Chapter 3

Quantitative Demand Analysis

 Learning Objectives

Apply Apply various elasticities of demand as a quantitative tool to forecast changes in revenues, prices, and/or units sold.

Illustrate Illustrate the relationship between the elasticity of demand and total revenues.

Discuss Discuss three factors that influence whether the demand for a given product is relatively elastic or inelastic.

Explain Explain the relationship between marginal revenue and the own price elasticity of demand.

Show Show how to determine elasticities from linear and log-linear demand functions.

Explain Explain how regression analysis may be used to estimate demand functions and how to interpret and use the output of a regression.

© 2022 by McGraw-Hill Education. All Rights Reserved. 2

TIKET GARUDA NAIK, PENUMPANG PESAWAT TURUN

Kompas.com - 27/12/2019, 17:49 WIB

Penumpang maskapai Garuda Indonesia mengalami penurunan hingga kuartal
III 2019. Penurunan ini ditengarai karena kenaikan harga tiket pesawat.
Pelaksana tugas (Plt) Direktur Utama Garuda Indonesia Fuad Rizal mengatakan,
pada kuartal III 2019 penumpang yang menggunakan maskapai plat merah itu
tercatat sebanyak 8,2 juta. Sedangkan di periode yang sama tahun lalu jumlah
penumpangnya sebesar 10,3 juta. “Karena penyesuaian harga (tiket pesawat)
penumpang (Garuda Indonesia) turun 20,6 persen,” ujar Fuad di kantornya,
Tangerang, Jumat (27/12/2019).

Penurunan jumlah penumpang itu terjadi untuk rute domestik maupun

internasional. Di rute domestik, jumlah penumpang Garuda di kuartal III 2019
tercatat sebanyak 4 juta. Jumlah itu menurun 18,83 persen dibanding periode
yang sama pada tahun lalu, yakni 5 juta penumpang. Selanjutnya, di rute
internasional pada kuartal III 2019 jumlah penumpang Garuda sebanyak 1 juta.
Di tahun lalu, penumpang Garuda sebanyak 1,1 juta.

Kendati penumpang Garuda turun, lanjut Fuad, pendapatan perusahaannya tak

ikut turun di kuartal III 2019 ini. Pendapatan usaha Garuda tercatat malah naik
sebesar 10,3 persen. Kuartal III tahun ini, pendapatan usaha Garuda tercatat
sebesar 1,35 miliar dollar AS. Di tahun lalu, pendapatan Garuda hanya 1,22
miliar dollar AS. “Dari sisi revenue kami bisa dapat lebih baik dari sebelumnya,”
kata Fuad.
 The Elasticity Concept

Elasticity
– A measure of the responsiveness of one variable to changes in another variable;
the percentage change in one variable that arises due to a given percentage
change in another variable.

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-5

 The Elasticity Concept

The elasticity between two variables, 𝐺 and 𝑆, is mathematically expressed

as:
%Δ𝐺
𝐸!,# =
%Δ𝑆

When a functional relationship exists, like 𝐺 = 𝑓 𝑆 , the elasticity is:

𝑑𝐺 𝑆
𝐸!,# =
𝑑𝑆 𝐺

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-6

 Measurement Aspects of Elasticity

Important aspects of the elasticity:

– Sign of the relationship:
• Positive
• Negative
– Absolute value of elasticity magnitude relative to unity:
• 𝐸!,# > 1 𝐺 is highly responsive to changes in 𝑆.
• 𝐸!,# < 1 𝐺 is slightly responsive to changes in 𝑆.

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-7

 Own Price Elasticity of Demand
Own price elasticity of demand
– Measures the responsiveness of a percentage change in the quantity demanded of good X to a
percentage change in its price.
%Δ𝑄$ %
𝐸! "
,#! =
! %Δ𝑃$
– Sign: negative by law of demand.
– Magnitude of absolute value relative to unity:
• 𝐸! " > 1: Elastic.
! ,#!

• 𝐸! " < 1: Inelastic.

! ,#!

• 𝐸! " = 1: Unitary elastic.

! ,#!

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-8

© 2022 by McGraw-Hill Education. All Rights Reserved.
 Linear Demand, Elasticity, and Revenue (Figure 3.1)
Price Linear Inverse Demand: 𝑃 = 40 − 0.5𝑄
$40 Demand: 𝑄 = 80 − 2𝑃
• Revenue = $30×20 = $600
$35 $%&
• Elasticity: −2× = −3
$30 '&
• Conclusion: Demand is elastic.
• Revenue = $20×40 = $800
Observation: Elasticity $25 $'&
varies along a linear • Elasticity: −2× (& = −1
$20
(inverse) demand curve • Conclusion: Demand is unitary elastic.
$15
• Revenue = $10×60 = $600
$10 $)&
• Elasticity: −2× *& = −0.333
$5 • Conclusion: Demand is inelastic.
Demand

0 10 20 30 40 50 60 70 80 Quantity

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-10

 Elasticity and Total Revenue (Figure 3.1)

• Total Revenue is maximized

when elasticity is = 1, Unitary
Elastic
• In the elastic range, total
revenue can be increased by
decreasing price.
• In the inelastic range, total
revenue can be increased by
increasing price.

© 2022 by McGraw-Hill Education. All Rights Reserved. 11

 Total Revenue Test

When demand is elastic:

– A price increase (decrease) leads to a decrease (increase) in total revenue.
When demand is inelastic:
– A price increase (decrease) leads to an increase (decrease) in total revenue.
When demand is unitary elastic:
– Total revenue is maximized.

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-12

Perfectly Elastic and Inelastic Demand (Figure 3.2)
Price
Demand

𝐸! " =0
! ,#!

Perfectly Demand
elastic
𝐸! ",# = −∞
! !

Perfectly Inelastic Quantity

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-13

 Factors Affecting the Own Price Elasticity

Three factors can impact the own price elasticity of demand:

1. Availability and number of substitutes
2. Time/duration of purchase horizon
3. Expenditure share of consumers’ budgets

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-14

 Marginal Revenue and the Own Price Elasticity of
Demand
The marginal revenue can be derived from a market demand curve.
– Marginal revenue measures the additional revenue due to a change in output.
This link relates marginal revenue to the own price elasticity of demand as
follows:
1+𝐸
𝑀𝑅 = 𝑃
𝐸
– When −∞ < 𝐸 < −1 then, 𝑀𝑅 > 0.
– When 𝐸 = −1 then, 𝑀𝑅 = 0.
– When −1 < 𝐸 < 0 then, 𝑀𝑅 < 0.

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-15

Demand and Marginal Revenue (Figure 3.3)
Price
6
Ela
sti Unitary
c
𝑃

MR
Ine
las
tic

Demand

0 1 3 6 Quantity

Marginal Revenue (MR)

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-16
 Cross-Price Elasticity

Cross-price elasticity
– Measures the responsiveness of a percent change in demand for good X due to a
percent change in the price of good Y.
%Δ𝑄, -
𝐸* " =
! ,+# %Δ𝑃.

– If 𝐸! "
,## > 0, then 𝑋 and 𝑌 are substitutes.
!

– If 𝐸! "
,## < 0, then 𝑋 and 𝑌 are complements.
!

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-17

 Cross-Price Elasticity in Action

Suppose it is estimated that the cross-price elasticity of demand between

clothing and food is -0.18. If the price of food is projected to increase by
10 percent, by how much will demand for clothing change?

%∆𝑄9:;<=>?@ %
−0.18 = ⇒ %∆𝑄9:;<=>?@ % = −1.8
10

– That is, demand for clothing is expected to decline by 1.8 percent when the price
of food increases 10 percent.

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-18

 Cross-Price Elasticity

• Cross-price elasticity is important for firms selling multiple products.

– Price changes for one product impact demand for other products.
• Assessing the overall change in revenue from a price change for one
good when a firm sells two goods is:

∆𝑅 = 𝑅, 1 + 𝐸* " + 𝑅. 𝐸* " ×%∆𝑃,

! ,+! # ,+!

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-19

 Cross-Price Elasticity in Action

Suppose a restaurant earns $4,000 per week in revenues from hamburger

sales (X) and $2,000 per week from soda sales (Y).
If the own price elasticity for burgers is 𝐸*!,+! = −1.5 and the cross-price
elasticity of demand between sodas and hamburgers is 𝐸*#,+! = −4.0,
what would happen to the firm’s total revenues if it reduced the price of
hamburgers by 1 percent?
∆𝑅 = $4,000 1 − 1.5 + $2,000 −4.0 −1% = $100
– That is, lowering the price of hamburgers 1 percent increases total revenue by
$100.

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-20

 Income Elasticity

Income elasticity
– Measures the responsiveness of a percent change in demand for good X due to a
percent change in income.
%Δ𝑄, -
𝐸* " =
! ,/ %Δ𝑀

– If 𝐸! "
,A > 0, then 𝑋 is a normal good.
!

– If 𝐸! "
,A < 0, then 𝑋 is an inferior good.
!

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-21

 Income Elasticity in Action

Suppose that the income elasticity of demand for organic potatoes is

estimated to be 2.26. If income is projected to decrease by 10 percent,
what is the impact on the demand for organic potatoes?
%Δ𝑄, -
2.26 =
−10
– Demand for organic potatoes will decline by 22.6 percent.

Are organic potatoes a normal or inferior good?

– Since demand decreases as income declines, organic potatoes are a normal good.

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-22

 Other Elasticities

Own advertising elasticity of demand for good X is the ratio of the

percentage change in the consumption of X to the percentage change in
advertising spent on X.

Cross-advertising elasticity between goods X and Y would measure the

percentage change in the consumption of X that results from a 1 percent
change in advertising toward Y.

© 2022 by McGraw-Hill Education. All Rights Reserved. 2-23

 Elasticities for Linear Demand Functions

From a linear demand function, we can easily compute various elasticities.

Given a linear demand function:
-
𝑄, = 𝛼0 + 𝛼, 𝑃, + 𝛼. 𝑃. + 𝛼/ 𝑀 + 𝛼1 𝑃1

C
– Own price elasticity: 𝐸!$ , 𝑝B = 𝛼$ !$
$
C%
– Cross price elasticity: 𝐸!$ , , 𝑃D = 𝛼E
!B
A
– Income elasticity: 𝐸!$ ,A = 𝛼A !
$

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-24

 Elasticities for Linear Demand Functions In Action

The daily demand for Invigorated PED shoes is estimated to be:

𝑄$ % = 100 − 3𝑃$ + 4𝑃E − 0.01𝑀 + 2𝑃F!

Suppose good X sells at $25 a pair, good Y sells at $35, the company utilizes 50
units of advertising, and average consumer income is $20,000. Calculate the own
price, cross-price and income elasticities of demand.
– 𝑄$ % = 100 − 3 $25 + 4 $35 − 0.01 $20,000 + 2 50 = 65 units.
&'
– Own price elasticity: −3( ) = −1.15.
('
)'
– Cross-price elasticity: 4( ) = 2.15.
('
&*,***
– Income elasticity: −0.01( ) = −3.08.
('

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-25

 Elasticities for Nonlinear Demand Functions

A log-linear specification is appropriate if quantity demanded is not

linearly related to the explanatory variables:

ln 𝑄, - = 𝛽0 + 𝛽, ln 𝑃, + 𝛽. ln 𝑃. + 𝛽/ ln 𝑀 + 𝛽1 ln 𝐻

– Own price elasticity: 𝛽$ .

– Cross price elasticity: 𝛽E .
– Income elasticity: 𝛽A .

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-26

 Elasticities for Nonlinear Demand Functions In Action
An analyst for a major apparel company estimates that the demand for its
raincoats is given by
𝑙𝑛 𝑄, - = 10 − 1.2 ln 𝑃, + 3 ln 𝑅 − 2 ln 𝐴.
where 𝑅 denotes the daily amount of rainfall and 𝐴E the level of advertising on good Y.
What would be the impact on demand of a 10 percent increase in the
daily amount of rainfall?
%∆*! " %∆*! "
𝐸* " = 𝛽2 = 3. So, 𝐸* " = ⇒3=
! ,2 ! ,2 %∆2 50

A 10 percent increase in rainfall will lead to a 30 percent increase in the demand for
raincoats

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-27

 Data-Driven Demand Curves
• Recall from Chapter 1, Table 1-3
the example relating quantity and
price for television using data
from 10 outlets.
• Suppose now that the data were
generated as part of a field
experiment. Using regression
analysis, the demand curve is
estimated to be
Q = 1631.47 – 2.60P

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-28

 Regression for Nonlinear Functions
and Multiple Regression
Regression techniques can also be applied to estimate log-linear demand
functions, a common application for nonlinear functions.

See the Excel file Demo03-05.xls at www.mhhe.com/baye10e

© 2022 by McGraw-Hill Education. All Rights Reserved. 3-29

Using Multiple Regression to Estimate Demand Curves with
Multiple Explanatory Variables

• Functional relationships with multiple variables:

• For linear demand relationship
-
𝑄, = 𝛼0 + 𝛼, 𝑃, + 𝛼/ 𝑀 + 𝛼1 𝑃1 + 𝑒
• Or for non-linear relationship
ln 𝑄, - = 𝛽0 + 𝛽, ln 𝑃, + 𝛽/ ln 𝑀 + 𝛽1 ln 𝑃1 + 𝑒
© 2022 by McGraw-Hill Education. All Rights Reserved. 30