Chapter 15

Market Demand

1
 From Individual to Market
Demand Functions
◆  Think of an economy containing n
consumers, denoted by i = 1, … ,n.
◆  Consumer i’s ordinary demand
function for commodity j is
x*ji (p1 , p2 , mi )

2
 From Individual to Market
Demand Functions
◆  When all consumers are price-takers,
the market demand function for
commodity j is
n *i
X j (p1 , p2 , m ,!, m ) = ∑ x j (p1 , p2 , mi ).
1 n
i= 1
◆  If all consumers are identical then
X j (p1 , p2 , M) = n × x*j (p1 , p2 , m)

where M = nm.

3
 From Individual to Market
Demand Functions
◆  The market demand curve is the
“horizontal sum” of the individual
consumers’ demand curves.
◆  E.g. suppose there are only two
consumers; i = A,B.

4
 From Individual to Market
Demand Functions
p1 p1
p1’ p1’
p1” p1”

20 x*A 15 *B
x1
1

5
 From Individual to Market
Demand Functions
p1 p1
p1’ p1’
p1” p1”

20 x*A 15 *B
x1
p1 1

p1’

x*1A + xB
1 6
 From Individual to Market
Demand Functions
p1 p1
p1’ p1’
p1” p1”

20 x*A 15 *B
x1
p1 1

p1’
p1”

x*1A + xB
1 7
 From Individual to Market
Demand Functions
p1 p1
p1’ p1’
p1” p1”

20 x*A 15 *B
x1
p1 1

p1’ The “horizontal sum”

p1” of the demand curves
of individuals A and B.
35
x*1A + xB
1 8
 Elasticities
◆  Elasticitymeasures the “sensitivity”
or “responsiveness” of one variable
with respect to another.
◆  The elasticity of variable X with
respect to variable Y is
% Δx
ε x,y = .
% Δy

9
 Economic Applications of
Elasticity
◆  Economists use elasticities to
measure the sensitivity of
– quantity demanded of commodity i
with respect to the price of
commodity i (own-price elasticity
of demand)
– demand for commodity i with
respect to the price of commodity j
(cross-price elasticity of demand).
10
 Economic Applications of
Elasticity
– demand for commodity i with
respect to income (income
elasticity of demand)
– quantity supplied of commodity i
with respect to the price of
commodity i (own-price elasticity
of supply)

11
 Economic Applications of
Elasticity
– quantity supplied of commodity i
with respect to the wage rate
(elasticity of supply with respect to
the price of labor)
– and many, many others.

12
Own-Price Elasticity of Demand
◆  Q:Why not use a demand curve’s
slope to measure the sensitivity of
quantity demanded to a change in a
commodity’s own price?

13
 Own-Price Elasticity of Demand
p1 p1
slope slope
10 =-2 10 = - 0.2

5 X1* 50 X *
1

In which case is the quantity demanded

X1* more sensitive to changes to p1?

14
 Own-Price Elasticity of Demand
p1 p1
slope slope
10 =-2 10 = - 0.2

5 X1* 50 X *
1

In which case is the quantity demanded

X1* more sensitive to changes to p1?

15
 Own-Price Elasticity of Demand
10-packs Single Units
p1 p1
slope slope
10 =-2 10 = - 0.2

5 X1* 50 X *
1

In which case is the quantity demanded

X1* more sensitive to changes to p1?

16
 Own-Price Elasticity of Demand
10-packs Single Units
p1 p1
slope slope
10 =-2 10 = - 0.2

5 X1* 50 X *
1

In which case is the quantity demanded

X1* more sensitive to changes to p1?
It is the same in both cases.
17
Own-Price Elasticity of Demand
◆  Q: Why not just use the slope of a
demand curve to measure the
sensitivity of quantity demanded to a
change in a commodity’s own price?
◆  A: Because the value of sensitivity
then depends upon the (arbitrary)
units of measurement used for
quantity demanded.

18
Own-Price Elasticity of Demand
*
% Δx1
ε x* ,p =
1 1 % Δp1
is a ratio of percentages and so has no
units of measurement.
Hence own-price elasticity of demand is
a sensitivity measure that is independent
of units of measurement.

19
 Arc and Point Elasticities
◆  An “average” own-price elasticity of
demand for commodity i over an
interval of values for pi is an arc-
elasticity, usually computed by a
mid-point formula.
◆  Elasticity computed for a single
value of pi is a point elasticity.

20
 Arc Own-Price Elasticity
pi What is the “average” own-price
elasticity of demand for prices
in an interval centered on pi’?
pi’+h
pi’
pi’-h

Xi*

21
 Arc Own-Price Elasticity
pi What is the “average” own-price
elasticity of demand for prices
in an interval centered on pi’?
pi’+h
pi’
pi’-h

Xi" Xi '" Xi*

22
 Arc Own-Price Elasticity
pi What is the “average” own-price
elasticity of demand for prices
in an interval centered on pi’?
pi’+h
pi’ *
% ΔXi
ε X* ,p =
pi’-h i i % Δpi

Xi" Xi '" Xi*

23
 Arc Own-Price Elasticity
pi What is the “average” own-price
elasticity of demand for prices
in an interval centered on pi’?
pi’+h
pi’ *
% ΔXi
ε X* ,p =
pi’-h i i % Δpi

Xi" Xi '" Xi*

2h
% Δpi = 100 ×
pi '
24
 Arc Own-Price Elasticity
pi What is the “average” own-price
elasticity of demand for prices
in an interval centered on pi’?
pi’+h
pi’ *
% ΔXi
ε X* ,p =
pi’-h i i % Δpi

Xi" Xi '" Xi*

2h * ( Xi"− Xi '")
% Δpi = 100 × % ΔXi = 100 ×
pi ' ( Xi"+ Xi '") / 2
25
 Arc Own-Price Elasticity
2h
% Δpi = 100 ×
* pi '
% ΔXi
ε X* ,p =
i i % Δpi ( Xi"− Xi '")
% ΔX*i = 100 ×
( Xi"+ Xi '") / 2

26
 Arc Own-Price Elasticity
2h
% Δpi = 100 ×
* pi '
% ΔXi
ε X* ,p =
i i % Δpi ( Xi"− Xi '")
% ΔX*i = 100 ×
( Xi"+ Xi '") / 2
So
%ΔX*i pi ' ( Xi "− Xi '" )
ε X* ,p = = × .
i i %Δpi ( Xi "+ Xi '" ) / 2 2h
is the arc own-price elasticity of demand.
27
 Point Own-Price Elasticity
pi What is the own-price elasticity
of demand in a very small interval
of prices centered on pi’?
pi’+h
pi’
pi’-h

Xi" Xi '" Xi*

*
%ΔXi pi ' ( Xi "− Xi '" )
ε X* ,p = = × .
i i %Δpi ( Xi "+ Xi '" ) / 2 2h
28
 Point Own-Price Elasticity
What is the own-price elasticity
pi of demand in a very small interval
of prices centered on pi’?
pi’+h As h → 0,
pi’
pi’-h

Xi" Xi '" Xi*

*
%ΔXi pi ' ( Xi "− Xi '" )
ε X* ,p = = × .
i i %Δpi ( Xi "+ Xi '" ) / 2 2h
29
 Point Own-Price Elasticity
What is the own-price elasticity
pi of demand in a very small interval
of prices centered on pi’?
pi’+h As h → 0,
pi’
pi’-h

Xi" Xi '" Xi*

*
%ΔXi pi ' ( Xi "− Xi '" )
ε X* ,p = = × .
i i %Δpi ( Xi "+ Xi '" ) / 2 2h
30
 Point Own-Price Elasticity
What is the own-price elasticity
pi of demand in a very small interval
of prices centered on pi’?
pi’+h As h → 0,
pi’
pi’-h

Xi ' Xi*
*
%ΔXi pi ' ( Xi "− Xi '" )
ε X* ,p = = × .
i i %Δpi ( Xi "+ Xi '" ) / 2 2h
31
 Point Own-Price Elasticity
What is the own-price elasticity
pi of demand in a very small interval
of prices centered on pi’?
As h → 0,
pi’ pi ' dX*i
ε X* ,p → ×
i i Xi ' dpi

Xi ' Xi*
*
%ΔXi pi ' ( Xi "− Xi '" )
ε X* ,p = = × .
i i %Δpi ( Xi "+ Xi '" ) / 2 2h
32
 Point Own-Price Elasticity
What is the own-price elasticity
pi of demand in a very small interval
of prices centered on pi’?
*
pi ' dXi
ε X* ,p = ×
pi’ i i Xi ' dpi
is the elasticity at the
point ( Xi ', pi ').
Xi ' Xi*

33
 Point Own-Price Elasticity
*
pi dXi
ε X* ,p = * ×
i i Xi dpi

E.g. Suppose pi = a - bXi.

Then Xi = (a-pi)/b and
*
dXi 1
= − . Therefore,
dpi b
pi ⎛ 1⎞ pi
ε X* ,p = × ⎜− ⎟ = − .
i i ( a − pi ) / b ⎝ b⎠ a − pi

34
 Point Own-Price Elasticity
pi pi = a - bXi*

a/b Xi*

35
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a

a/b Xi*

36
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a
p= 0⇒ε =0

a/b Xi*

37
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a
p= 0⇒ε =0

ε=0

a/b Xi*

38
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a a a/2
p= ⇒ε =− = −1
2 a−a/2

ε=0

a/b Xi*

39
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a a a/2
p= ⇒ε =− = −1
2 a−a/2
a/2 ε = −1

ε=0

a/2b a/b Xi*

40
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a a
p=a⇒ε = − = −∞
a−a
a/2 ε = −1

ε=0

a/2b a/b Xi*

41
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a ε = −∞ a
p=a⇒ε = − = −∞
a−a
a/2 ε = −1

ε=0

a/2b a/b Xi*

42
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a ε = −∞
own-price elastic
a/2 ε = −1
own-price inelastic
ε=0

a/2b a/b Xi*

43
 Point Own-Price Elasticity
pi
pi pi = a - bXi* ε X* ,p = −
i i a − pi
a ε = −∞
own-price elastic
a/2 ε = −1 (own-price unit elastic)
own-price inelastic
ε=0

a/2b a/b Xi*

44
 Point Own-Price Elasticity
*
pi dXi
ε X* ,p = * ×
i i Xi dpi

dX*i
E.g. X*i = kpia . Then =a kp a-1
i
dp i
so a
pi a −1 pi
ε X* ,p = × kapi =a = a.
a a
i i kpi pi

45
 Point Own-Price Elasticity
pi * a −2 k
Xi = kpi = kpi =
2
pi

ε = −2 everywhere along
the demand curve.

Xi*

46
 Revenue and Own-Price
Elasticity of Demand
◆  Ifraising a commodity’s price
causes little decrease in quantity
demanded, then sellers’ revenues
rise.
◆  Hence own-price inelastic demand
causes sellers’ revenues to rise as
price rises.

47
 Revenue and Own-Price
Elasticity of Demand
◆  Ifraising a commodity’s price causes
a large decrease in quantity
demanded, then sellers’ revenues
fall.
◆  Hence own-price elastic demand
causes sellers’ revenues to fall as
price rises.

48
 Revenue and Own-Price
Elasticity of Demand
*
Sellers’ revenue is R ( p ) = p × X (p ).

49
 Revenue and Own-Price
Elasticity of Demand
*
Sellers’ revenue is R ( p ) = p × X (p ).
*
dR dX
So = X* (p) + p
dp dp

50
 Revenue and Own-Price
Elasticity of Demand
*
Sellers’ revenue is R ( p ) = p × X (p ).
*
dR dX
So = X* (p) + p
dp dp
⎡ *⎤
* p dX
= X (p )⎢1 + ⎥
*
⎢⎣ X (p ) dp ⎥⎦

51
 Revenue and Own-Price
Elasticity of Demand
*
Sellers’ revenue is R ( p ) = p × X (p ).
*
dR dX
So = X* (p) + p
dp dp
⎡ *⎤
* p dX
= X (p )⎢1 + ⎥
*
⎢⎣ X (p ) dp ⎥⎦

= X* (p)[1 + ε ].

52
 Revenue and Own-Price
Elasticity of Demand
dR
= X* (p)[1 + ε ]
dp

53
 Revenue and Own-Price
Elasticity of Demand
dR
= X* (p)[1 + ε ]
dp
dR
so if ε = −1 then =0
dp

and a change to price does not alter

sellers’ revenue.

54
 Revenue and Own-Price
Elasticity of Demand
dR
= X* (p)[1 + ε ]
dp
dR
but if − 1 < ε ≤ 0 then >0
dp

and a price increase raises sellers’

revenue.

55
 Revenue and Own-Price
Elasticity of Demand
dR
= X* (p)[1 + ε ]
dp
dR
And if ε < −1 then <0
dp

and a price increase reduces sellers’

revenue.

56
 Revenue and Own-Price
Elasticity of Demand
In summary:
Own-price inelastic demand; − 1 < ε ≤ 0
price rise causes rise in sellers’ revenue.
Own-price unit elastic demand; ε = −1
price rise causes no change in sellers’
revenue.
Own-price elastic demand; ε < −1
price rise causes fall in sellers’ revenue.

57
 Marginal Revenue and Own-
Price Elasticity of Demand
◆  Aseller’s marginal revenue is the rate
at which revenue changes with the
number of units sold by the seller.

dR( q)
MR( q) = .
dq

58
 Marginal Revenue and Own-
Price Elasticity of Demand
p(q) denotes the seller’s inverse
demand function; i.e. the price at which
the seller can sell q units. Then
R( q) = p( q) × q
so dR( q) dp( q)
MR( q) = = q + p( q)
dq dq
⎡ q dp( q) ⎤
= p( q) ⎢1 + ⎥ .
⎣ p( q) dq ⎦
59
Marginal Revenue and Own-
Price Elasticity of Demand
⎡ q dp( q) ⎤
MR( q) = p( q) ⎢1 + .
⎣ p( q) dq ⎥⎦

dq p
and ε= ×
dp q
⎡ 1⎤
so MR( q) = p( q) ⎢1 + ⎥ .
⎣ ε⎦

60
 Marginal Revenue and Own-
Price Elasticity of Demand
⎡ 1⎤
MR( q) = p( q) ⎢1 + ⎥ says that the rate
⎣ ε⎦
at which a seller’s revenue changes
with the number of units it sells
depends on the sensitivity of quantity
demanded to price; i.e., upon the
value of the own-price elasticity of
demand.

61
 Marginal Revenue and Own-
Price Elasticity of Demand
⎡ 1⎤
MR(q) = p(q)⎢1 + ⎥
⎣ ε⎦

If ε = −1 then MR( q) = 0.
If − 1 < ε ≤ 0 then MR( q) < 0.
If ε < −1 then MR( q) > 0.

62
 Marginal Revenue and Own-
Price Elasticity of Demand
If ε = −1 then MR( q) = 0. Selling one
more unit does not change the seller’s
revenue.
If − 1 < ε ≤ 0 then MR( q) < 0. Selling one
more unit reduces the seller’s revenue.
If ε < −1 then MR( q) > 0. Selling one
more unit raises the seller’s revenue.

63
 Marginal Revenue and Own-
Price Elasticity of Demand
An example with linear inverse demand.
p( q) = a − bq.

Then R( q) = p( q)q = ( a − bq)q

and MR( q) = a − 2bq.

64
 Marginal Revenue and Own-
Price Elasticity of Demand
p

p( q) = a − bq

a/2b a/b q
MR( q) = a − 2bq

65
 p
Marginal Revenue and Own-
a Price Elasticity of Demand
MR( q) = a − 2bq
p( q) = a − bq

$ a/2b a/b q
R(q)

a/2b a/b q
66