Contents

Chapter Two
1. The concept of demand;
2. Estimating the demand function;
3. Elasticity of demand and price decision; and
4. The consumers’ preference and demand
 Introduction
 This chapter describes mainly demand, which are the driving
forces behind the market economies that exist in Ethiopia and
around the globe.
 Supply and demand analysis is a tool that managers can use to
visualize the “big picture”, though our emphasis demand
analysis.
 Many companies fail because their managers get bogged down
in the day-to-day decisions of the business without having a
clear picture of market trends and changes that are on the
 DEMAND
What is Demand?
 Demand for a commodity refers to the quantity of the
commodity that people are willing to purchase at a
specific price per unit of time, other factors (such as price
of related goods, income, tastes and preferences,
advertising, etc) being constant.
 Demand for a commodity by all individuals/households in
the market in total constitute market demand.
 Demand …
 Suppose a clothing manufacturer desires information
about the impact of its pricing decisions on the demand
for its jeans in a small foreign market.
 To obtain this information, it might engage in market
research to determine how many pairs of jeans
consumers would purchase each year at alternative
prices per unit.
 The numbers from such a market survey would look
something like those in Table bellow.
The Demand Schedule for Jeans in a Small Foreign Market
Demand …
 The market research reveals that if jeans were priced at $10 per
pair, 60,000 pairs of jeans would be sold per year; at $30 per
pair, 20,000 pairs of jeans would be sold annually.
 The above table indicate that, holding all other things constant, the
quantity of jeans consumers are willing and able to purchase goes
down as the price rises.
 This fundamental economic principle is known as the law of demand:
Price and quantity demanded are inversely related. That is, as the
price of a good rises (falls) and all other things remain constant, the
quantity demanded of the good falls (rises).
 The Demand Curve
 Figure at the side plots the
data in Table given above.
The straight line, called the
market demand curve,
interpolates the quantities
consumers would be willing
and able to purchase at
prices not explicitly dealt
with in the market research.
 Demand Shifters
 Economists recognize that variables other than the price of a
good that influence demand are known as demand shifters.
 For example, the number of pairs of jeans individuals are
willing and financially able to buy also depends on the
price of shirts, consumer income, advertising expenditures,
and so on.
 When we graph the demand curve for good X, we hold
everything but the price of X constant. A representative
demand curve is given by D0 in Figure bellow.
Changes in Demand
The movement along a demand curve,
such as the movement from A to B, is
called a change in quantity demanded.
Whenever advertising, income, or the
price of related goods changes, it
leads to a change in demand; the
position of the entire demand curve
shifts.
A rightward shift in the demand curve is
called an increase in demand, since
more of the good is demanded at
each price.
A leftward shift in the demand curve is
called a decrease in demand.
 Demand Shifters …
 Now that we understand the general distinction between a
shift in a demand curve and a movement along a demand
curve, it is useful to explain how five demand shifters
 Consumer income,

 Prices of related goods,

 Advertising and consumer tastes,

 Population, and

 Consumer expectations—affect demand.

 Demand Shifters …
Income
Because income affects the ability of consumers to purchase a
good, changes in income affect how much consumers will buy at
any price.
In graphical terms, a change in income shifts the entire demand
curve. Whether an increase in income shifts the demand curve to
the right or to the left depends on the nature of consumer
consumption patterns.
Accordingly, economists distinguish between two types of goods:
normal and inferior goods.
 Demand Shifters …
 A good whose demand increases (shifts to the right) when
consumer incomes rise is called a normal good. Normal
goods may include goods such as airline travel, and
designer jeans: As income goes up, consumers typically
buy more of these goods at any given price. Conversely,
when consumers suffer a decline in income, the demand
for a normal good will decrease (shift to the left).
 Demand Shifters …
Income
 In some instances, an increase in income reduces the demand for a
good. Economists refer to such a good as an inferior good. Bologna,
bus travel, and “generic” jeans are possible examples of inferior
goods.
 As income goes up, consumers typically consume less of these goods
at each price. It is important to point out that by calling such goods
inferior, we do not imply that they are of poor quality; we use this
term simply to define products that consumers purchase less of when
their incomes rise and purchase more of when their incomes fall.
 Demand Shifters …
Prices of Related Goods
 Changes in the prices of related goods generally shift the demand curve
for a good.
 Goods are substitutes when an increase in the price of one good increases
the demand for the other good.
 Goods that interact in this way are known as substitutes.
 For example, if the price of a iPhone increases, most consumers will begin
to substitute Galaxy S, because the relative price of iPhone is higher than
before. In effect, an increase in the price of iPhone increases the demand
for Galaxy S.
Demand Shifters …
Prices of Related Goods
Not all goods are substitutes; there are also
Complementary goods, goods that are used/consumed together.
examples of complementary goods include cars and gasoline,
computer and software, smartphones and apps, flights and taxi
services, and shoes and polish.
Notice that when good X is a complement to good Y, a reduction in the
price of Y actually increases (shifts to the right) the demand for good
X. More of good X is purchased at each price due to the reduction in
the price of the complement, good Y.
 Demand Shifters …
Advertising and Consumer
Tastes
 Another variable that is held constant
when drawing a given demand curve is
the level of advertising. An increase in
advertising shifts the demand curve to the
right, from D1 to D2
 why does advertising shift demand to the
right? Advertising often provides consumers
with information about the existence or
quality of a product, which in turn induces
more consumers to buy the product. These
types of advertising messages are known as
informative advertising.
 Demand Shifters …
Population
 The demand for a product is also influenced by changes in the size and composition of the
population. Generally, as the population rises, more and more individuals wish to buy a
given product, and this has the effect of shifting the demand curve to the right. Over the
twentieth century, the demand curve for food products shifted to the right considerably with
the increasing population.
Consumer Expectations
 Changes in consumer expectations also can change the position of the demand curve for a
product. For example, if consumers suddenly expect the price of automobiles to be
significantly higher next year, the demand for automobiles today will increase.
Other Factors
 In concluding our list of demand shifters, we simply note that any variable that affects the
willingness or ability of consumers to purchase a particular good is a potential demand
shifter.
DEMAND FUNCTION Is a function that describes how much
of a good will be purchased at alternative prices of that good
and related goods, alternative income levels, and alternative
values of other variables affecting demand.
 the factors that influence demand may be
summarized in what economists refer to as a demand
function.
Then the demand function for good X may be written as
𝑸𝒅𝒙 = 𝒇(Px, Py, M, H)
Where 𝑸𝒅𝒙 represent the quantity demanded of good X,
Px = the price of good X,
Py = the price of a related good,
M = income, and H = the value of any other variable that affects
demand, such as the level of advertising, the size of the
population, or consumer expectations.
Linear Demand Function
 A representation of the demand function in which the demand for
a given good is a linear function of prices, income levels, and
other variables influencing demand.
 Thus, the demand function explicitly recognizes that the quantity
of a good consumed depends on its price and on demand shifters.
 Different products will have demand functions of different forms.
 Demand is linear if 𝑸𝒅𝒙 is a linear function of prices, income, and
other variables that influence demand.
The following equation is an example of a linear demand function:
𝑸𝒅𝒙 = 𝜶𝒐 + 𝜶𝒙 𝑷𝒙 + 𝜶𝒚 𝑷𝒚 + 𝜶𝑴 𝑴 + 𝜶𝑯 𝑯
 Where 𝜶𝒊 s are fixed numbers that the firm’s research department
or an economic consultant typically provides to the manager.
 By the law of demand, an increase in 𝑷𝒙 leads to a decrease in
the quantity demanded of good X. This means that 𝜶𝒙 < 0.
 The sign of 𝜶𝒚 will be positive or negative depending on whether
goods X and Y are substitutes or complements.
 If 𝜶𝒚 is a positive number, an increase in the price of good Y will lead to an
increase in the consumption of good X; therefore, good X is a substitute for good Y
 If 𝜶𝒚 is a negative number, an increase in the price of good Y will lead to a
decrease in the consumption of good X; hence, good X is a complement to good Y.
 The sign of 𝛂𝐌 also can be positive or negative depending on whether X is a
normal or an inferior good.
 If 𝜶𝑴 is a positive number, an increase in income (M) will lead to an increase in the
consumption of good X, and good X is a normal good.
 If 𝜶𝑴 is a negative number, an increase in income will lead to a decrease in the
consumption of good X, and good X is an inferior good.
 An economic consultant for X Corp. recently provided the firm’s marketing
manager with this estimate of the demand function for the firm’s product:
𝑸𝒅𝒙 = 𝟏𝟐, 𝟎𝟎𝟎 − 𝟑𝑷𝒙 + 𝟒𝑷𝒚 − 𝟏𝑴 + 𝟐𝑨𝒙
 Where 𝑄𝑥𝑑 represents the amount consumed of good X, Px is the price of
good X, Py is the price of good Y, M is income, and Ax represents the
amount of advertising spent on good X.
 Suppose good X sells for $200 per unit, good Y sells for $15 per unit, the
company utilizes 2,000 units of advertising, and consumer income is
$10,000.
How much of good X do consumers purchase? Are goods X and Y substitutes or
complements? Is good X a normal or an inferior good?
To find out how much of good X consumers will purchase, we substitute the
given values of prices, income, and advertising into the linear demand
equation to get
𝑸𝒅𝒙 = 𝟏𝟐, 𝟎𝟎𝟎 − 𝟑(𝟐𝟎𝟎) + 𝟒(𝟏𝟓) − 𝟏(𝟏𝟎, 𝟎𝟎𝟎) + 𝟐(𝟐, 𝟎𝟎𝟎)
 Adding up the numbers, we find that the total consumption of X is 5,460
units. Since the coefficient of Py in the demand equation is 4 > 0, we know that
a $1 increase in the price of good Y will increase the consumption of good X
by 4 units. Thus, goods X and Y are substitutes.
 Since the coefficient of M in the demand equation is -1 < 0, we know that a
$1 increase in income will decrease the consumption of good X by 1 unit. Thus,
good X is an inferior good.
The information summarized in a demand function can be used to graph a
demand curve. Since a demand curve is the relation between price and quantity,
a representative demand curve holds everything but price constant. This means one
may obtain the formula for a demand curve by inserting given values of the
demand shifters into the demand function, but leaving Px in the equation to allow
for various values. If we do this for the demand function in Demonstration Problem
above (where Py = $15, M = $10,000, and Ax = 2,000), we get
𝑸𝒅𝒙 = 𝟏𝟐, 𝟎𝟎𝟎 − 𝟑𝑷𝒙 + 𝟒(𝟏𝟓) − 𝟏(𝟏𝟎, 𝟎𝟎𝟎) + 𝟐(𝟐, 𝟎𝟎𝟎)
Which simplifies to
𝑸𝒅𝒙 = 𝟔, 𝟎𝟔𝟎 − 𝟑𝑷𝒙
Because we usually graph this relation with the price of the
good on the vertical axis, it is useful to represent Equation
above with price on the left-hand side and everything else
on the right-hand side. This relation is called an inverse
demand function. For this example, the inverse demand
function is
𝑷𝒙 = 𝟐, 𝟎𝟐𝟎 − 𝟏/𝟑 𝑸𝒅𝒙
 Graphing the Inverse Demand Function

 It reveals how much consumers are willing and able to pay for each additional
unit of good X. This demand curve is graphed in Figure above.
Consumer Surplus
 Is the value consumers get from a good but do not have to pay for.
 Consumer surplus is a measure of the welfare that people gain from
consuming goods and services
 Consumer surplus is defined as the difference between the total amount
that consumers are willing and able to pay for a good or service
(indicated by the demand curve) and the total amount that they actually
do pay (i.e. the market price).
 Managers can use the notion of consumer surplus to determine the total
amount consumers would be willing to pay for a package of goods.
 By the law of demand, the amount a consumer is willing to pay for an
additional unit of a good falls as more of the good is consumed.
 For instance, imagine that the demand curve in Figure (a) bellow represents
your demand for water.
 Initially, you are willing to pay a very high price—in this case, $5 per liter—
for the first drop of water. As you consume more water, the amount you are
willing to pay for an additional drop declines from $5.00 to $4.99 and so on
as you move down the demand curve.
 Notice that after you have consumed an entire liter of water, you are willing
to pay only $4 per liter for another drop. Once you have enjoyed 2 liters of
water, you are willing to pay only $3 per liter for another drop.
 Fortunately, you don’t have to pay different prices for the different
drops of water you consume. Instead, you face a per-unit price of, say,
$3 per liter and get to buy as many drops (or even liters) as you want
at that price.
 Given the demand curve in Figure (a) bellow, when the price is $3 you
will choose to purchase 2 liters of water. In this case, your total out-of-
pocket expense for the 2 liters of water is $6. Since you value 2 liters
of water at $8 and only have to pay $6 for it, you are getting $2 in
value over and above the amount you have to pay for water.
 This “extra” value is known as consumer surplus—the value consumers
get from a good but do not have to pay for.
 This concept is important to managers because it tells how much extra money
consumers would be willing to pay for a given amount of a purchased product.
 Atypical consumer’s demand for the Happy Beverage
Company’s product looks like that in Figure (a) above. If the
firm charges a price of $2 per liter.
 How much revenue will the firm earn and how much consumer
surplus will the typical consumer enjoy?
 What is the most a consumer would be willing to pay for a
bottle containing exactly 3 liters of the firm’s beverage?
 At a price of $2 per liter, a typical consumer will purchase 3 liters of
the beverage. Thus, the firm’s revenue is $6 and the consumer surplus
is $4.50 (the area of the consumer surplus triangle is one-half the
base times the height, or .5(3)($5 - $2) = $4.50). The total value of 3
liters of the firm’s beverage to a typical consumer is thus $6 + $4.50,
or $10.50. This is also the maximum amount a consumer would be
willing to pay for a bottle containing exactly 3 liters of the firm’s
beverage.
 Expressed differently, if the firm sold the product in 3-liter bottles
rather than in smaller units, it could sell each bottle for $10.50 to
earn higher revenues and extract all consumer surplus.
 An elasticity measures the responsiveness of one variable to
changes in another variable.
 For example, the elasticity of your grade with respect to studying,
denoted EG,S, is the percentage change in your grade (%ΔG) that
will result from a given percentage change in the time you spend
studying (%ΔS). In other words,
%∆𝑮
EG,S, =
%∆𝑺

 Since %ΔG = ΔG/G and %ΔS =ΔS/S, we may also write this as
EG,S =(ΔG/ΔS) (S/G).
 Notice that ΔG/ΔS represents the slope (coefficient) of the functional relation
between G and S; it tells the change in G that results from a given change in S.
 By multiplying this by S/G, we convert each of these changes into
percentages, which means that the elasticity measure does not depend on the
units in which we measure the variables G and S.
A Calculus Alternative
 If the variable G depends on S according to the functional relationship G=f(S),
the elasticity of G with respect to S may be found using calculus:
𝒅𝑮 𝑺
EG,S, =
𝒅𝑺 𝑮
 Price elasticity of demand is a way of looking at sensitivity of
price related to product demand. Demand elasticity is an economic
concept also known as price elasticity.
 As a business administrator, you need to understand price and
demand elasticity when building pricing strategies for the
products or services.
 Pricing the product or service is a key element in the success of the
business.
Price Elasticity
 Price elasticity measures the responsiveness of a good’s
sales to changes in its price. This concept is important for
two reasons.
 First, knowledge of a good’s price elasticity allows firms to
predict the impact of price changes on unit sales.
 Second, price elasticity guides the firm’s profit-maximizing
pricing decisions.
What are the important values for price elasticity of demand?

 Elasticity measures the sensitivity of demand with respect to price.

In describing elasticities, it is useful to start with a basic benchmark
 First, demand is said to be unitary elastic if EP = -1. In this case, the
percentage change in price is exactly matched by the resulting
percentage change in quantity, but in the opposite direction.
 Second, demand is inelastic if -1 < EP ≤ 0. The term inelastic
suggests that demand is relatively unresponsive to price: The
percentage change in quantity is less (in absolute value) than the
percentage change in price.
 Finally, demand is elastic if EP < -1. In this case, an initial
change in price causes a larger percentage change in
quantity. In short, elastic demand is highly responsive, or
sensitive, to changes in price.
 The easiest way to understand the meaning of inelastic and
elastic demand is to examine two extreme cases. Figures
bellow depicts clearly, a vertical demand curve representing
perfectly inelastic demand, EP = 0. And a horizontal demand
curve where demand is perfectly elastic, EP = ∞
 What determines whether the demand for a good is price elastic
or price inelastic? Here are four important factors
 A first factor is the degree to which the good is a necessity. If a
good or service is not considered essential, the purchaser can
easily do without it—if and when the price becomes too high—
even if there are no close substitutes. In that case, demand is
elastic.
 If the good is a necessary component of consumption, it is more
difficult to do without it in the face of a price increase. Thus,
demand tends to be price inelastic.
 A second factor is the availability of substitutes. With many
substitutes, consumers easily can shift to other alternatives if the
price of one good becomes too high; demand is elastic.
 Without close substitutes, switching becomes more difficult; demand
is more inelastic. For this reason, industry demand tends to be much
less elastic than the demand facing a particular firm in the industry.
If one firm’s price increases, consumers are able to go to other firms
quite easily.
 Thus, the demand facing a single firm in an industry may be quite
elastic because competitors produce goods that are close substitutes
 Factors Affecting Price Elasticity …

 A third determinant of price elasticity is the proportion of income a consumer

spends on the good in question.
 The issue here is the cost of searching for suitable alternatives to the good. It
takes time and money to compare substitute products.
 If an individual spends a significant portion of income on a good, he or she
will find it worthwhile to search for and compare the prices of other goods.
Thus, the consumer is price sensitive.
 If spending on the good represents only a small portion of total income,
however, the search for substitutes will not be worth the time, effort, and
expense. Thus, other things being equal, the demand for small-ticket items
tends to be relatively inelastic.
 Factors Affecting Price Elasticity …
 Finally, time of adjustment is an important influence on elasticity. When the
price of gasoline dramatically increased in the last five years, consumers
initially had little recourse but to pay higher prices at the pump.
 Much of the population continued to drive to work in large, gas-guzzling
cars. As time passed, however, consumers began to make adjustments.
 Some commuters have now switched from automobiles to buses or other
means of public transport/transit. Gas guzzlers have been replaced by
smaller, more fuel-efficient cars including yaris or vitz or Atoz. Some workers
have moved closer to their jobs, and when jobs turn over, workers have
found new jobs closer to their homes.
 Thus, in the short run, the demand for gasoline is relatively inelastic.
 Own Price Elasticity Of Demand
 We begin with a very important elasticity concept: the own price elasticity of
demand, which measures the responsiveness of quantity demanded to a
change in price. Later in this section we will see that managers can use this
measure to determine the quantitative impact of price hikes or cuts on the
firm’s sales and revenues. The own price elasticity of demand for good X,
denoted is defined as
(%∆𝑸𝒅𝒙)
𝑬𝑷𝒙,𝑸𝒙 = You may replace %Δ by 𝜕 or differential / partial
(%∆𝑷𝒙
 If the own price elasticity of demand for a product is -2, for instance, we
know that a 10 percent increase in the product’s price leads to a 20 percent
decline in the quantity demanded of the good, since -20%/10% = -2.
Own Price Elasticity Of Demand …
 Recall that two aspects of an elasticity are important: (1) its
sign and (2) whether it is greater or less than 1 in absolute
value. By the law of demand, there is an inverse relation
between price and quantity demanded; thus, the own price
elasticity of demand is a negative number. The absolute
value of the own price elasticity of demand can be greater
or less than 1 depending on several factors that we
discussesed above.
 The consumers’ preference Definition

 Consumer preference is defined as the subjective tastes of

individual consumers, measured by their satisfaction with those
items after they’ve purchased them.
 This satisfaction is often referred to as utility. Consumer value can
be determined by how consumer utility compares between
different items.
 Consumer preferences can be measured by their satisfaction with
a specific item, compared to the opportunity cost of that item
since whenever you buy one item, you forfeit the opportunity to
buy a competing item.
 Importance of Consumer Preference

It is important, because
 Consumer preference determines what products people
will buy within their budget,
 Understanding consumer preference will give a manager
an indication of consumer demand.
 This information will help to ensure that you have
enough product to meet demand and will help you
determine the price for your product.
 How to Determine Consumer Preference
 To determine what consumers prefer, you have to give them similar
products to compare.
 A common way to determine consumer preferences is to create a consumer
panel. The panel is typically selected based on the demographics you
hope your product will appeal to.
 There are four different ways to determine preferences with a consumer
panel.
a)Preference Tests
b)Acceptance Tests
c)Ranking Tests
d)Difference Tests
 How to Determine

a) Preference Tests
 Preference testing is useful when you want to compare
one product to another. The consumers are given two or
more products and asked which they prefer. Once their
preferences, or lack of preference, are recorded, you
can then analyze the results to determine which product
is preferred. You cannot, however, determine how much
each product was liked using this method.
 How to Determine …

b)Acceptance Tests
 Acceptance testing can determine how much a product is liked. Instead of
stating which product is preferred compared to others, the consumers are
asked to give a score to each product based on their like or dislike for it.
This test is also called hedonic ranking.
 Usually, the scoring system is based on a seven/nine-point scale, ranging
from extreme like to extreme dislike, with neither dislike or like in the
middle.
 Depending on the products being evaluated, you can ask for different
scores for different properties, such as physical appearance, color or
other attributes.
How to Determine …

c)Ranking Tests
 A third way of determining consumer preferences is to
use a ranking test. Ranking tests are usually best for
comparing consumer preference between three or
more products, which the panel ranks according to
their preference. A ranking test does not reveal how
much more consumers like one product over another.
 How to Determine …
d)Difference Tests
 As its name suggests, difference testing measures how well
consumers can tell the difference between two products. For
example, if your company has developed a new soda, you could
ask consumers to compare it to a previous version you sold, as well
as to similar competitors’ sodas, for aspects like sweetness. While this
test itself doesn’t reveal preferences, it can provide insight into
products when used with any of the other tests.
 The Theory of the Consumer
 Central to consumer preferences is the idea of utility.
 What is meant by ‘utility’?
 Utility refers to the ability of a commodity to serve human wants.
It is the amount of satisfaction a consumer gets from the
consumption of a good or service.
 ‘Utility’ can be of two types:
a) Cardinal Utility Approach

b) Ordinal Utility Approach

 The Theory of the Consumer …
a) Cardinal Utility Approach
 Also known as Marginal Utility Analysis.
 Cardinal utility theory states that utility is measurable in
number.
 The unit in which utility can be measured is ‘utils’.

 Thus, those goods that give a consumer higher level of

satisfaction will be assigned higher utils than those which give
the consumer lower satisfaction.
 Cardinal theory is a quantitative method of utility
measurement.
 The Theory of the Consumer …

 Marginal Utility: It is the additional satisfaction obtained from

consuming one more unit of a commodity. It is the change in total
utility brought about by one more unit consumption of the
commodity.
 Total Utility: It is the total psychological satisfaction obtained
from consuming a given amount of a commodity. Thus, it is the sum
of all marginal utilities obtained from consuming
each successive unit of a commodity.
 The Theory of the Consumer …

 Both, marginal and total utilities are measured in ‘utils’.

Thus, TU = ∑ MU. And, MU = ΔTU / ΔQ It can be
derived from the above two definitions.
 You must note that since MU is the change in TU from
consuming one more unit, it can also be written as:
MU = TUn – TUn-1
 The Theory of the Consumer …
 This will become simple with the table MU = TUn – TUn-1
at the side. If the commodity is an
orange, MU of 2 units of orange using
the first definition of MU is, using the
second definition of MU, MU of 2 units
is again, 18-10 = 8.

 To calculate TU, we perform

cumulative addition over MU. So, TU of
2 units of orange is 10+8 = 18. Thus,
if one of MU or TU is given, the other
can be found out easily.
 The Theory of the Consumer …

Law of Diminishing Marginal Utility

 The crucial point of consumer preference theory is this law.

 It states that as more and more of a commodity is consumed,

consumers receive less and less satisfaction from its consumption.

 More formally, it means that the Marginal utility of a commodity

declines as successive units of it are consumed.

 The consequence of this law is that the Total utility of the

commodity increases at a diminishing rate (see table above).
 The Theory of the Consumer …
Relation between MU and TU diagrammatically

To understand the relationship

between MU and TU, note that:

 When MU decreases but remains

positive, TU increases at a
diminishing rate.
 When MU = 0, TU reaches its
maximum.
 Also when MU is negative, TU
starts declining.
 The Theory of the Consumer …
b)Ordinal Utility Approach
 Also known as Indifference Curve Analysis.
 It states that satisfaction derivable from consumption of goods
cannot be measured in numbers.
 It uses ‘ranks’ to describe different levels of utility.
 Thus, goods that provide a higher level of satisfaction should be
assigned higher ranks than those which give the consumer lower
satisfaction.
 The ordinal theory is a qualitative method of utility measurement.