FMG 24: Theory Of Demand

Managerial Economics
Dr. Subhasis Bera

What is Demand?
The amount of a particular goods or services that a consumer is willing to buy at a
particular price during a specified period under a given set of economic conditions is
called demand.
Demand of a product depends on numbers of variables known as determinants of
demand and demand function is expressed as
Quantity of Product X demanded = Qx
= f (Price of X, Prices of Related Goods, Expectations of Price Changes,
Consumer Incomes, Demanded Tastes and Preferences, Advertising Expenditures, and
so on)
Mathematically we can express this function as Qx f Px , Py ,..., I ,..., T , A,..

Changes in demand is sensitive to the change of any one these variable.

A good Manager needs to have clear idea about the sensitivity of demand

Measures of Sensitivity of Demand

Changes in the demand leads to a change in the total revenue as TR=P.Q
Therefore managerial decision regarding entering into a market or setting up price will be
based on the comparison of the sensitivity of demand among various markets.
In a market, as a result of change in P, there will be a change in Q depending on the slope
of demand curve. Therefore a manager can a take a decision on the basis of the slope of
demand curve.

However units of measurement are different in different market.

How a Manager will compare sensitivity of demand in two different market?

Elasticity of Demand
Now it is important to know how demand changes as a result of change in the determinants
of price to understand the change in Total Revenue (TR). Other than slope of the demand
curve, Elasticity concept can help in this regard. Elasticity is a unit free measurement
therefore can be utilised to compare sensitivity of demand in two different market. This
helps a manager can understand how many extra unit he can sell due to a change in price.
There are three types of elasticity
1. Own price elasticity
2. Cross price elasticity
3. Income elasticity
There are two ways to measure the elasticity
1. Point elasticity
2. Arc elasticity

Point Elasticity
The point elasticity concept is used to measure the effect on a dependent variable Y of a
very small or marginal change in an independent variable X.
Although the point elasticity concept can often give accurate estimates of the effect on Y of
very small (say, less than 5 percent) changes in X, it is not used to measure the effect on Y
of large-scale changes, because elasticity typically varies at different points along a
function.

Price Elasticity of Demand

Changes in the quantity demanded due to one percent change in the price of the same
commodity is known as Price elasticity.

Price elasticity of X = Px =

Px

Px

percenatge change in the quantity demanded for X

percentage change in the price of X

Qx

Q
x

Px

P
x

.100

.100

Px Qx

p
Q
x x

if E < 0, goods are Normal or Inferior

Income Elasticity of Demand

Changes in the quantity demanded due to one percent change in the Income of the
consumer is known as Income elasticity.

percenatge change in the quantity demanded for X

Income elasticity of X = Mx =
Percentage change in the income of the consumer
Mx

Qx

Q
x

M Q

x
Yx

When good X is a normal good, an increase in income leads to an increase in the

consumption of X. Thus, when X is a normal good then Mx 0
When X is an inferior good , an increase in income leads to a decrease in the consumption
of X. Thus, when X is an inferior good then Mx 0

Income Elasticity of Demand: Demonstration Problem

Problem 1: Your firms research department has estimated the income elasticity of
demand for FMCG product to be - 1.94. You have just read in The Wall Street Journal that
due to an upturn in the economy, consumer incomes are expected to rise by 10 percent
over the next three years. As a manager of a FMCG company, how will this forecast affect
on purchases of FMCG product?
Solution: here Mx 1.94
And
M 10
Now putting these value in the income elasticity formula we get
% change in quantity demanded
10
Solving this equation for yields Qx 19.4
1.94

Since FMCG product has an income elasticity of -1.94 and consumer income is expected
to rise by 10 percent, you can expect to sell 19.4 percent less FMCG product over the next
three years.
Therefore, you should decrease of FMCG product by 19.4 percent, unless something else
changes.

Cross Price Elasticity of Demand

Changes in the quantity demanded for the commodity X due to one percent change in the
price of the commodity Y is known as Cross Price elasticity.
percenatge change in the quantity demanded for X
Cross Price elasticity of X = xy =
Percentage change in the price of Y

If call rate goes up people will

buy less number of Mobile
Handset
(in case of Complementary)

xy

xy

Qx

Q
x

Py

Py

Py Qx

p
x y

If price of iphone goes up

people will buy more number of
Samsung Mobile Handset
(in case of Substitute goods)

Point Elasticity: Limitation

Our demand function is Q = 8,500 5,000P + 3,500PV + 150 I + 1,000A
When P = $7, PV = $3, and I = $40,000 and A = $20,
Then demand Q = 10,000
In the above equation

Q
5000
P

and

Q
1000
A

Therefore point elasticity = A = point advertising elasticity

percentage change in quantity demanded

percentage change in advertising expenditure

A q
x
qx A

20

1000 2
10000

i.e., 1 per cent change in advertising will result in a 2 per cent change in demand.

Point Elasticity: Limitation- continuation

Now assume that advertising expenditure increases from $20 to $50 (i.e., A = 30) and demand
increases by 30,000(i.e., =qx ) ( i.e., total demand is now (10,000 + 30,000 = 40,000)
Therefore advertising elasticity

A q
x
qx A

20 30000

2
10000 30

Now if we move in the opposite direction i.e., there is a decrease in the advertising expenditure
then advertising elasticity
A qx
50 30000

1.25

40000 30
qx A
The indicated elasticity A = 1.25 is now quite different. This problem occurs because elasticities are
not typically constant but vary at different points along a given demand function.
To overcome the problem of changing elasticity along a demand function, the arc elasticity formula
was developed to calculate an average elasticity for incremental as opposed to marginal changes.

Arc Elasticity
To overcome the problem of changing elasticities along a demand function, the arc
elasticity formula was developed to calculate an average elasticity for incremental as
opposed to marginal changes.
Arc elasticity measures the average elasticity over a given range of a function.
Change in q
Arc elasticity is measured as
Average q

Change in P
Average P
P

p2

Demand
Curve

p1
q1

q2

q 2 - q1

q2 q1 /2 q P2 P1

P2 - P1

P q2 q1

P
/2

2
1

Elasticity and Total Revenue

Changes in the price changes the demand hence the total revenue.

Decision to change price to change total revenue

will depend on elasticity of demand

Relation between Elasticity and Total Revenue

As a result of change in Price P, quantity demanded Q change. Therefore, the Total
Revenue = TR =P.Q also change

Px

Loss In
Revenue

Px

D1

P1
P2

Gain In
Revenue

D2

P1

P2

B
D2

D1
Q1 Q2

Qx

Q1

Q2

Qx

Here D2D2 is more elastic than the demand curve D1D1

Relation Between Elasticity and Total Revenue: Mathematical

TR pq
Therefore, MR

d (TR)
dp
p q.
dq
dq

d (TR)
0
dq

Now if

dp
then p q. 0
dq

q dp

Therefore when |e| > 1 TR increases as a result of

decrease in the price
Similarly we can prove that when |e| < 1 then TR
decreases as a result of decrease in the price.
When |e| = 1 then TR remain unchanged

Or, p 1 . 0
p dq

Or,

q dp
1 . 0
p dq

1
Or, 1 0
e

1
1
Or,
e

1
1
e

e 1

Relation between AR, MR and Elasticity

AR

TR p.q

p
q
q

q dp
MR p 1

p dq

1
1
MR p 1 AR 1
e
e

With the help of elasticity producer can determine the profit max price of his product
provided that he has price elasticity data and marginal cost.
Although there is no unanimous agreement but still price elasticity information is useful for
policy formulation especially in the case of energy sectors.

Determinants of Elasticity of Demand

Responsiveness of a demand for a product, as a result of change in price, changes
depending on the following factors
The number of close substitute of the product

The cost of switching between the products

The degree of necessity

Nature of demand ( whether subject to
habitual consumption)

4
5

Peak and off peak demand

Application of Elasticity of Demand

Elasticity is a unit free measurement.
Concept of elasticity is very important in economic analysis especially when one wants
to compare the changes in the demand or supply in various market.
Price elasticity of demand affects a business's ability to increase the price of a product.
Elastic goods are more sensitive to increases in price, while inelastic goods are less
sensitive.
Assuming that there are no costs in producing the product, businesses would simply
increase the price of a product until demand falls. Things become more complicated,
however, after introducing costs.
Since the main profits of a company come from products in higher demand, it is
important to understand the changes in demand due to change in the price of the
product.

If Price falls Total

Revenue Increases
It is Advisable to
reduce price to
generate more
revenue

As Price increases
Total Revenue
Increases.
If Price falls Total
Revenue Falls
It is Advisable to
increase price to
generate more
revenue
The Government
The Business Sector
Input Price

Unit Price Elastic

As Price increases
Total Revenue Falls.

Price Inelastic

Price Elastic

Application of Elasticity of Demand

As Price increases
Total Revenue
remain Unchanged.
If Price falls Total
Revenue Remain
Unchanged
It is Advisable not to
change price

Application of Elasticity of Demand: Optimum Price

Firms use price discounts, specials, coupons, and rebate programs to measure the price
sensitivity of demand for their products. Armed with such knowledge, and detailed unit
cost information, firms have all the tools necessary for setting optimal prices.
The relation between marginal revenue, price, and the point price elasticity of demand
follows directly from the mathematical definition of a marginal relation. In equation below,
the link between marginal revenue, price, and the point price elasticity of demand is
1
MR p 1
e
Now if e < 1 then MR > P and the gap between MR and P will fall as |e| increases.
Now since MR = MC from the profit maximization condition, we can write the above
1
equation as
MC p 1

Therefore optimal profit making price will be

P*

MC

1
1

Time Effect on the Elasticity of Demand

People may not react to the price change quickly. There may be some other demand
factors that customer will consider before considering the change in price.

But in the long run demand is more elastic since customers adjust their demand
accordingly.

Demand Curve Estimation

Suppose Delhi Dare Devils offered Rs. 200 off the Rs. 1200 regular price of reserved
seats and sales spurted from 3200 to 4000 seats per game.
Now demand curve is P = a + b Q
Here 3200 seats were sold at a regular price of Rs. 1200 per game and 4000 seats were
sold at the discount price of Rs. 1000.
This indicates that two points on the teams linear demand curve are identified.
Now we have 1200 = a + b. 3200
And
1000 = a +b. 4000
Subtracting 2 from 1 we get 200 = - b. 800
Or, b = - 0.25
Now substitute b in 1 or in 2 and get 1200 = a + (-0.25) 3200
Or, a =1200+ 800 = 2000
Therefore demand curve is P = 2000 + (-0.25).Q

Problems of Estimation of Demand

Demand is more dynamic than an economic analysis can capture in linear demand
analysis. There are numbers of factor that change at much faster speed than the process of
adjustment conducted by the clients.

Researcher/ Manager has to do a survey to collect

qualitative as well as quantitative information for
estimating Demand.

Estimation of Demand : Sample Questionnaire Idea

Question 1

Question 2

Question 3

Question 4

Question 5

Would you pay a

medium increase
in price?
What is your
Monthly
Income?

What Price
Currently do
you Pay?

What is the highest

Price you would
like to pay?

What would you do

if the Price is too
high?

Would you pay a

Higher increase in
price?

Respondent must understand the purpose of the study

Estimation of Demand : Market Experiment

There are various ways of doing market experiment.
In some select cities firm may change the price and observe the change in demand to
estimate relation between p and Q.
Company can give some money to customer and ask
them to shop in a simulated shop to understand their
preference pattern.
One major problem with this direct approach that
consumer knows that he/she is being monitored hence
will not reveal his/her true preference.
Another problem is that in this method sample error is
much higher than survey method.

Estimation of Demand
Sometime it is difficult to estimate demand accurately as there are interplay between
demand and supply.
Change in Price may not be an indication of changes in demand alone. Changes in the
supply also have effect on the price and therefore it is difficult to have relation between P
and Qd while other assumption holds.
Since there are other unobservable variables those have impact on the demand, we need
to take into account of all these variable to estimate demand more accurately. Regression
analysis is one method with which we can include them in our model using a term called
disturbance- term.
We use regression method to estimate the demand. We have to estimate the parameter in
such a way so that sum of the square of the error will be minimum.
Demand specifications can be of various types.
1) Linear
2) Multiplicative Q 1P P A A I I
3) Log model. It can be semilog or log log.
After specification of the model i.e., identifying the variables we need to use a method to
estimate the parameters. Most common method is OLS method.

How to do Regression in MS Excel 2007

How to do Regression in MS Excel 2007

How to do Regression in MS Excel 2007

How to do Regression in MS Excel 2007: Interpretation of the result

SUMMARY OUTPUT
Regression Statistics
Multiple R

0.8301

R Square

0.689

Adjusted R Square

0.6393

Standard Error

1.7183

Observations

30

ANOVA
df

SS

MS

Significance F

Regression

163.55237

40.888094

13.84829
8

4.384E-06

Residual

25

73.814293

2.9525717

Total

29

237.36667

Coefficients

Standard
Error

t Stat

P-value

Lower 95%

Upper 95%

Lower 95.0%

Upper 95.0%

Intercept
X Variable 1

27.261
-0.0834

3.4103023

7.9936982

20.237279

34.284577

20.237279

34.28457688

0.0186916

-4.4612825

2.384E-08
0.0001506

-0.1218848

-0.0448925

-0.1218848

-0.044892537

X Variable 2

0.0038

0.0116303

0.3249293

0.7479381

-0.020174

0.027732

-0.020174

0.027731974

X Variable 3

-0.0732

0.0200602

-3.6468858

0.0012194

-0.1144722

-0.0318426

-0.1144722

-0.031842565

X Variable 4

-0.276

0.9132764

-0.3021558

0.7650328

-2.1568796

1.6049761

-2.1568796

1.604976133

Interpretation of The Result

In the table above first we need to look at the sign of the coefficient and then to P values. If
p values are less than 0.005 than we can say that the values of the estimates are significant
and we can rely on the coefficient.
Once we find that coefficients are significant we can say look at the values of the
coefficient to conclude about the relationship between explanatory and dependent
variable. In general, in case of linear model, coefficient represents the elasticity.
Therefore from the value we can say about the change in demand due to a change in the
explanatory.

Statistical Evaluation of Regression Results: t test

The regression result mentioned above are based on a sample across the country which
may not be a true representation of the population. The basic test of the statistical
significance of each estimated regression coefficient is called t-test. To test this we need to
calculate the t statistics.
Where,

b
S.E. of b

After calculating the t-statistics we compare the value with the t-table. Conventionally, we
select 0.05 level of significance i.e., we can be 95 per cent confident that results obtained
from sample are representative of the population.

Statistical Evaluation of Regression Results: F test

Another test is called F-test which is often used in conjunction with R2. Instead of testing
the significance of each coefficient, this test is applied to test the overall significance of the
regression equation. Therefore F-test measures the significance of the R2. To test this we
need to calculate the F-statistics
R2
explained variation/(k-1)
(k 1)
Fk 1,n k

R2
Unexplained Variation /(n-k)
1
(n k )
As a rule of thumb, a calculated F statistics greater than 3 permits rejection of the
hypothesis that there is no relation between the dependent and explanatory variables at
0.05 per cent level of significance.

Estimation of Demand Curve using a sample Data

Now you need to estimate demand function

using a sample data from Claroline and
explain each of the coefficient.

Thank You!

Use of Elasticity of Demand: The Government

The concept of elasticity demand is of great use to the government in formulating
its revenue-collecting and welfare policies.
while levying and collecting taxes, the government has to keep in mind the
response of the market.
For example, basic necessities of life have a very low elasticity of demand and the
government, by taxing them, can collect a large amount of tax revenue without
reducing their demand by the consumers. However, while taxing such goods, it has
also to think of the fact that this may lead to an undue burden upon the consumers.
They may reduce their consumption of some other (non-taxed or taxed at lower
rates) goods which happen to be health giving and nutritious, such as milk, cereals
and vegetables. However, if the good in question is considered a harmful one and
has an elastic demand, then the government can deliberately levy a huge tax on it
with the objective of reducing its consumption.

Use of Elasticity of Demand: The Business Sector

When a firm changes Px, its total revenue changes both on account of the change in
Px and the resultant change in Dx. Therefore, a firm finds that while determining
the price of its product, it should take into account its elasticity of demand as well.
Business firms also realize that they can charge higher prices with a limited
reduction in demand only in the short run. If faced with persistent high price, the
consumers shift their demand to lower priced substitutes in the long run.

Use of Elasticity of Demand: Input Market

With an objective of profit maximization a firm also needs to consider the input price. i.e.,
the respective elasticities of demand for the productive resources.
If price elasticity of input is higher then the price of the product produced by the firm will
also be sensitive enough. However how much a firm can charge that will again depend on
the price elasticity of demand of the product.