2-Demand Theory and Transport Demand

Demand Theory and
Transport Demand
Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

Contents
The Demand for Transportation
Demand and Traffic Are Two Different Things
Transportation Demand is Derived Demand
Microeconomic Demand Theory
Preference and Indifference
Choice under Budget Constraint
Effects of Change in Income
Effects of Change in Prices
Consumer Demand Function
Empirical Demand Functions
Sensitivity of (Travel) Demand
Price Elasticity
Income Elasticity
Direct and Cross Elasticity
Consumer Surplus

The Demand of Transportation
A Hypothetical Example
Consider the hypothetical situation in which there are

two towns in a rural setting, separated by a distance
of rugged, mountainous terrain, and not connected by
a road or any other means of transport.
The first of these towns A is an agricultural production

center where a surplus of food products is generated.
A second town B is an industrial town with no food

production. It is easy to see that town B would make a
good market in which to sell the food products
produced at A, if it were possible to bring these
products to B at a reasonable cost.
In the situation as it is, an enterprising merchant, from

either A or B might carry a small quantity of highly
prized food products, say on a muleback, and
transport them with rather great difficulty between A
and B.
The selling price of these commodities would have to

be quite a bit higher than their price at the production
center A in order to make up the time the merchants
has to spend on the journey and for the loss and
deterioration of these food products that are incurred
during the journey either due to their perishability or
simply to the dangers of a long trek through the
mountainous jungle.
Consequently with the high selling price at B will be

only be a few people who can afford, or who would be
willing to pay for, the high price of the imported
foodstuffs.

Consider now a second situation in which a rail or
clearing is establish between A and B, such that it is
now possible to use horse-drawn carriages for
transport. The travel time is now cut in half from what
it was in the muleback case, and the deterioration of
products in transit is further reduced.
It now pays for the merchant to reduce the selling

price at B, and hence sell the foodstuffs to more
people. The amount of traffic between A and B is
increased.
Consider now a third scenario in which a primitive road

is built between two towns in such a way as to permit
small trucks to operate. This further reduces the
transportation cost and permits the merchant (or by
new merchants) the transport larger quantities at
relatively lower costs.
The selling price in B now be reduced further, and

more people will be able to buy the product. The traffic
between A and B will be again increase. One can now
imagine further improvements to the road leading to
further reductions in transport cost, and, as before, to
increase in the traffic between A and B.
Traffic
Improved Primitive Trail Muleback

Road Road
Figure 2.1 Effect of transportation system on traffic
The evolution of traffic volume between A and B as

described in this example can be shown graphically as

in Figure 2.1. The increase in traffic resulting from the
improvement of transportation system is a direct
result of the increase in the amount of sold at B that is
brought about by the reduction in the selling price.
Now if a traffic counter had been placed along the

route between the two towns, the conclusion that
would be drawn from the traffic counts in the first
case would be that there is not much traffic between
two towns and that perhaps there is not much
demand for transportation.
As the road is built and improved, the observer will be

forced to change the conclusion and, in the last case,
may in fact have to admit that the demand for
transportation between A and B depends on the type
of transportation system that connects them and the
demand can be increased by improving it. This
conclusion is wrong and demonstrates the danger of
confusing traffic flow with demand.
Demand and Traffic Are Two

Different Things
The curve shown in Figure 2.1 represents one demand
condition but many traffic conditions. If we were to
convert the horizontal axis of the figure to represent
the “cost” of transportation (the cost is reduced as the
transportation system is improved), then we would
see that the curve represents a relationship between
traffic volume and transportation cost (see Figure 2.2).
As the cost is reduced, the traffic volume increases,

and vice versa. It is this relationship that reflects the
demand for transportation and not any of the single
traffic volume values, for it is easy to see that any
such single value could come from an unlimited
number of curves such as the one shown.

Traffic
Transport cost
Figure 2.2 Effect of generalized cost on traffic
We can then define the demand for transportation as a

potential for traffic flow. This potential is itself related
to the production and consumption activities at A and
B, or indeed, in general, to any socioeconomic
activities.
The “transportation cost” to which we converted the

horizontal axis of the Figure 2.1 is a very generic cost
and includes all the attributes that in this particular
case make for difficulty of transporting the food stuff
between A and B. It includes the actual money cost of
transportation when relevant, the value of time
involved, the deterioration of the commodities being
shipped, and the discomfort and inconvenience of the
journey; it is usually referred to as generalized cost. It
suffices now to think of it as a resistance to the
movement between A and B.
Transportation Demand is
Derived Demand
While the volume of traffic on the road between A and
B is affected by the condition of the road and by the
transportation cost, it is also affected by the market
for foodstuffs in B. Indeed, if the demand for these
products in B is low or nonexistent, then there would
be no traffic flow between A and B, no matter what

improvements are made to the road. Likewise, for the
same road conditions, given by particular location on
the horizontal axis of Figure 2.2, more or less traffic
will flow, depending on the amount of demand for
foodstuffs that exists in B.
For this reason, we say that the demand for

transportation between A and B is derived from the
demand in B for foodstuffs imported from A. Indeed,
there is little point in transporting these commodities
simply for the sake of transportation, no matter how
inexpensive this might be.
Activity 2.1
Give more examples showing that
transportation demand is derived demand.
The relationship between transportation demand and

the demand for socioeconomic activities can be
extended to all forms of transportation, whether it is
transportation of goods or people. The demand for
shopping trips in an urban area is derived from the
demand for shopping; air travel demand for vacation
trips is derived from the demand from the demand for
recreation at particular destinations, and so forth.
Because of this strong relationship between the

demand for transportation and the demand for
socioeconomic activities, it is essential for the study of
transport demand to develop an understanding of the
way in which the phenomena of demand arise and to
develop the methodology for the analysis. For this
purpose the classical approach of microeconomics is
adopted and the modified as appropriate for its
application in transportation.

Microeconomics Demand
Theory
In microeconomic theory, demand is approached at
two levels: an individual level, referred to as
consumer demand, and an aggregate level, referred
to as market demand. The latter is obtained simply by
aggregating, or summing, all individual consumer
demands, although it is often studies directly at an
aggregate level without explicit attention to individual
consumers.
Basic assumptions
1. Consumer has a choice. If the consumer has no

choice, there is little use of demand theory. Demand
theory is a theory to predict such choice.
2. Every consumption good possesses certain

characteristics that give utility, or satisfaction, to
the consumer.
3. The consumer has a consistent preference

structure that is based on the relative utilities of the
various good available.
4. The consumer is assumed to be insatiable. More is

always better than less.
5. The choice of the consumer is limited by a budget

constraint.
Preference and Indifference

MrsBiondo
One can speak of comparing, e.g., 5 kg of oranges
with one pair of shoes, or six shopping trips by bus
with one trip to the movies by automobile. The specific
units used are not very important, particularly since
they can always be converted into monetary terms by
multiplying each by the unit price.
Using an example of two goods X1 and X2, the

quantities consumed of these goods can be
represented on a two dimensional diagram (x1, x2)
which is referred to as a consumption field (See Figure
2.3)
X2
M P M N
x2 M M
M
N
x1 X1
Figure 2.3 Consumption field
The combination of goods (x1, x2) gives the consumer a

certain level of consumption utility which is the
combined utility of the two quantities. From our
assumption, since more is always better than less, P
is preferred to M and M is preferred to N (P> M> N).
Moving from the point N to the point P as the path in

Figure 2.3 is moving from a point inferior to M to a
point superior to it. Therefore, somewhere along this
path must be a point such as M which is equivalent to
M.
We can say that the consumer is indifferent between

two choices. Tracing the locus of all such points in the
consumption field (X1, X2) results in a line referred to as
the indifferent curve as in Figure 2.4.

X2
X1
Figure 2.4 Indifference curve between goods x1 and x2
X2
U 3 U 2 U1
U3
U2
U1
X1
Figure 2.5 Indifference map (Utility map)
In Figure 2.4, any points along the curve will lead to

exactly the same utility to the consumer. It is also
useful to think of the indifference curve as the trace of
a three dimensional function U(x1,x2) which gives the
utility of consumption in terms of the quantity of goods
X1 and X2. The indifference curve is thus referred to as
an isoutility curve.
A consumption field on which a number of indifference

curves are shown would then look as shown in Figure
2.5. The farther from the origin an indifference curve is,
the larger is the utility implied. Such a representation is
referred to as an indifference map, or utility map.
The map is also describes the manner by which the

consumer is willing to substitute one good to another.
The slope of the curve represents the relative rate of
change of x1 and x2, and can be represented by either
dx1 dx2 or dx2 dx1 . This slope is called the marginal rate
of substitution and has the interpretation as the
number of units of X1 that the consumer is willing to
give up in order to receive one unit of X2, or vice versa,
while maintaining the same level of consumption utility.
Now let U(x1, x2) be a utility function, and let the

constant utility generated at indifference curve 1 be
given by U(x1, x2) = U1. Since U is constant on isoutility
curve, the total derivative of U must be zero:
dU x1 , x 2 dU 1 0 (2.1)
U U
dU x1 , x 2 dx1 dx 2 0 (2.2)
x1 x2
Which gives
U x1 dx 2
(2.3)
U x2 dx1
Equation 2.3 says that the marginal rate of substitution

between two goods is equal to the ratio of marginal
utilities. The marginal utility of a good is the rate of
change in utility with the quantity consumed of that
good. Since the assumption of insatiability implies that
the marginal utility of any good is always non-negative
(left-hand side of equation 2.3), the marginal rate of
substitution is always negative since the consumer
will always give up some of one good for some of the
other.
It is important to note that the utility function is

assumed to have certain regularity properties,
including differentiability at all points. In particular, the
assumption of insatiability implies that U 0 for all i.
xi
In addition, it is normally assumed that the second

derivative may have any sign, although a common
assumption is that it is negative, implying that the
marginal utility from consumption is decreasing (For
example, imagine when you eat 10 pieces of cake.
Your utility will increase as you consume more, but
the utility increase from consuming unit 9-10 will be
less than the utility increase from consuming unit 1-2.)
Choice under Budget
Constraint
The choice of a consumption pattern is not solely
determined by the indifference map of consumer.
Indeed, if this were the case, then the assumption of
insatiability would imply infinite consumption of all
goods under consideration. The choice is normally
constrained by a number of limitations on the
resources required for the consumption activity. Most
important of these are the budget constraints that limit
the amount of money a consumer can allocate to a
group of goods.
For transportation, other constraints are important, for

example, the time spent in transportation. As we shall
see later on, time can be incorporated into monetary
budget using the concept of the value of travel time
(convert all costs aspects into generalized costs).

The total amount of money spent on consumption
cannot exceed the budget B
pi xi B (2.4)
i
pi = Price of goods i
xi = Amount of goods i consumed
B = Consumer’s budget
The expression is in terms of n goods. For concrete

illustration, we use an example of two goods again.
The feasible choice of consumption in equation 2.1 can
be shown as shaded region in Figure 2.6.
X2
B p1 x1 p 2 x2 B
p2
B X1
p1
Figure 2.6 Feasible consumption choices
The insatiability assumption implies that the consumer

will maximize amount of consumption which leads to
pi xi B (2.5)
i
X2
B p1 x1 p 2 x2 B
p2
B X1
p1
Figure 2.7 A budget line with fixed unit prices

The consumer will choose the combination of goods
X(x1, x2, …, xn) which maximize the utility U(x1, x2, …, xn)
subject to the constraint p i xi B. The analytical
i
formulation of constrained maximization is to

construct a lagrangian L:
L U x1 , x2 , , xn pi xi B (2.6)
i
= Lagrange multiplier
The first order conditions require that the derivatives

of the Lagrangian with respect to each of its
arguments are zero.
L U
p1 0
x1 x1
L U
p2 0
x2 x2
n+1 system of equations; (2.7)
L U
pn 0
xn xn
L
p i xi B 0
i
Then solve for x1 , x 2 , , xn and
Example 2.1
(Two goods case)
Given
The consumer’s utility function
U x1 , x2 x1 x2
The budget constraint:
x1 2 x2 100
1. What is the price of X1 and X2? (p1=1, p2=2)

2. How much is the budget of this consumer?
(B=100 $)
3. What is the optimum consumption pattern?
Solution: Utility maximization subjected to

budget constraint problem
Construct lagrangian L:
L x1 x 2 x1 2 x2 100
First order conditions:
L
x2 0
x1
L
x1 2 0 Solve for x1, x2, and
x2
L
x1 2 x 2 100 0
We get x1 = 50, x2 = 25, and 25
Therefore, the optimum consumption pattern

is to consume x1 = 50 units and x2 = 25 units
4. What is the meaning of ?
It can be interpreted as the utility change

for 1$ change (relaxation) in budget
constraint (income) !!!!
The graphic interpretation of the optimum

consumption of two goods case can be shown in
Figure 2.8.

X2
B
p2
x*
x2*
U*
x1* B X1
p1
Figure 2.8 Optimum consumption pattern of two goods
U is the highest utility that can be reached without

leaving the feasible region of budget. The tangency
point x represents the optimal consumption choice
x1* , x 2* .
Effect of Change in Income

Effect of income change can be illustrated graphically
as in Figure 2.9.
X2
B
p2
B
p2
B B X1
p1 p1
Figure 2.9 Change in income or budget constraint
For changes in income only, it is noted that the unit

costs of two goods (p1 and p2) are fixed (the slope of
budget lines are not changed).
What is the effect to the optimum consumption

pattern?

(Note: Here the explanation will be the case of increase
income, the case of income decrease can also be
explained vice versa)
1. Using two goods example, the optimum

consumption pattern will change from point M to M .
2. Budget Utility
3. As the consumer’s income , consumption of each
good can be or depending on type of goods
(normal goods or inferior goods)
4. For normal goods, income consumption of goods
(See Figure 2.10)
5. For inferior goods, income consumption of goods
(See Figure 2.11)
6. Examples, Dove and Parrot soap. For transportation,
Automobile and Bus.
7. Giffen paradox: price consumption (case of
strong inferior good)
Figure 2.10 Income effect with two normal goods

Figure 2.11 Income effect with one inferior goods
Effect of Change in Prices

Price changes will affect the slope of the budget line.
Therefore, the new consumption pattern can be
obtained based on the new budget line.
Figure 2.12 Effect on budget line of price change (change in price of

goods 1)

Figure 2.13 The combination of income and substitution effects of normal
goods X1 and X2
Figure 2.14 The case of inferior goods (X1). (a) Income effect smaller than
substitution effect
Figure 2.15 The case of inferior goods (X1). (b) Income effect larger than
substitution effect

Figure 2.16 Generation of price-consumption curve
Consumer Demand Function

How to define consumer demand function? Ask
yourself what factors or variables affect the
consumer demand.
Consumer demand function is usually expressed in

terms of relationships between consumer demand
(quantity xi) and income or budget (B), price of the
good, price of other goods.

Above statement can be written in mathematical form
of demand function as
xi f B, P1 , P2 , Pn (2.8)
If other factors are fixed except Pi, the demand

function may be plotted in two-dimensional diagram
as in Figure 2.16. Consider the derivation of demand
function in an example 2.2.
Example 2.2
By utility maximization, derive the demand

function of goods 1 and goods 2. Consider
the following utility function.
U x1 1 x 2 2
Where x1, x2 are quantities of each good and

1 and 2 are constant parameters.
For the budget B, a budget constraint is
B p1 x1 p2 x2
Where p1 and p2 are unit prices. Maximizing

U subject to the budget constraint (How? See
example 1). Finally we can get
1 B
x1
1 2 p1
And by symmetry
2 B
x2
1 2 p2

Empirical Demand Functions
We have seen that the demand function can be
derived from utility maximization. It is not possible in
general to specify the utility function (the topic of how
to specify the utility function is still under researched).
In practice, demand function is sometimes estimated
ad hoc assuming priori forms of demand function and
using empirical analysis to validate it.
They are, for example, linear, multiplicative or

exponential forms. Hybrid forms combining any of
these three are also to be found in transportation
applications.
How to choose the correct functional form? The

choice must be based on a logical postulation of the
relationships involved.
For example, linear demand function implies that all

the factors that affect the traffic, such as income, cost,
and travel time, have independent addictive effects.
The multiplicative form on the other hand implies that

the effects are not independent but do interact. An
example of this statement can be shown in the
following section regarding the elasticity of demand.
Sensitivity to (Travel) Demand

How do we study the effect of changes in factors
affecting travel demand? (For example, change in
gasoline price, change income, change in travel time,
etc) The effect of these factors may be studied by
keeping other factors unchanged while varying the
factor of interest and seeing its effect to the travel
demand. For example, if we want to study how the
change in bus fare affect the demand for using bus we

must keep other factors such as income, travel time
unchanged. This concept is called elasticity. Elasticity
indicates percentage of change in demand (xi) to the
percentage of change in other factors (prices, income,
etc.) affecting the demand.
Price Elasticity
Price elasticity indicates how the demand changes
when price changes. In the above example, cost
elasticity or price elasticity can be derived as
type I
x i / xi log xi xi p i
e pi (2.9)
pi / pi log pi p i xi
Equation 2.9 is defined as point elasticity.
When change is large, Arc elasticity is defined as
xi
x1 x 2
2 x2 x1 / x1 x 2
e pi
pi p2 p1 / p1 p 2 (2.10)
p1 p 2
2
Arc elasticity is sometimes calculated as estimate of

point elasticity.
For example, when the price of bus fare decrease,

how much people will use bus more? You can answer
it if you know price elasticity.
Income Elasticity
The effect of change in income to the demand can be
indexed by income elasticity. Income elasticity
indicates how the demand changes when income

changes. Income elasticity can be defined in the same
way as price elasticity.
xi / xi log xi xi B
eI (2.11)
B/B log B B xi
For example, when people have more income, how

much they travel more? You can answer it if you
know income elasticity.
Refer to the definition of normal goods and inferior

goods in previous sections; they can be interpreted
using income elasticity. The good is normal if eI 0
(people use it more if they have more income) and the
good is inferior if eI 0 .
Direct and Cross Elasticity

The effect of changes in price can be further
categorized into direct effect and cross effect. The
direct effect is explained in previous section. Cross
effect occurs when the price of other related goods
change.
The cross price elasticity of the demand for good i

with respected to the price of goods j change can be
expressed as
xi / xi
eij (2.12)
pj / pj
For example, change in price of using bus (bus fare)

may affect to the demand for automobile.
The concept of cross elasticity is not limited only to

the price variables but apply to all relevant attributes
of the system. For example, change in travel time of
the bus may affect to the demand automobile also.

It can be seen that the demand function in example 2.2
expressed no cross price elasticity.
Goods are substitutes when their cross elasticities are

positive, and goods are complements when their cross
elasticities of demand are negative.
If e > 1 : We can say that the demand is ‘elastic’.

(Responsive to change!)
If e < 1 : We can say that the demand is ‘inelastic’.

(Not so responsive to change!)
Consumer Surplus
Consumer surplus is a measure of monetary value
made available to consumers by the existence of a
facility. It is defined as the difference between what
consumers might be willing to pay for service and
what they actually pay. For example, a patron of bus
service pays a fare of 50 cents per trip but would be
willing to pay up to as much as 75 cents per trip, in
this case, his surplus is 25 cents.
The demand curve can be considered as an indicator

of the utility of the service in terms of price. The
consumer surplus concept is shown in Figure 2.17(a).
The area ABC represents the total consumer surplus.
Maximization of consumer surplus is indeed the

maximization of the economic utility of consumer. In
project evaluation, the use of this concept is common,
particularly in transit systems.

Figure 2.17 (a) Consumer surplus concept (b) Change in consumer surplus
In general, a transportation improvement can be

measured in terms of the change in consumer surplus.
Figure 2.17(b) indicates the case of a street having a
traffic supply curve S1, intersecting a demand curve at
E1. An additional lane has been added, shift in the
supply curve to S2 and therefore intersecting the
demand curve at E2. The change in consumer surplus
can be quantified as the area of the trapezoid P1P2E2E1
which equals to (P1-P2)(Q1+Q2)/2.
The additional trips (Q2-Q1) is the trips that the travelers

would make if the price per trip were lower than the
current price. The number of such potential travelers
is called latent demand.

Additional Reading
1. Transportation Engineering: An Introduction by C.Jotin Khisty and B.Kent
Lall. 2nd Edition. Prentice-Hall International Inc., Chapter 2
2. Transportation Demand Analysis, by Adib Kanafani, McGraw-Hill, Inc., 1983.

2-Demand Theory and Transport Demand

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Demand Theory and

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

Consider the hypothetical situation in which there are

The first of these towns A is an agricultural production

A second town B is an industrial town with no food

In the situation as it is, an enterprising merchant, from

The selling price of these commodities would have to

Consequently with the high selling price at B will be

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

It now pays for the merchant to reduce the selling

Consider now a third scenario in which a primitive road

The selling price in B now be reduced further, and

Improved Primitive Trail Muleback

Figure 2.1 Effect of transportation system on traffic

The evolution of traffic volume between A and B as

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

Now if a traffic counter had been placed along the

As the road is built and improved, the observer will be

Demand and Traffic Are Two

As the cost is reduced, the traffic volume increases,

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

We can then define the demand for transportation as a

The “transportation cost” to which we converted the

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

For this reason, we say that the demand for

The relationship between transportation demand and

Because of this strong relationship between the

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

1. Consumer has a choice. If the consumer has no

2. Every consumption good possesses certain

3. The consumer has a consistent preference

4. The consumer is assumed to be insatiable. More is

5. The choice of the consumer is limited by a budget

Preference and Indifference

Using an example of two goods X1 and X2, the

Figure 2.3 Consumption field

The combination of goods (x1, x2) gives the consumer a

Moving from the point N to the point P as the path in

We can say that the consumer is indifferent between

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

In Figure 2.4, any points along the curve will lead to

A consumption field on which a number of indifference

The map is also describes the manner by which the

Now let U(x1, x2) be a utility function, and let the

Equation 2.3 says that the marginal rate of substitution

It is important to note that the utility function is

In addition, it is normally assumed that the second

For transportation, other constraints are important, for

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

The expression is in terms of n goods. For concrete

The insatiability assumption implies that the consumer

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

formulation of constrained maximization is to

The first order conditions require that the derivatives

Then solve for x1 , x 2 , , xn and

1. What is the price of X1 and X2? (p1=1, p2=2)

Dr.Mongkut Piantanakulchai CES 341 Transportation Engineering and Planning

Solution: Utility maximization subjected to

First order conditions:

We get x1 = 50, x2 = 25, and 25

Therefore, the optimum consumption pattern

4. What is the meaning of ?