lect. 2, chapter 2, demand

7/28/2019 Lect. 2, Chapter 2, Demand

1/38

Managerial Economics Oxford University Press, 2006 All rights reserved

Chapter 2

Demand


2/38

Major Divisions of Economics

Consumption: Optimizing unlimited human

wants, limited means with alternative uses

and consequent priced goods and services.

Production: Meaning creation of values to

satisfy consumption and growth needs

Exchange: Money is the medium ofexchange,

DistributionManagerial Economics OxfordUniversity Press, 2006

All rights reserved


3/38


Demand

Consumption results in demands of all sorts

Demand: meaning: desire backed by willingness

and ability to pay for a commodity/service. Compliments and substitute goods:

Compliments have to be used together: car and

petrol Substitutes: When one can replace the other:

tea/coffee or wheat and riceQx

Px


4/38


Demand schedule and graphs

Individual demand schedule: table

Market demand schedule: table

Demand curve: linear

Effect on demand of changes in its own price

results in movement alongthe demand curve.

Effect on demand of changes in other factorsresults inshifts in demand curve


5/38

The law of demand

States the relationship between price and

quantity demanded of the same good. This

relationship is mostly inverse. Thus the lawof demand states that demand for a good or

service is inversely related to its price

subject to the condition other thingsremaining the same These other things are

income, prices of other goods, tastes and

preferences( Ceteris peribus).Managerial Economics OxfordUniversity Press, 2006

All rights reserved


6/38


Why is demand curve negatively sloped?

1. when price falls, commodity becomes

relatively cheaper than its substitutes: this is

called substitution effect 2. When price falls, real income rises, so

consumer may buy more of it with the same

amount as before: income effect

3. The total effect of a price change equals

income plus substitution effects


7/38

Exceptions to the law of demand

Managerial Economics OxfordUniversity Press, 2006

All rights reserved

1.When prices are expected to rise in

future.

2. Absolute necessities: when their price

goes up, poor consumers may buy more

even at the higher prices. This happens

because these necessities even at higherprices remain the cheapest sources of their

consumption, rather survival.


8/38

Exceptions to the law

Such goods are known by Giffen Goods.

The poor consumers buy more of these by

giving up the consumption of superior

goods as prices of absolute necessities

increase.

Sir Robert Giffen (1837-1910) used incomeand substitution effects to explain this

phenomenon.


All rights reserved


9/38

Giffen Goods..

1. If the negative income effect works

against the substitution effects and

outweighs it, we would have a positiverelationship between Px and Qx.Income

effect is negative when a consumer buys

less of a commodity when his real incomegoes up.

2. If real income falls, he may buyanagerial Economics Oxford

University Press, 2006 All rights reserved


10/38

Giffen goods

more quantity of the good whose price goes

up.

Giffen goods are those where the combined

effect of substitution and income effects

results in a positive relationship between

PX and Qx.


All rights reserved


11/38


Giffen good

Income effect

Price effect +

Substitution effect

Substitution effect is inversely related to price.

Income effect can be inversely related to

changes in incomeInferior Good Income effect can be positively related to

income-Superior good


12/38


Giffen Goods

If income effect of a price increase is inverse

and large enough to offset the substitutioneffect, then it is a Giffen Good

The Demand curve for Giffen Good will have apositive slope


13/38

Shifts in demand

When the price of a commodity changes,

other things remain constant, the

relationship between price and quantitydemanded happens on the same demand

curve. This gives us extension/contraction

of demand. When other things like income change,

demand curve shifts up or down and we

have increase and decrease in demand.Managerial Economics OxfordUniversity Press, 2006All rights reserved


14/38


Slope and Elasticity of Demand

Slope can not be standard measure of

elasticity as this measure is sensitive to

unit of measurement.

Proportionate change: proportionate

change in quantity demanded to a

proportionate change inprice/income/other price is the exact

measure and independent of units

choosen.


15/38


Elasticity

Pe Greater than1 (ignoringsign): Elastic

Pe Equal to 1 (ignoringsign) : Unit Elastic

Pe Less than 1 ( ignoringsign): Inelastic

Price Elasticity and Expenditure:

- Pe less than 1 a fall in price lower exp

- Pe equal to 1 a fall in price exp.constant

- Pe greater than 1 a fall in price higher exp


16/38


Elasticity

Income Elasticity

Qx/I * I/Qx

Could be negative or positive:

Negative for Inferior goods

Positive for Superior goods


17/38


Elasticity

Cross Price Elasticity:

Qx/Py * Py/Qx

Could be negative or positive

- Negative for complements

- Positive for substitutes


18/38


Point and arc elasticity

Point Elasticity: when price change is very small.

Arc Elasticity: when price change is large enough.

Price Elasticity measurements:

i) Proportionate method: Q/ P x P/Q

Examples: if demand function is Q =30 -5P + P2

Marginal function Q/ P = -5+ 2P and averagefunction, or Q/P = (30 -5P + P2)/ P


19/38


Elasticity of demand

Now ed = Q/ P x P/Q, so it equals

Marginal function/average function, or

Ed= (-5 +2P) x P/( 30 -5P + P2)

If P = Rs. 5, ed = (-5 + 10) x 5/( 3010 +

25) = 50/45 = 1.1,

Find ed when P = Rs.3/2, Rs 10


20/38


Demand schedule

Price Rs. Quantity demanded

6 50

5 72

4 112.5

3 200

2 450


21/38


Elasticity .

The interesting feature of this type of

demand function is that price elasticity of

demand is constant and is equal to to theexponent of P.

Let P = 3, ed = P/Q> dQ/dP = 3/200X

3600/27 = -2, Let P = 2, ed = 2/450X -3600/8 = -2


22/38


Elasticity

If Q = 20/(P + 1), find elasticity with

respect to price.

Now dQ/dP = -20( P +1)-2,

Ed = P/Q. dQ/dP = P/Q X -20P/ Q( P + 1)2

= -20P/20/(P + 1)( P + 1)2 = -P/( P + 1)

If, P = 5, ed = -5/6 = .833


23/38


Income elasticity

Q. If income increases from Rs. 80,000 toRs. 81000, the quantity demanded of good

Q1 increases from 3000 to 3050, findincome elasticity of demand.

Given a small change in income, we usepoint elasticity method, therefore

Ed (income) = I/Q1XdQ1/dI=(80000/3000) X 50/1000 = 1.33


24/38


Cross price elasticity of demand

The price of desktop computers declines from

Rs.50,000 to rs.25,000, sale of printers goes up

from 50 to 150 per month: Ed (cross price) = dQx/dPy x Py/Qx, Since the the

change is large, we use arc elasticity measure, so

Qx = (50 + 150)/2 = 100,

Py = (50000 + 25000)/2 = 37500, dQx = 100, and

dPy = 25000, Ed = 100/25000(37500/100) = - 1.5


25/38


Elasticity

If price elasticity of petrol is 0.5, how much

of price increase would be required to

reduce consumption by 10%? Ed = (dQ/Q)/ dP/P= 0.5

Now dQ/Q = 10% = 0.1, so dP/P = .1/.5= .2

or 20%


26/38


Elasticity of demand

Elasticity of demand can also be expressed

as: ed = Marginal quantity demanded

divided by Average quantity demanded=Q/ P divided by Q/P,


27/38


Determinants of price elasticity

Availability of substitutes: Cases of closesubstitutes like cold drinks and no substitutes likesalt

Number of uses for a commodity: greater usesleads to greater elasticity like for electricity, whenrestricted uses like for wheat demand is relativelyinelastic

Relative importance of a commodity in totalexpenditure of a consumer: Salt/ match box casesvs cloth/ readymade garments. Consider theimpact of doubling of their prices on total demandof consumer


28/38


Determinants of elasticity continued

Nature of the need being satisfied by a

commodity, like necessities, comforts, luxuries

Time allowed for adjustment to price change, thelonger the time period

greater the elasticity and vice versa

* Habits tend to make demand inelastic

* Joint demand like for machine oil and machines

makes demand relatively inelastic


29/38


Determinants of elasticity continued

Nature of the need being satisfied by a

commodity, like necessities, comforts, luxuries

Time allowed for adjustment to price change, thelonger the time period

greater the elasticity and vice versa

* Habits tend to make demand inelastic

* Joint demand like for machine oil and machines

makes demand relatively inelastic


30/38


Distinctive types of elasticity

Industry elasticity:

Refers to the change in total industry sales

with a change in the general level of pricesfor the industry as a whole. The industry

demand has elasticity with respect to

competition from other industries.


31/38


Distinctive types of el

Market share elasticity:

Relates the change in companys share of

industry-wide sales to the price differentialbetween the companys price and industry-

wise price level.

Expectations elasticity:

Refers to responsiveness of sales to buyers


32/38


Distinctive types.

guesses about the values of demand determinants, such asthe future price of a commodity or of its substitutes, futureincomes of buyers, prospects of easy availability or

otherwise in the future, or future promotional outlays.

Interest rate elasticity and demand for consumersdurables:

In USA elasticity of interest rates to housing demand isestimates at .15 which means a ten per cent increase ininterest rates would result in 1.5% change in housingdemand.


33/38


Engles Law of Consumption

Dr. Engle was a German statistician.

He made a study of family budgets around themiddle of the nineteenth century

He arrived at the following major conclusions:

i) As income increases the percentage expenditureon food decreases and vice versa

ii) The percentage expenditure on clothing, etc.remains more or less constant at all levels ofincome


34/38


Engles

iii) The percentage expenditure on fuel, light,

rent, etc. also remains practically the same

at all levels of income.iv) However, the percentage expenditure on

what may be called comforts and luxuries

of life increases with increase in incomeand vice versa.


35/38


Propensity to consume and save

concepts These are macro-economic concepts.

The propensity to consume refers to theproportion of income consumed

Average propensity to consume refers to economyas a whole, say like C/I

Marginal propensity to consume refers to the

proportion of change in consumption toproportion of change in income, say, C/ Iincome to


36/38


Propensity to save and consume..

The propensity to save is reverse of

propensity to consume.

The concepts, especially marginalpropensity to consume and save, exercise

considerable influence on the growth

performance of an economy


37/38


Propensity continued

A higher marginal propensity to consume

leads to faster economic growth through its

multiplier effects, unless there existbottlenecks on the supply side like in the

developing world

The propensity to consume declines asincomes keep on increasing


38/38

Managerial Economics Oxford University Press, 2006

Hyperbolic demand functions

Q = ap-n or Q = a/Pn where a and n are

constants,

Suppose a = 1800 and n = 2, demand funct

Q = 1800/P2 = 1800x p-2 , the resulting demandschedule at different prices can be as follows:

lect. 2, chapter 2, demand

Documents