Managerial Economics in a

Global Economy

Chapter 3
Demand Theory
Ghazi Homsi
 Types of Demand (1)

• Demand by individual consumer

Amount of good or service an individual is
willing to purchase during a specific time
period.

• Market demand
Sum of demands by individual consumers
for a good or service
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 Types of Demand (2)

• Demand facing a producer

Demand for a good or service produced by
an individual firm.

• Demand for inputs

Derived demand by firms for inputs to be
used in the production of a firm’s output.

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 Representation of Demand (1)

1. Demand SCHEDULE Price Quantity

65 0
Tabular representation of a 60 100
relation between QUANTITY
50 300
and PRICE.
40 500
Example  30 700
20 900
10 1100
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 Representation of Demand (2)
P
2. Demand
CURVE

______________________________________
Quantity
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 Representation of Demand (3)
3. Demand Function

Q = 1300 – 20 P  Draws as a negatively

sloped straight line with:

Vertical intercept of ?
Horizontal intercept of ?
Slope of ?
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 Law of Demand

• 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

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Individual Consumer Demand (1)

Qdx = a + b Px + c I + d Py + e T
Qdx = quantity demanded of commodity X by
an individual per time period

PX = price per unit of commodity X

consumer’s income
I=
price of related (substitute or
PY =
complementary) commodity
tastes of the consumer
T=
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 Individual Consumer Demand (2)

Generalized demand function indicates that all

variables Px, I, Py, and T contained in the relation

Qx = a + b P x + c I + d P y + e T

Operate JOINTLY to determine quantity

demanded. Isolating the effect of a single variable
requires that all other variables affecting Qx be
held constant.
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 Individual Consumer Demand (3)

Coefficients b, c, d, and e measure the response

of Qd to each of the separate determinants.

Quantitative estimation of demand functions

involves using data to estimate values for the
coefficients in order to make inferences about
amounts demanded of good X at specified levels
of Px, I, Py, and T.
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 Individual Consumer Demand (4)
Interpretation of coefficients b, c, and d

• b = QdX/PX < 0
• c = QdX/I > 0 if a good is normal
• c = QdX/I < 0 if a good is inferior
• d = QdX/PY > 0 if X and Y are
substitutes
• d = QdX/PY < 0 if X and Y are
complements
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Individual Consumer Demand (5)

• Movement along same demand curve:

Change in QUANTITY corresponding to a
change in the OWN PRICE

• Shift in entire demand curve:

Movement in entire curve corresponding to
a change in other determinants (Income,
Prices of other goods, Tastes)
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 Market Demand (1)

• Function: Sum of functions of individual

consumers

• Curve: Horizontal summation of demand

curves of individual consumers

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 Market Demand (2)
Horizontal summation of demands by different individuals

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 Demand Faced by a Firm

• Market Structure
– Monopoly
– Oligopoly
– Monopolistic Competition
– Perfect Competition
• Type of Good
– Durable Goods
– Nondurable Goods
– Producers’ Goods - Derived Demand
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Own Price Elasticity of Demand (1)

1. Point elasticity

Q / Q Q P
EP   
P / P P Q

P
If using Linear Function EP  a1 
Q

Difference between Elasticity and Slope

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Own Price Elasticity of Demand (2)

2. Arc elasticity

Q2  Q1 P2  P1
EP  
P2  P1 Q2  Q1

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 Own-Price Elasticity of Demand (3)
Relation between Elasticity and Total Revenue
• When Ep > 1 P TR

• When Ep < 1 P TR

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 Own Price Elasticity of Demand (4)
Relation between Elasticity and Marginal Revenue
 1 
MR  P  1  
 EP 

PROOF:

TR = P x Q;
∂TR/ ∂ Q = P ∂ Q/ ∂ Q + Q ∂ P/ ∂ Q =
P (1 + Q/P x ∂ P/ ∂ Q)
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 Own Price Elasticity of Demand (5)

Elasticity changes along same demand curve

PX
EP  1
EP  1

EP  1

QX
MRX 20
Own Price Elasticity of Demand (6)
Elasticity, TR, and MR

TR MR>0 MR<0
EP  1 EP  1

QX
EP  1 MR=0
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 Own-Price Elasticity of Demand (7)
Elasticity differences between different demand
curves:
1. Perfectly inelastic curves
2. Inelastic curves
3. Elastic curves
4. Perfectly elastic curves

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 Own Price Elasticity of Demand (8)
Demand for a commodity will be more elastic if:
• It has many close substitutes
• It is narrowly defined
• More time is available to adjust to change in P
Questions:
1. Would Ep be higher for Chevrolets or for all automobiles?
2. Would Ep for residential consumption of electricity be higher
or lower than for industrial consumption?
3. Would Ep for all electricity consumption be higher or lower in
long-run than in short-run?

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 Income Elasticity of Demand (1)

1. Point Definition

Q / Q Q I
EI   
I / I I Q

I
If Linear Function EI  a3 
Q

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 Income Elasticity of Demand (2)

2. Arc Definition

Q2  Q1 I 2  I1
EI  
I 2  I1 Q2  Q1

Normal Good Inferior Good

EI  0 EI  0

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 Income Elasticity of Demand (3)

For most commodities, income elasticity > 0

Most goods are normal goods.

When Income elasticity is < 1, a good may

be referred as a necessary good.

When Income elasticity is > 1, a good may

be referred to as a luxury good.
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 Income Elasticity of Demand (4)
Question:

Agricultural commodities are known to have

price-inelastic demand and to be necessities in
consumption. How can this information allow us
to explain why the income of farmers (a) falls
after a good harvest?, and (b) in relation to
income in other sectors of the economy?

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Cross-Price Elasticity of Demand (1)

1. Point Definition
QX / QX QX PY
E XY   
PY / PY PY QX

If Linear Function PY
E XY  a4 
QX

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Cross-Price Elasticity of Demand (2)

2. Arc Definition

QX 2  QX 1 PY 2  PY 1
E XY  
PY 2  PY 1 QX 2  QX 1

Substitutes Complements
E XY  0 E XY  0

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