations –Demonstration effects –Consumer-credit facility –Population of the Country –Distribution of National income

36 Analysis of demand Linear demand function Non-linear demand function Elasticities of demand Arc elasticities Point elasticities Price elasticity and marginal revenue

37 Demand function Dx = 100 – 5Px –When price = 0, Dx = 100 –When price =10, Dx = 50 –When price =20, Dx = 0 –Such demand function is called LINEAR DEMAND FUNCTION

38 Non Linear: Dx = 10(Px)-3 Dynamic or long run demand function : Qx = Px +1.5 I Py – 3.0 Pm A Qx = Sales of corn flakes, in millions of 10 ouces boxes Px = the price of cornflakes, in rupees I = personal disposal income Py = price of competitive brand of cornflakes Pm = price of milk A = advertising expenditures

39 Exercise think of a product Identify the determinants of demand for the your product –E.g. tomatoes, restaurants meals, glassware, taxi service, furniture, housing, alcohol, movies, foreign air travel, shoes, auto repair, medical insurance, gasoline, owner occupied housing

Application An economic consultant for X Corp. recently provided the firm’s marketing manager with this estimate of the demand function for the firm’s product: Q x = 12,000 – 3P x + 4P y – 1M +2A x where Q x represents the amount consumed of good X, P x is the price of good X, P y is the price of good Y, M is income, and A x represents the amount of advertising spent on good X. Suppose good X sells for Rs200 per unit, good Y sells for Rs15 per unit, the company utilises 2,000 units of advertising, and consumer income is Rs10,000. How much of good X do consumers purchase? Are goods X and Y substitutes or complements? Is good X a normal or an inferior good? 40

Application You are the manager of a chain of computer stores. The state has recently passed a two- tier program designed to further enhance the computer industry position. The legislation provides increased funding for computer education in primary and secondary schools, as well as tax breaks for firms that develop computer software. As a result, what do you predict will happen to the equilibrium price and quantity of software? 41

42 Review Question Distinguish between individual and market demand for a product. Market demand is the main concern of business managers. Why should business managers then study individual demand curve? What are main determinants of market demand for a commodity? How do the changes in the following factors affect the demand for a commodity? 1. Price, 2. Income 3. Price of substitute 4. advertisement 5. Population