Law of Demand

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3. Law of Demand • Holding all other things constant (ceteris paribus), 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

4. Components of Demand:The Substitution Effect • Assuming that real income is constant: • If the relative price of a good rises, then consumers will try to substitute away from the good. Less will be purchased. • If the relative price of a good falls, then consumers will try to substitute away from other goods. More will be purchased. • The substitution effect is consistent with the law of demand.

5. Components of Demand:The Income Effect • The real value of income is inversely related to the prices of goods. • A change in the real value of income: • will have a direct effect on quantity demanded if a good is normal. • will have an inverse effect on quantity demanded if a good is inferior. • The income effect is consistent with the law of demand only if a good is normal.

6. Individual Consumer’s DemandQdX = f(PX, I, PY, T) QdX = PX = I = PY = T = quantity demanded of commodity X by an individual per time period price per unit of commodity X consumer’s income price of related (substitute or complementary) commodity tastes of the consumer

7. QdX = f(PX, I, PY, T) QdX/PX < 0 QdX/I > 0 if a good is normal QdX/I < 0 if a good is inferior QdX/PY > 0 if X and Y are substitutes QdX/PY < 0 if X and Y are complements

10. Market Demand Curve • Horizontal summation of demand curves of individual consumers • Exceptions to the summation rules • Bandwagon Effect • collective demand causes individual demand • Snob (Veblen) Effect • conspicuous consumption • a product that is expensive, elite, or in short supply is more desirable

12. Market Demand FunctionQDX = f(PX, N, I, PY, T) QDX = PX = N = I = PY = T = quantity demanded of commodity X price per unit of commodity X number of consumers on the market consumer income price of related (substitute or complementary) commodity consumer tastes

13. Demand Curve Faced by a Firm Depends on Market Structure • Market demand curve • Imperfect competition • Firm’s demand curve has a negative slope • Monopoly - same as market demand • Oligopoly • Monopolistic Competition • Perfect Competition • Firm is a price taker • Firm’s demand curve is horizontal

14. Demand Curve Faced by a Firm Depends on the Type of Product • Durable Goods • Provide a stream of services over time • Demand is volatile • Nondurable Goods and Services • Producers’ Goods • Used in the production of other goods • Demand is derived from demand for final goods or services

16. Linear Demand Function QX = a0 + a1PX + a2N + a3I + a4PY + a5T PX Intercept:a0 + a2N + a3I + a4PY + a5T Slope:QX/PX = a1 QX

17. Linear Demand Function Example Part 1 Demand Function for Good X QX = 160 - 10PX + 2N + 0.5I + 2PY + T Demand Curve for Good X Given N = 58, I = 36, PY = 12, T = 112 Q = 430 - 10P

18. Linear Demand Function Example Part 2 Inverse Demand Curve P = 43 – 0.1Q Total and Marginal Revenue Functions TR = 43Q – 0.1Q2 MR = 43 – 0.2Q

23. Price Elasticity of Demand Point Definition Linear Function

24. Price Elasticity of Demand Arc Definition

25. Marginal Revenue and Price Elasticity of Demand

26. Marginal Revenue and Price Elasticity of Demand PX QX MRX

27. MR>0 MR<0 MR=0 Marginal Revenue, Total Revenue, and Price Elasticity TR QX

28. Determinants of Price Elasticity of Demand The demand for a commodity will be more price elastic if: • It has more close substitutes • It is more narrowly defined • More time is available for buyers to adjust to a price change

29. Determinants of Price Elasticity of Demand The demand for a commodity will be less price elastic if: • It has fewer substitutes • It is more broadly defined • Less time is available for buyers to adjust to a price change

31. Income Elasticity of Demand Point Definition Linear Function

32. Income Elasticity of Demand Arc Definition Normal Good Inferior Good

34. Cross-Price Elasticity of Demand Point Definition Linear Function

35. Cross-Price Elasticity of Demand Arc Definition Substitutes Complements

37. Example: Using Elasticities inManagerial Decision Making A firm with the demand function defined below expects a 5% increase in income (M) during the coming year. If the firm cannot change its rate of production, what price should it charge? • Demand: Q = – 3P + 100M • P = Current Real Price = 1,000 • M = Current Income = 40

38. Solution • Elasticities • Q = Current rate of production = 1,000 • P = Price = - 3(1,000/1,000) = - 3 • I = Income = 100(40/1,000) = 4 • Price • %ΔQ = - 3%ΔP + 4%ΔI • 0 = -3%ΔP+ (4)(5) so %ΔP = 20/3 = 6.67% • P = (1 + 0.0667)(1,000) = 1,066.67

40. Other Factors Related to Demand Theory • International Convergence of Tastes • Globalization of Markets • Influence of International Preferences on Market Demand • Growth of Electronic Commerce • Cost of Sales • Supply Chains and Logistics • Customer Relationship Management

42. Chapter 3 Appendix

43. Indifference Curves • Utility Function: U = U(QX,QY) • Marginal Utility > 0 • MUX = ∂U/∂QX and MUY = ∂U/∂QY • Second Derivatives • ∂MUX/∂QX < 0 and ∂MUY/∂QY < 0 • ∂MUX/∂QY and ∂MUY/∂QX • Positive for complements • Negative for substitutes

44. Marginal Rate of Substitution • Rate at which one good can be substituted for another while holding utility constant • Slope of an indifference curve • dQY/dQX = -MUX/MUY

46. QY QY QX QX Indifference Curves:Complements and Substitutes Perfect Complements Perfect Substitutes

47. The Budget Line • Budget = M = PXQX + PYQY • Slope of the budget line • QY = M/PY - (PX/PY)QX • dQY/dQX = - PX/PY

48. Budget Lines: Change in Price GF: M = $6, PX = PY = $1 GF’: PX = $2 GF’’: PX = $0.67

50. Budget Lines: Change in Income GF: M = $6, PX = PY = $1 GF’: M = $3, PX = PY = $1