This Session

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This Session

• 1. Factors that determine the demand for a good
• 2. Demand estimation Know Your Market.
• 3. From demand functions to demand curves.
• 4. Elasticity Measuring the responsiveness of
  demand to changes in price/income.

Next Session
Production and Costs
2
Understanding Cost (session 3)
Revenue Understanding Demand (session 2)
Profit Revenue Cost
Pricing
Monopoly Trade off b/w high P and low Q
(session 6)
Perfect Competition Supply and entry decisions
(session 4 5)
What if we can price discriminate? (i.e.,
different consumers pay different
prices) (session 9 10)
How pricing depends on demand through the
elasticities (session 7)
Strategic Competition Solving for the NE
price and quantity competition (session 12)
How timing matters Stackelberg (session 14)
Exotic topics Strategic Demand Network
externalities and Auctions. (session 15)
Tools Games Theory (session 11)
Externalities and Strategic interaction
Collusion (session 13)
3
The Big Picture

• We introduce firms and the assumption that their
  objective is to maximize profits.
• Profits Revenue Cost
• This class Revenue (Price)(Quantity)
• Session 3 Cost
• Following sessions Pricing decision under
  different market structure?

Demand
4
Factors that affect demand

• Own Price (P)
• Prices of other goods (Po)
• Income (I)
• 4. Tastes (T)
• That is, demand is a function of own price,
  prices of other goods, income and tastes.

In what direction do these factors affect
demand? (if x increases does demand
increase/decrease?)
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Factors that affect demand

• Own Price (-)
• Law of Demand An increase in the price of a
  good, reduces the demanded quantity
• Prices of other goods (,-)
• Substitute Goods An increase in the price of
  Mercedes cars, increases the demand for BMW cars
• Complement Goods An increase in the price of
  gasoline, decreases the demand for cars

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Factors that affect demand

• Income (,-)
• Normal Goods The demand for cars in the Balkans
  will increase as per capita GDP increases.
• Inferior Goods The increase in per capita GDP
  will decrease the demand for cheap food.
• Tastes (,-)
• Advertising .
• People become more environmentally conscious.

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A summary table

8
Know Your Demand Regression Analysis
Case Deriving and Interpreting Demand
Equations

• Procedure
• Write down model (equation) for product demand
  with unknown coefficients.
• Collect data.
• 3. Fit line or curve to data points using
  statistical techniques (regression).
• Some sources of data
• 1. Consumer surveys.
• 2. Consumer focus groups.
• 3. Market experiments.
• 4. Historical (real) data cross-section,
  time-series, or both (panel).

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Regression Analysis Write down model (equation)

• The model (equation with unknown coefficients)
  describes qualitatively how demand looks like
• Linear Demand
• Constant-elasticity Demand
• Taking logs

• Fit line or curve to data points using
  statistical techniques Left to Statistics Courses

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Estimating DemandThe case of Mini-vans
The manufacturer has these data if it tracks
where its customers live, and what they paid.
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Estimating Demand Plot It!
Quantity 184.47 - 7.56Price
Every 1000 increase in price results in a
reduction of about 8 minivans sold in each zip
code.
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Estimating Demand Other Factors?
ObjectiveIsolate the effect price has on sales,
holding all other variables constant.
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Estimating Demand Multivariate Regression
Analysis
Estimated Sales - 6.66 - 5.22(Minivan
Price) 0.45(Income)
0.93(Population) 1.78( of Population lt 18
Years) 0.96(Advertising)
3.00(Chryslers Minivan Price) Variable
Definitions (for each zip code) Income
Average household income in thousands of
dollars. Population Population in thousands.
Under 18 Percentage of the population
under 18 years old. Price Average price
(in 1000s) of mini-vans sold. Advertising
Advertising money (in 1000s) spent.
Chrysler Price Average price (in 1000s) of
DaimlerChrysler mini-vans sold. Controlling
for other variables, a 1000 increase in the
price of this manufacturers minivans results
(on average) in a reduction of about 5 minivans
sold in each zip code.
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From Demand Functions to Demand Curves.
Estimated Sales - 6.66 - 5.22(Minivan
Price) 0.45(Income)
0.93(Population) 1.78( of Population lt 18
Years) 0.96(Advertising)
3.00(Chryslers Minivan Price)

• What is the demand curve when
• Income is 25K
• Population is 20K
• of Population lt 18 Years is 25
• Advertising is 3000
• Chrysler price of station wagons is 16K

• Demand function Estimated Sales 118.57
  5.22(Minivan Price)
• Inverse Demand Function Price 22.71
  0.19Sales
• We can plot this!
• If you have difficulties graphing the inverse
  demand function, you should attend the tutorial
  on Friday

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Movement Along and Movement of Demand Curve

• What if the mini-van manufacturer lowered the
  price of its vehicles by 1000? Do you need to
  write a new demand equation?
• No! Own price changes are movements along the
  demand curve
• If the manufacturer increased advertising, what
  would happen to the demand relationship?
• Demand curve would shift up. Movement of the
  demand curve
• If Chrysler reduced prices, what would happen to
  the demand relationship
• Demand curve would shift down. Movement of the
  demand curve

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Lessons so far

• Demand is a function of own price, prices of
  other goods, income and tastes.
• Law of demand An increase in the price of a good
  decreases the demanded quantity.
• The effects of the other factors on demand depend
  on whether goods are normal/inferior and
  substitutes/complements.
• With data on the variables that affect demand,
  you can estimate the demand curve
• It is possible to graph demand as a function of
  one variable keeping the other ones fixed.
• ? Moving along the demand vs. shifting the
  demand.

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Elasticity
Measuring responsiveness of demand to changes
in price
Loosely
Arc Elasticity Given two points (P1, Q1) and
(P2,Q2)
Point Elasticity If d(P) is smooth then
elasticity at point (P, Q)
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Elasticity and Expenditure
Loosely Precisely
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Some Price Elasticity
Air travel
Cars 0.78
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Why using elasticities rather than slopes?
P
change in Price 10
Elastic
100
90
Inelastic
10
9
Q
change Q large
change Q small

• Elasticity changes along the Demand Curve
• Elasticity decreases moving along the demand
  curve

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Price Elasticity of Demand in Westerville OH P
20.97?
Est. Sales -6.66 - 5.22(Price) 0.45(Income)
0.93(Pop) 1.78( Pop lt 18) 0.96(Adv)
3.00(Chryslers Price) -6.66 -
5.22(Price) 0.45(29.74) 0.93(24.66)
1.78(33.24) 0.96(4.87)
3.00(19.57) Sales 152.3- 5.22Price
E -(dQ/dP)(P/Q) 5.22(18.99 / 53.2)
1.9 53.2 Q 152.3 5.22(18.99)
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Other useful elasticity formulas

• Income elasticity of Demand
• normal goods - inferior goods
• Cross price elasticity of demand
• substitutes - complement

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Wrap Up on Elasticities

• Price (Income) elasticity is a measure of
  responsiveness of demand
• to its price (income).
• Arc elasticity measures discrete jumps.
• Point elasticity is measure when demand is
  smooth.
• Inelastic, unit elastic, and elastic demand.
• Empirical regularity demand becomes more
  elastic moving up
• demand curve (higher price, lower quantity).

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Wrap Up session 2

• Demand for a good depends on own price, prices of
  other goods, income and tastes.
• The law of demand says that as own price goes up
  demanded quantity goes down.
• The direction towards which other prices and
  income affect demand depends on whether the good
  is normal/inferior and substitute/complement.
• The correct way to measure the responsiveness of
  demand is elasticity (not the slope).
• Everything discussed today, especially
  elasticity, will be used numerous times in this
  and your other courses.