Demand Analysis and

Estimation of Demand Function

Reading
•Required: Jones, T. T. (2004). Business economics and
managerial decision making. John Wiley & Sons (Chap 4,5,6)
•Recommended: Griffiths, A., & Wall, S. (2005). Economics for
business and management. Pearson Education. (Chap 2)
Demand Analysis
Demand Curves
•Law of demand: lower the price of a good, the larger the
quantity consumers wish to purchase, ceteris paribus
•Let’s try to gain a better understanding of why the demand
curve is downward sloping
•Need to introduce the concept of marginal utility
Utility
•The satisfaction (or benefit) received from some action or activity
•Total Utility
•Marginal Utility
Marginal Utility (Benefit)
•Additional satisfaction or benefit (utility) derived from an
additional unit of the commodity
•MU is (always? Or not?) positive but tends to decline as
consumption increases
Law of diminishing MU (MB)
•as a person consumes more and more of a given commodity
(ceteris paribus) MU will decline
Law of diminishing MU (MB)
Equilibrium market basket
•Market basket where consumer’s income is allocated among
commodities so that for every commodity purchased the MU
of the commodity is proportional to price
•MUx/Px = MUz/Pz
•Or MBx/Px = MBz/Pz
Constrained Maximization
•Maximize output/outcome subject to a budget constraint or
minimize costs associated with a specified output level
•Concept of the marginal benefit per dollar is useful when
dealing with constrained maximization problems
Individual Demand Curve
P

P1

P2

Q1 Q
Q2
Direct Demand Function
Qdi = f()

Y = income
T = tastes
Pi = price of the good
P≠i = price of related goods
A = all other things (age, occupation, expectations, etc.)
 Change in Demand versus
Change in Amount Demanded
Change in Amount Demanded
P

P1

P2

Q1 Q
Q2
Change in Demand
P

Q
 Market Demand Curve
Horizontal Summation of Individual Demand Curves
$ da

db

dc

P2 MC = S

P1 MC = S

Market demand

QT QT Q
More on the Inverse Demand Function
•P = f(Q )
dx
•The mathematical inverse of the direct demand function
•Provides the demand price for a corresponding quantity
•Every point on the curve shows:
• The maximum amount of a good that will be purchased if a given price is
charged
• The maximum price that consumers will pay for a specific amount of a
good
 Elasticity
1. Own price elasticity of demand
2. Elasticity and Total Revenue
3. Cross-price elasticity
4. Income elasticity
Elasticity
•A measure of the responsiveness of one variable to
changes in another variable
•The percentage change in one variable that arises due
to a given percentage change in another variable
Price elasticity of demand
•the percentage change in quantity demanded resulting from
a one percent change in price.
•%DQ / %DP
D
Point Elasticity of Demand

hX = ΔQD/ΔP * P/QD
price elastic if >1
price inelastic if <1
unitary elastic if =1
perfectly elastic if = - ∞
perfectly inelastic if = 0

ABSOLUTE VALUES
Elastic demand (Ped >1)

Source: tutor2u
Perfectly inelastic demand (Ped = zero)

Source: tutor2u
Perfectly elastic demand

Source: tutor2u
Unitary price elasticity of demand

Source: tutor2u
Total Revenue and Elasticity
when absolute value of own price elasticity is less than one,
an increase in price increases total revenue
when absolute value of own price elasticity is greater than
one, an increase in price decreases total revenue
“if demand is elastic, an increase (decrease)
in price will lead to a decrease (increase) in
total revenue. If demand is inelastic, an
increase (decrease) in price will lead to an
increase (decrease) in total revenue. Finally,
total revenue is maximized at the point
where demand is unitary elastic”
Factors affecting own price elasticity
•Available Substitutes
•Expenditure Share
•Time Period
•Optionality (how much discretion is involved in
consumption of good)
Arc Elasticity of Demand
DQ
Q1 + Q 2
2 where
hx =
DP
P1 + P 2 ΔQ = Q2 – Q1
2 ΔP = P2 – P1

DQ hX = (ΔQ/ΔP) * [(P1+P2)/(Q1+ Q2)]

Q1 + Q 2
hx =
DP
P1 + P 2

DQ é ( P1 + P 2) ù
hx = ( )´ ê
DP ë (Q1 + Q 2 úû
Why Use Arc Rather Than Point Elasticity?
•Software example
•Calculate the point elasticity going from point C to D
•Remember at C: P = 10, Q = 60 and at D: P = 15, Q = 50
X x
•If use C as reference point,
• (-10/60)/(5/10) = 0.1667/0.5 = 0.334
•If use D as reference point,
• (-10/50)/(5/15) = 0.2/0.333 = 0.601
•Makes a big difference which point you choose to use as
your reference point
Why Use Arc Rather Than Point Elasticity
continued
•When the price change involves a large interval of demand
(large percentage change in quantity demanded), use the arc
elasticity
•When the price change involves a small interval of demand
(relatively small percentage change in quantity demanded),
use the point elasticity
Marginal Revenue
demand curve: P = a - bQ

total revenue curve: R = PQ = aQ – bQ2

marginal revenue curve:

(dR/dQ) = d(PQ)/dQ = a - 2bQ
Total revenue is maximized when MR=0

This is where price elasticity is equal to one

P

Ŋx > 1

Ŋx = 1

Ŋx < 1

D
Q
MR
P

TR

Q
example
QD = 150 – 10P

P = 15 – QD/10

TR = P * QD

TR = (15 – QD/10) QD

TR = 15 QD – (Q2D/10)

MR = d(TR)/d(QD) MR is equal to the first derivative of

TR with respect to QD
MR = 15 – QD/5

To maximize TR, set MR = 0 and solve for QD

0 = 15 – QD/5

QD = 75 units

P = 15 – QD/10

P = $7.50 per unit

h = ¶QD/¶P * P/QD = (-10) (7.5)/(75) = -1 (QD = 150-10P)

|h| = 1
Income elasticity
•A measure of responsiveness of consumer demand to
changes in income
Income Elasticity of Demand (Arc)
DQ
Q1 + Q 2 where
hy = 2
DY ΔQ = Q2 – Q1
Y1 + Y 2
ΔY = Y2 – Y1
2
hY = (ΔQ/ΔY) * [(Y1+Y2)/(Q1+ Q2)]
DQ
Q1 + Q 2
hy =
DY
Y1 + Y 2

DQ é (Y 1 + Y 2) ù
hy = ( )´
DY êë (Q1 + Q 2 úû
Income Elasticity of Demand (Point)

hY = ¶QD/¶Y * Y/QD
or
hY = ΔQD/ΔY * Y/QD
Cross-price elasticity
•A measure of the responsiveness of the demand for a
good to changes in the price of a related good
•The percentage change in quantity demanded of one
good divided by the percentage change in the price of a
related good
Cross Price Elasticity of Demand (Arc)
DQx
Qx1 + Qx 2 where
hxz = 2
DPz ΔQ = Qx2 – Qx1
Pz1 + Pz 2
2 ΔP = Pz2 – Pz1

DQx hXZ = (ΔQX/ΔPZ) * [(PZ1+PZ2)/(QX1+ QX2)]

Qx1 + Qx 2
h xz =
DPz
Pz1 + Pz 2

DQx é ( Pz1 + Pz 2) ù
h xz = ( )´
DPz êë (Qx1 + Qx 2 úû
Cross Price Elasticity of Demand (Point)
hXZ = ¶QX/¶PZ * PZ/QX
or
hXZ = ΔQX/ΔPZ * PZ/QX

•Substitutes
•Complements
 Empirical Estimates of Elasticity
• Price Elasticities
• Butter -0.24
• Chicken -0.30
• Pork -0.77
• Eggs -0.26
• Ground Beef -1.01
• Beef (Steaks) -1.15
• Fruit -3.20
• Beer -0.20
• Wine -0.67
• Cigarettes -0.51
• Clothing -0.62
• Dynamic Random Access Memory -0.00
• Transnational Fiber-optic Bandwidth -2.00
• Kellogg’s Raisin Bran -2.06
• Post Raisin Bran -2.03
• Electricity (short run)/(long run) -0.28/-0.90
• Gasoline (short run)/(long run) -0.43/-1.50
Source: Thomas and Maurice, Managerial Economics, 9th edition, New York: McGraw-Hill Irwin, 2008, p. 231.
Empirical Estimates of Elasticity continued
• Income Elasticities
• Ground Beef -0.19
• Beef (Steaks) 1.87
• Chicken 0.42
• Pork 0.34
• Potatoes -0.81
• Beer 0.76
• Wine 1.72
• Life Insurance in Japan 2.99
• Life Insurance in United States 1.65
• Cross Price Elasticities
• Beef (steaks) and chicken 0.24
• Margarine and butter 1.53
• Beer and wine 0.56
• Kellogg’s Raisin Bran and Post Raisin Bran 0.01
Source: Thomas and Maurice, Managerial Economics, 9th edition, New York: McGraw-Hill Irwin, 2008, p. 231.
Obtaining Elasticities from Demand Functions

QX= αo + αx Px + αz Pz + αY Y + αH H

the coefficient αx effectively represents the percentage

change in QX divided by the percentage change in price of
QX and so forth for each coefficient
own price elasticity for good X
hx = αx (Px / QX)

income elasticity for good X

hY = αY (Y / QX)

cross price elasticity between goods X and Z

hxz = αz (Pz / QX)
QX = 16,000 - 3Px + 4Pz -1Y + 2Ax

where:
Ax = advertising spent on shoes X

values:
Px = $25
Pz = $35
Y = $20,000
Ax = 2,000 units
is demand elastic, inelastic, or unitary elastic?

ax = -3 and Px = 25
need to solve for QX:
QX = 16,000 -3(25) + 4(35) - 1(20,000) + 2(2,000) again, one point on
the demand curve…
QX = 65
hx = -3(25/65) = -3(0.3846) = -1.15 elastic
cross price elasticity
aZ = 4 and Pz = $35 and QX = 65

hxz = 4(35/65) = 4(0.538) = 2.15 substitutes

income elasticity of X
aY = -1 and Y = 20,000

hY = -1(20,000/65) = -1(307.6923076923) = -307.69

Use of elasticities
•Pricing
•Managing cash flows
•Impact of changes in competitors’ prices
•Impact of economic booms and recessions
•Impact of advertising campaigns
 Estimation of
Demand Function
Estimation of Demand Function
•Empirical demand functions
• Demand equations derived from actual market data
•Two basic methods for demand estimation
• Direct methods
Ø Consumer interviews
Ø Market studies and experiments

• Indirect methods (econometrics/ regression techniques)

Estimation of Demand Function
•Direct methods:
• Consumer interview:
• Methods:
Ø Interview consumers
Ø Administer questionnaires
Ø Run focus groups

• Ask customers’ buying habits, methods, motives, and intention

• Discern consumers’ tastes
Estimation of Demand Function
•Direct methods:
• Consumer interview:
• Pitfalls:
Ø Sample bias: right questions, wrong people
Ø Responsive bias: response do not reflect the potential customer’s true
preferences
Ø Response accuracy: customers have difficulty in answering a question
accurately
Estimation of Demand Function
•Direct methods:
• Market experiments – controlled market data:
• Carry out direct market experiments
• Vary key demand determinants across the markets
• Simulation: controlled laboratory experiments, in which consumers are
given money and told to shop in a simulated store
Estimation of Demand Function
•Direct methods:
• Market experiments:
• Generate:
Ø Cross-sectional data
Ø Time-series data
Estimation of Demand Function
•Direct methods:
• Uncontrolled market data:
• The market itself produces a large amount of data
• Many firms operate in multiple markets
• Opportunity: see how changing factors affect demand
• Challenge: many factors change at the same time
Estimation of Demand Function
•Indirect methods:
• Regression Analysis:
• To estimate demand function
• Important concepts:
Ø Least square regression model
Ø Least squares regression line
Ø Confidence intervals
Ø T-statistic
Ø R-square or coefficient of determination
Ø F-statistic
Estimation of Demand Function
•Indirect methods:
• Regression Analysis:
• Collect data on the variables in question
• Specify the form of the equation relating the variables
• Estimate the equation coefficients
• Evaluate the accuracy of the equation
Estimation of Demand Function
•Indirect methods:
• Regression Analysis:
• Pitfalls:
• Equation specification
• Omitted variables
• Multicollinearity
• Simultaneity
• Other problem
• Serial correlation
• Heterogeneity
Choice and Demand
Brief Review: Utility
•The satisfaction (or benefit) received from some action or activity
•Marginal Utility
•Law of Diminishing Marginal Utility
•Equilibrium Market Basket
• Market basket where consumer’s income is allocated among commodities so
that for every commodity purchased the MU of the commodity is proportional
to price
• MUx/Px = MUz/Pz
Indifference Curves
•useful tool for understanding choices individuals make
with regard to the purchase and use of goods and services
•an indifference curve is a graph of all combinations of
market baskets among which the individual is indifferent
•each point on an indifference curve gives the individual
exactly the same level of satisfaction (TU) during a given
period of time
•Because it is assumed that individuals prefer more to less,
the indifference curve is downward sloping
Expenditure on Other
Goods in Mkt. Basket Indifference Curve
per month ($)
Z
MRSXfor Z = - ΔZ/ΔX

MRSXforZ = - (ZB1 – ZB2)/(XB1 – XB2)

MRSXforZ = -1(the slope between pt. B1 and pt. B2)

B1
ZB1

ZB2 B2

U3

U2
U1
Gallons of Gasoline per
X month
XB1 XB2
 Discussion of Previous Slide from Hyman, sixth edition pp. 32-39

• Market basket corresponding to point B1 on the graph has 40 gallons

of gasoline per month and $60 of expenditures on all other goods per
month.
• The market basket depicted by B2 must have more gasoline but less
expenditure on other goods if it is a point on the indifference curve.
This is due to the assumption that people prefer more to less (of a
good).
• If the market basket depicted at B2 had both more gasoline and more
expenditures on other goods than in market basket B1, s/he would be
better off
• If s/he is better off, it means B2 would have to be on a higher
indifference curve than U1, say U2
 Discussion continued
• the amount of expenditure on goods other than gasoline that a person
will give up to obtain another unit of good X (gasoline) and still remain
on the indifference curve is the marginal rate of substitution of good X
for good Z (MRSXforZ)
• The MRSXforZ is the slope of the indifference curve multiplied by -1
• The assumption that the marginal benefit of a good declines implies
that indifference curves become flatter as good X is substituted for
good Z (gasoline for expenditures on other goods) in her/his market
basket
• an indifference map shows a person’s preferences. As you move out,
the indifference curves show more satisfaction. Points on higher
curves are preferred to points on lower curves.
Consumer Constraint
•Budget constraint restricts consumer behavior by forcing the
consumer to select a bundle of goods that is affordable
•Budget set
•Budget line
Budget Constraint
•Indicates the monthly market baskets that the person can
afford, given her/his income and the prices of goods X and Z
•Y = P X + P Z
X Z
•Y – P X = P Z (want it in the form y = a + bx)
X Z
•Y/P – (P /P )X = Z (where Z is the y axis intercept)
Z X Z
•Slope of budget line is -P /P
x Z
•Changes in prices of X and Z cause the appropriate intercept
to change and the slope of the budget line to change
Expenditure on Other Goods in
Mkt. Basket per month ($)
Budget Line
Y = PXX + PZZ
Z

intercept: Z = Y/PZ

Slope of Budget Line is

– PX/PZ

intercept: X
= Y/PX

Gallons of
Gasoline per
X month
Consumer Equilibrium
•It is assumed that the consumer wants to obtain the most
satisfaction (or utility) possible, given the budget constraint
•The consumer substitutes expenditures on goods other than
good X (in this case Z) for purchases of good X, up to the
point at which the highest level of satisfaction is obtained
•The equilibrium condition is a tangency between the
indifference curve and the budget line, implying that the
slopes of these two curves are equal (MRSXforZ = PX/PZ)
 Budget Line Consumer Equilibrium
Z

MRS XforZ = PZ/PX

Note: The indifference curves

do not cross even though they
may look like they do on this
diagram. Also, as you move
out from the origin, the
Indifference curves represent
greater levels of satisfaction
Zε

X
Xε
Income and Substitution Effects
•When the price of either good X or good Z changes, there
are two separate effects due to this price change
•The income effect is the change in the consumption of a
good due to the variation in purchasing power of income
caused by its price change
•The substitution effect is the change in the consumption of
the good due to the change in its price relative to other
goods.
•It is difficult to see the two separate effects. The point here
is to do just that so you can see both more clearly
The Income and Substitution Effects
in Words…
1. Income effect: if the price of a good declines, you can buy
the same amount of everything you did before and still have
some $$ left over
2. Substitution effect: when the price of one good declines,
you can buy more of it and the same amount of the other
goods (you might want to do this because now the one good
is cheaper relative to the other good relative to the starting
point…) Therefore your total satisfaction goes up
 Z Income and Substitution Effect

Z3 E3

E1
Z1

E2 U2
Z2
U1

X2 X3 X1 X
 Discussion
•Initial equilibrium is at E with a market basket of Z
1 1
and X 1
•Now, the price of X goes up, causing the budget line
to get steeper
•With a higher price for X, the consumer is worse off.
This is shown by the new equilibrium at E2 where the
market basket consists of X2 and Z2 (less of both
goods)
•The movement from E1 to E2 is the total effect of the
increase in the price of good X
 Discussion continued
•Now assume the consumer is offered a subsidy sufficient to
make up for the loss in purchasing power due to the increase
in the price of good X. In other words, the subsidy allows the
consumer to return to the original indifference curve U2
• Remember, that the relative prices are still changed from the
original relative prices (because PX is still larger and PZ has not
changed).
• This means there is a new budget line parallel to the budget
line after the change in the price of X and our focus is on the
tangency point between this new budget line and the original
indifference curve, point E3
 Discussion continued
•Now, we can separate the income and substitution effects.
•The substitution effect is the movement from E to E . It
1 3
shows how the consumer would choose to buy more of Z
and less of X due solely to the change in the price of good
X, assuming her/his buying power is unchanged due to the
subsidy (X1, Z1) to (X3, Z3)
• The income effect is the movement from E3 to E2 Because
the price increase reduces the consumer’s overall buying
power, s/he will choose to buy less of both X and Z from
(X3, Z3) to (X2, Z2)