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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 2
 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

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

T= tastes of the consumer

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 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
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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 8
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 9
 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
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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 11
 Market Demand Function
QDX = f(PX, N, I, PY, T)
QDX = quantity demanded of commodity X
PX = price per unit of commodity X
N = number of consumers on the market
I = consumer income
PY = price of related (substitute or
complementary) commodity

T= consumer tastes
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 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
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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
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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 15
 Linear Demand Function
QX = a0 + a1PX + a2N + a3I + a4PY + a5T

PX Intercept:
a0 + a2N + a3I + a4PY + a5T

Slope:
QX/PX = a1

QX
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 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

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 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
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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 19
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 20
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 21
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 22
 Price Elasticity of Demand

Q / Q Q P
Point Definition EP   
P / P P Q

P
Linear Function EP  a1 
Q

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 23
 Price Elasticity of Demand

Q2  Q1 P2  P1
Arc Definition EP  
P2  P1 Q2  Q1

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 Marginal Revenue and Price
Elasticity of Demand

 1 
MR  P 1  
 EP 

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 Marginal Revenue and Price
Elasticity of Demand
PX
EP  1
EP  1

EP  1

QX
MRX
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 Marginal Revenue, Total
Revenue, and Price Elasticity
TR MR>0 MR<0
EP  1 EP  1

QX
EP  1 MR=0
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 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

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 28
 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

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 29
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 30
 Income Elasticity of Demand

Q / Q Q I
Point Definition EI   
I / I I Q

I
Linear Function EI  a3 
Q

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 31
 Income Elasticity of Demand

Q2  Q1 I 2  I1
Arc Definition EI  
I 2  I1 Q2  Q1

Normal Good Inferior Good

EI  0 EI  0

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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 33
Cross-Price Elasticity of Demand

QX / QX QX PY
Point Definition E XY   
PY / PY PY QX

Linear Function PY
E XY  a4 
QX

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 34
Cross-Price Elasticity of Demand

QX 2  QX 1 PY 2  PY 1
Arc Definition E XY  
PY 2  PY 1 QX 2  QX 1

Substitutes Complements
E XY  0 E XY  0

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 35
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 36
 Example: Using Elasticities in
Managerial 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

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 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
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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 39
 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
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 40
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 41
 Chapter 3 Appendix

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 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
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 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

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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 45
 Indifference Curves:
Complements and Substitutes

Perfect Perfect
Complements Substitutes
QY QY

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

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

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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 49
Budget Lines: Change in Income

GF: M = $6, PX = PY = $1
GF’: M = $3, PX = PY = $1

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 Consumer Equilibrium
• Combination of goods that maximizes
utility for a given set of prices and a
given level of income
• Represented graphically by the point of
tangency between an indifference curve
and the budget line
– MUX/MUY = PX/PY
– MUX/PX = MUY/PY
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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 52
 Mathematical Derivation
• Maximize Utility: U = f(QX, QY)
• Subject to: M = PXQX + PYQY
• Set up Lagrangian function
– L = f(QX, QY) + (M - PXQX - PYQY)
• First-order conditions imply
–  = MUX/PX = MUY/PY

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PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 54
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright  2007 by Oxford University Press, Inc. Slide 55