Varian9e LecturePPTs Ch15

Chapter 15
Market Demand
From Individual to Market
Demand Functions
u Think of an economy containing n
consumers, denoted by i = 1, … ,n.
u Consumer i’s ordinary demand
function for commodity j is
x*j i (p1 , p 2 , mi )
Demand Functions
u When all consumers are price-takers,
the market demand function for
commodity j is
n
X j (p1 , p 2 , m1 ,L, mn ) = å x*j i (p1 , p 2 , mi ).
i= 1
u If all consumers are identical then
X j (p1 , p 2 , M) = n ´ x*j (p1 , p 2 , m)
where M = nm.
Demand Functions
u The market demand curve is the
“horizontal sum” of the individual
consumers’ demand curves.
u E.g. suppose there are only two
consumers; i = A,B.
Demand Functions
p1 p1
p1’ p1’
p1” p1”
20 x*A 15 x*1B
1
Demand Functions
p1 p1
p1’ p1’
p1” p1”
20 x*A 15 x*1B
p1 1
p1’
x*1A + xB
1
Demand Functions
p1 p1
p1’ p1’
p1” p1”
20 x*A 15 x*1B
p1 1
p1’
p1”
x*1A + xB
1
Demand Functions
p1 p1
p1’ p1’
p1” p1”
20 x*A 15 x*1B
p1 1
p1’ The “horizontal sum”

p1” of the demand curves
of individuals A and B.
35
x*1A + xB
1
Elasticities
u Elasticitymeasures the “sensitivity”

of one variable with respect to
another.
u The elasticity of variable X with
respect to variable Y is
% Dx
e x,y = .
% Dy
Economic Applications of
Elasticity
u Economists use elasticities to
measure the sensitivity of
– quantity demanded of commodity i
with respect to the price of
commodity i (own-price elasticity
of demand)
– demand for commodity i with
respect to the price of commodity j
(cross-price elasticity of demand).
Elasticity
– demand for commodity i with
respect to income (income
elasticity of demand)
– quantity supplied of commodity i
with respect to the price of
commodity i (own-price elasticity
of supply)
Elasticity
– quantity supplied of commodity i
with respect to the wage rate
(elasticity of supply with respect to
the price of labor)
– and many, many others.
Own-Price Elasticity of Demand
u Q:Why not use a demand curve’s

slope to measure the sensitivity of
quantity demanded to a change in a
commodity’s own price?
p1 p1
slope slope
10 =-2 10 = - 0.2
5 X1* 50 X *
1
In which case is the quantity demanded

X1* more sensitive to changes to p1?
p1 p1
slope slope
10 =-2 10 = - 0.2
5 X1* 50 X *
1

10-packs Single Units
p1 p1
slope slope
10 =-2 10 = - 0.2
5 X1* 50 X *
1

10-packs Single Units
p1 p1
slope slope
10 =-2 10 = - 0.2
5 X1* 50 X *
1

It is the same in both cases.
u Q: Why not just use the slope of a

demand curve to measure the
sensitivity of quantity demanded to a
change in a commodity’s own price?
u A: Because the value of sensitivity
then depends upon the (arbitrary)
units of measurement used for
quantity demanded.
% Dx*1
e x* ,p =
1 1 % Dp1
is a ratio of percentages and so has no
units of measurement.
Hence own-price elasticity of demand is
a sensitivity measure that is independent
of units of measurement.
Arc and Point Elasticities
u An “average” own-price elasticity of

demand for commodity i over an
interval of values for pi is an arc-
elasticity, usually computed by a
mid-point formula.
u Elasticity computed for a single
value of pi is a point elasticity.
Arc Own-Price Elasticity
pi What is the “average” own-price
elasticity of demand for prices
in an interval centered on pi’?
pi’+h
pi ’
pi’-h
Xi*
pi’+h
pi ’
pi’-h
Xi" Xi '" Xi*

pi’+h
pi ’ % DX*i
e X* ,p =
pi’-h i i % Dpi
Xi" Xi '" Xi*

pi’+h
pi ’ % DX*i
e X* ,p =
pi’-h i i % Dpi
Xi" Xi '" Xi*

2h
% Dpi = 100 ´
pi '
pi’+h
pi ’ % DX*i
e X* ,p =
pi’-h i i % Dpi
Xi" Xi '" Xi*

2h ( Xi"- Xi '")
% Dpi = 100 ´ % DX*i = 100 ´
pi ' ( Xi"+ Xi '") / 2
2h
% Dpi = 100 ´
% DX*i pi '
e X* ,p =
i i % Dpi ( Xi"- Xi '")
% DX*i = 100 ´
( Xi"+ Xi '") / 2
2h
% Dpi = 100 ´
% DX*i pi '
e X* ,p =
i i % Dpi ( Xi"- Xi '")
% DX*i = 100 ´
( Xi"+ Xi '") / 2
So
%DX*i pi ' ( X "- Xi '" )
e X* ,p = = ´ i .
i i %Dp i ( Xi "+ Xi '" ) / 2 2h
is the arc own-price elasticity of demand.
Point Own-Price Elasticity
What is the own-price elasticity
pi of demand in a very small interval
of prices centered on pi’?
pi’+h
pi ’
pi’-h
Xi" Xi '" Xi*

%DX*i pi ' ( X "- Xi '" )
e X* ,p = = ´ i .
i i %Dp i ( Xi "+ Xi '" ) / 2 2h
pi’+h As h ® 0,
pi ’
pi’-h
Xi" Xi '" Xi*

%DX*i pi ' ( X "- Xi '" )
e X* ,p = = ´ i .
i i %Dp i ( Xi "+ Xi '" ) / 2 2h
pi’+h As h ® 0,
pi ’
pi’-h
Xi" Xi '" Xi*

%DX*i pi ' ( X "- Xi '" )
e X* ,p = = ´ i .
i i %Dp i ( Xi "+ Xi '" ) / 2 2h
pi’+h As h ® 0,
pi ’
pi’-h
Xi ' Xi*
%DX*i pi ' ( X "- Xi '" )
e X* ,p = = ´ i .
i i %Dp i ( Xi "+ Xi '" ) / 2 2h
As h ® 0,
pi ’ pi ' dX*i
e X* ,p ® ´
i i Xi ' dpi
Xi ' Xi*
%DX*i pi ' ( X "- Xi '" )
e X* ,p = = ´ i .
i i %Dp i ( Xi "+ Xi '" ) / 2 2h
*
p ' dXi
e X* ,p = i ´
pi ’ i i Xi ' dpi
is the elasticity at the
point ( Xi ', pi ' ).
Xi ' Xi*
*
p dX
e X* ,p = *i ´ i
i i Xi dpi
E.g. Suppose pi = a - bXi.

Then Xi = (a-pi)/b and
dXi* 1
= - . Therefore,
dpi b
pi 1 pi
e X* ,p = ´ æç - ö÷ = - .
i i ( a - pi ) / b è bø a - pi
pi pi = a - bXi*
a/b Xi*
pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a
a/b Xi*
pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a
p= 0Þe = 0
a/b Xi*
pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a
p= 0Þe = 0
e=0
a/b Xi*
pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a a a/2
p= Þe =- = -1
2 a-a/2
e=0
a/b Xi*
pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a a a/2
p= Þe =- = -1
2 a-a/2
a/2 e = -1
e=0
a/2b a/b Xi*

pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a a
p=aÞe = - = -¥
a-a
a/2 e = -1
e=0
a/2b a/b Xi*

pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a e = -¥
a
p=aÞe = - = -¥
a-a
a/2 e = -1
e=0
a/2b a/b Xi*

pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a e = -¥
own-price elastic
a/2 e = -1
own-price inelastic
e=0
a/2b a/b Xi*

pi
pi pi = a - bXi* e X* ,p = -
i i a - pi
a e = -¥
own-price elastic
a/2 e = -1 (own-price unit elastic)
own-price inelastic
e=0
a/2b a/b Xi*

*
p dX
e X* ,p = *i ´ i
i i Xi dpi
E.g. X*i = kpia . Then dX*i

= apia -1
dpi
so
pi a -1 pia
e X* ,p = ´ kapi =a = a.
i i kpia pia
k
pi X*i = kpia = kpi- 2 =
pi2
e = -2 everywhere along
the demand curve.
Xi*
Revenue and Own-Price
Elasticity of Demand
u If raising a commodity’s price causes
little decrease in quantity demanded,
then sellers’ revenues rise.
u Hence own-price inelastic demand
causes sellers’ revenues to rise as
price rises.
u Ifraising a commodity’s price causes
a large decrease in quantity
demanded, then sellers’ revenues fall.
u Hence own-price elastic demand
causes sellers’ revenues to fall as
price rises.
*
Sellers’ revenue is R(p ) = p ´ X (p ).
*
*
So dR = X* (p ) + p dX
dp dp
*
*
dp dp
* é p dX* ù
= X (p )ê1 + ú
*
ëê X (p ) dp ûú
*
*
dp dp
* é p dX* ù
= X (p )ê1 + ú
*
ëê X (p ) dp ûú
= X* (p )[1 + e ].
dR
= X* (p )[1 + e ]
dp
dR
= X* (p )[1 + e ]
dp
dR
so if e = -1 then =0
dp
and a change to price does not alter

sellers’ revenue.
dR
= X* (p )[1 + e ]
dp
dR
but if - 1 < e £ 0 then >0
dp
and a price increase raises sellers’

revenue.
dR
= X* (p )[1 + e ]
dp
dR
And if e < -1 then <0
dp
and a price increase reduces sellers’

revenue.
In summary:
Own-price inelastic demand; - 1 < e £ 0
price rise causes rise in sellers’ revenue.
Own-price unit elastic demand; e = -1
price rise causes no change in sellers’
revenue.
Own-price elastic demand; e < -1
price rise causes fall in sellers’ revenue.
Marginal Revenue and Own-
Price Elasticity of Demand
uA seller’s marginal revenue is the rate
at which revenue changes with the
number of units sold by the seller.
dR( q)
MR( q) = .
dq
p(q) denotes the seller’s inverse demand
function; i.e. the price at which the seller
can sell q units. Then
R ( q) = p( q) ´ q
so dR( q) dp( q)
MR( q) = = q + p( q)
dq dq
é q dp( q) ù
= p( q) ê 1 + .
ë p( q) dq úû
é q dp( q) ù
MR( q) = p( q) ê1 + .
ë p( q) dq úû
dq p
and e= ´
dp q
1
so MR( q) = p( q) éê1 + ùú .
ë eû
1
MR( q) = p( q) éê1 + ùú says that the rate
ë eû
at which a seller’s revenue changes
with the number of units it sells
depends on the sensitivity of quantity
demanded to price; i.e., upon the
of the own-price elasticity of demand.
1
MR(q) = p(q)éê1 + ùú
ë eû
If e = -1 then MR( q) = 0.
If - 1 < e £ 0 then MR( q) < 0.
If e < -1 then MR( q) > 0.
If e = -1 then MR( q) = 0. Selling one
more unit does not change the seller’s
revenue.
If - 1 < e £ 0 then MR( q) < 0. Selling one
more unit reduces the seller’s revenue.
If e < -1 then MR( q) > 0. Selling one
more unit raises the seller’s revenue.
An example with linear inverse demand.
p( q) = a - bq.
Then R( q) = p( q)q = ( a - bq)q

and MR( q) = a - 2bq.
p
p( q) = a - bq
a/2b a/b q
MR( q) = a - 2bq
p
a Price Elasticity of Demand
MR( q) = a - 2bq
p( q) = a - bq
$ a/2b a/b q
R(q)
a/2b a/b q

Varian9e LecturePPTs Ch15

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Varian9e LecturePPTs Ch15

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Chapter 15

p1’ The “horizontal sum”

u Elasticitymeasures the “sensitivity”

u Q:Why not use a demand curve’s

In which case is the quantity demanded

In which case is the quantity demanded

In which case is the quantity demanded

In which case is the quantity demanded

u Q: Why not just use the slope of a

u An “average” own-price elasticity of

Xi" Xi '" Xi*

Xi" Xi '" Xi*

Xi" Xi '" Xi*

Xi" Xi '" Xi*

Xi" Xi '" Xi*

Xi" Xi '" Xi*

Xi" Xi '" Xi*

E.g. Suppose pi = a - bXi.

a/2b a/b Xi*

a/2b a/b Xi*

a/2b a/b Xi*

a/2b a/b Xi*

a/2b a/b Xi*

E.g. X*i = kpia . Then dX*i

and a change to price does not alter

and a price increase raises sellers’

and a price increase reduces sellers’

Then R( q) = p( q)q = ( a - bq)q

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E.g. Xi = kpia . Then dXi