2.

DEMAND ANALYSIS

Definition of Demand
Quantity of goods/services that customers
have desire, willing and able to buy during
specific period of time, ceteris paribus.
Law of Demand
There is an inverse/negative relationship
between Px and Qdx, ceteris paribus.
Determinants of Demand
Demand depends on price of the product,
price of related products, consumer
income, taste, advertising, etc.

Determinants of demand
1.

Price
Inverse relationship between price and
quantity demanded.
Increase in price- Decrease demand
Decrease in price- Increase demand

2.

Consumer preference or taste

When consumer prefer the products,
demand increases.
The amount spent on advertising would
change the preference of consumers.

3.

Income
Positive relationship between income and
demand for normal goods
Negative relationship between income
and demand for inferior goods.
2

4.

Price of Other Goods

a) Substitute goods- Goods that satisfy
the same needs
Increase in price of meat will increase
demand for fish
Positive relationships between price
of substitute good and demand for
one good.
b) Complementary goods-Goods that are
jointly consumed or used together.
Increase in price of camera will
decrease demand for film.
Negative relationship

Demand function vs Demand Curve

function
Demand function- shows the relationship between
Qd of a product and all determinants of
demand for the products.
Qx = f( Px, Py, Y,A)
Qx = 40 3Px+ 4Py +0.6 Y + 1.5 linear
function

Qx = aPxb1Pyb2Yb3

- multiplicative function

Demand curve function

Express the relation between price and quantity
demanded holding other factors (determinant
of demand) constant.
Qx =f(Px)
Qx = a b1Px
Px = a/b1 Qx/b1 conventional demand curve
function
4

 Ex 1
Given the estimated demand function is :
Qx = 2 3Px + 2Y + 3Py + T
Given :
Px = 2, Y = 4, Py = 3, T = 1
Q1 : Derive the demand curve function.
Qx = 2 3Px + 2(4) + 3(3) + (1)
Qx = 20 3Px
Px = 20/3 Qx/3

Individual Demand vs Market Demand

Individual demand- It shows an individual/
one person demand demand. It had an
inverse relationship between price of X
and quantity demanded of X.
P

D
Qty

Market Demand-Summation of all

individual demand
Qm = Q1 +Q2 +Q3
e.g Q1 = 110 2P
Q2= 50 0.5 P
Q3 = 40 P
Qm = (110 2P) + (50-0.5P) +(40 P)
Qm = 200- 3.5 P
6

DETERMINING MARKET PE AND

QE
A market is in equilibrium if QD equal to
QS
The price at which equilibrium occurs is
called PE
When D curve or S curve or both curve
changes, market equilibrium changes.
Condition for equilibrium :
PA = PB OR QD = QS
Ex 2.
Given QD = 10 PA
QS = 2 + PB
Q : Find equilibrium price and quantity?
7

DEMAND, TOTAL REVENUE & MARGINAL

REVENUE
Demand: P = 20 4Qx
Total Revenue = Price x quantity
TR = PQ
TR= (20 4 Q) Q
TR =20 Q 4Q 2
Average Revenue= TR/Q
AR = Price .. AR = PQ
Q
Marginal revenue (MR)= d(TR) /dQ
= 20 - 8Q

Price

Quantity

TR

MR

$ 10

$ 10

18

24

28

30

30

28

-2
8

Graph: Demand,Total Revenue, Marginal

Revenue
TR
TR
TR

TR

Qty
Elastic
Inelastic

P,MR
Unitary
elastic

MR>0

MR=0
MR < 0

Qty

MR

Note
MR has the same intercept as demand equation
Slope of MR is twice the slope of demand curve
MR > 0--------- TR increases
MR < 0---------TR decreases
MR =0----------TR maximum

ELASTICITY OF DEMAND
A) PRICE ELASTICITY OF DEMAND
Responsiveness of demand towards a change in price
A % change in price -------------- effect on % change
in quantity demanded?
Law of demand-Inverse relationship between price
and quantity demanded
Ep= % change in Quantity demanded
% change in price
Two formula for Ep:
a) Point price elasticity of demand
Elasticity at a given point on demand curve
Ep= % Q
%P
= Q/Q
P/P
=Q.P
P Q
Ep = dQ .P
dP Q
10

 E.g Q = 100 4P
dQ/dP = -4
If P = $10, Q= 100-40
Q =60
Ep = dQ . P
dP Q
=-4 x 10
60
= -0.67
1 % increases in price will decrease Quantity demanded
by 0.67%
b) Arc price elasticity of demand
Measures the percentage effect on Quantity
demanded because of a percentage change in price
Ep= % Q
%P
Midpoint formula:
Ep = (Q2 Q1)
(Q2 +Q1)/2
____________
(P2- P1)
(P2+ P1)/2
11

Ep= (Q2- Q1) x

(Q2 +Q1)

(P2 + P1)
(P2 P1)

Use this formula

e.g Ep = (40-30) x (8+12)

(40 +30) (8-12)
=10 x 20
-4 70
=-0.7
1 % change in Px--------- 0.7 % change in Qx
Character of demand
lEpl > 1 Elastic demand
lEpl < 1 Inelastic demand
PlEpl = 1 Unitary elastic demand
Elastic

Unitary elastic

Inelastic

D
MR> 0
MR =0
MR <0

MR
12

 Price Elasticity and marginal revenue

Pric Qty Price
TR
MR
Character of
e
demand
Elastici
ty
$10

-10

$10

Elastic

-4.5

18

-2.67

24

-1.75

28

67

-1.2

30

-0.83

30

Inelastic

-0.57

28

-2

-0.38

24

-4

Degrees of price elasticity

a) Perfectly elastic
b) Relatively Elastic
P
lEpl=
P
lEpl > 1
D
D

13

 c) Unitary elastic

d) Relatively Inelastic

lEpl
=1

lEpl < 1
D

D
Q

Q
e) Perfectly Inelastic

P
lEpl = 0

Q
Determinants of Price Elasticity
1. Availability of substitutes
Many substitutes- more elastic (e.g drinks)
Few substitutes-inelastic (e.g sugar)
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2. Proportion of Income Spent

Large proportion of income spent- More elastic
(e.g electrical equipment)
Small proportion of income spent Inelastic
(e.g newspaper)
3. Time Period given to consumer
Long run- Consumers have more
opportunities to
adjust to changes in
price.therefore, demand is
more elastic
Short run- Demand is Inelastic
4. Types of product
Luxury Goods- More Elastic
Necessity goods- Inelastic
Price Elasticity of Demand and Decision
making
Important for pricing decision
There is a relationship between price elasticity of
demand and total revenue
TR= PQ
MR=dTR/dQ=d(PQ)/dQ= P + Q dp/dQ
=P (1 + Q/P. dP/dQ)
=P(1 + 1/Ep)

15

MR is a function price elasticity

Changes in price will influence a change in TR based
on price elasticity of demand
a) Unitary elastic ( Ep =-1 )
MR=P(1 + 1/-1)
MR=0
No change in TR
b) Elastic (Ep =-2)
MR=P(1 +1/-2)
MR=0.5 > 0
Decrease Price-------Increase TR
Increase Price-------Decrease TR
P and TR move in the opposite direction
c) Inelastic (Ep=-0.5)
MR= (1 + 1/-0.5) =1-2 = -1 < 0
Decrease price--------Decrease TR
Increase price---------Increase TR
P and TR move in the same direction
16

Price elasticity of demand and decision

making
Relationship between price elasticity and total revenue is
important for pricing decision
TR = PQ
MR =d (TR)/dQ
= d(PQ) / dQ
= P + Q dP/dQ
=P (1 + Q / P . dP / dQ)
=P(1 +1/EP)
MR is a function of price elasticity (Refer page 69 Text
Book).
Change in TR depends on price elasticity of demand:
a)Demand is unitary elastic
Change in price will not change TR
b) Demand is elastic
Decrease in Price will increase TR
Increase in Price will decrease TR
P and TR move in the opposite direction
c) Demand is inelastic
Decrease in Price will decrease TR
Increase in Price will increase TR
P and TR move in the same direction
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INCOME ELASTICITY
Measures a change in demand because of a change in
income.
Responsiveness of demand towards a change in income
Income elasticity of = % change in demand
Demand
% change in income
a) Point income elasticity of demand
Ey= dQ x Y
dY Q
e.g Q=500+2Y
Y = 1000
Q=500 + 2000=2500
Ey =2 x 1000/2500 =2000/2500=4/5 =0.8
1 % change in income------ quantity demand
will change by 0.8%
This product is a necessity good
b) Arc income elasticity of demand
Ey= ( Q2-Ql) x Y2 +Y1
(Q2 +Q1) (Y2-Y1)

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Rule:
i) Ey > 0
Normal goods
a) 0<Ey<1
% Q < % Y
Necessity good (E, =0.7)
e.g rice
b) Ey> I
Luxury goods (Ey =2.4)
% Q >% Y
e.g jewelleries
Positive relationships between income and demand
for normal goods
ii) Ey <0 Inferior goods
e.g Ey= -4.3
Negative relationships between income and
demand for inferior goods
Income elasticity and decision making
(Important uses)
1 .To forecast the changes in demand for the products
that a firm sell under different economic conditions
(different stages of business cycle)
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a) Economic expansion
Demand for luxury good increases
Large changes in demand (e.g vacations)
Demand for product with low income elasticity of
demand such as necessity will be less affected
and less fluctuates.
b) Recessionary period
Sharp decrease in demand for luxury goods.
For necessity goods, demand will be less affected.
2. Marketing strategy
Identify the markets of the products
-which types of customers are most likely to buy
the products.(e.g high income or lower income )
-determine the most suitable media for its
promotional campaign to reach the target
customers.

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CROSS PRICE ELASTICITY OF DEMAND

Measures the responsiveness of consumers towards a
change in price of other product.
To see the effect of price of A on quantity demanded for
good B.
Cross price elasticity =% change in Qty B
of demand
%change in price of Good A
a) Point cross price elasticity of demand
Ec=d QB. PA
d P A QB
e.g QB = 60 + 0.2PA
PA = $20,
QB = 60 + 0.2(20)
=60 + 4
=64
Ec=0.2 x 20
64
=0.06
1 % change in PA causes 0.06% increase in QB
b) Arc cross price elasticity of demand
Ec =( Q2 BQ1 B) x (P 2 A +P2 A )
(Q2 B +Q1B) (P2 A -P1 A )

21

Q B = 60 + 0.2P A
P1 A =$30
Q1 B = 60 +0.2 (30)
=66
P2 A = $40 Q2 B = 60 + 0.2 (40)
=68
Ec= (68-66)x (40+30)
(68 +66) (40 -30)
=0.1
1 % increase in price of A will cause 0.1 %
increase in Qty of B

Relationship between the two products.

a) Ec> 0
Goods A and B are substitutes e.g beef and chicken
Increase in price of A------- Increase in Qty
demand for Good B
Positive relationship
Demand curve for B shifts to the right.
b) Ec < 0
Goods A and B are complementary goods
e.g car and petrol
Increase in P of A---------Decrease in demand
for Good B
Negative relationship
22

Cross price elasticity of demand and decision making

1. Important for firms that produce related products e.g
Gillette -razor and razor blade
Decrease in price of razor will increase the quantity
of razor
This will increase the demand for razor blade
2. To establish boundaries between industries -to define
the industry
High & positive Ec
---same industries
Low & negative Ec
---belong to different
industries
e.g to control monopoly

23

ADVERTISING ELASTICITY OF DEMAND

The purpose of advertising is to increase the
consumer preference
From sellers point of view, the purpose of
advertising is to make demand more inelastic.
Therefore, this will allow producer to charge higher
price
Ea=
% change in Qty
% change in advertising
a) Point advertising elasticity of demand
Ea= dQ x A
dA Q
b) Arc advertising elasticity of demand
Ea= (Q2-Q1) x (A2+A1)
(Q2+Q1) (A2-A1)
RULE:
1) Ea> 1
Larger impact on demand due to a change in
advertising
2) Ea< 1
Smaller impact on demand due to a change in
advertising
24

-more difficult to see changes in quantity demanded

as a result of change in advertising
-many factors can affect the Ea.
i) stage of product market development
ii) the extent of competitors reaction to companys
advertising
iii) importance of other determinants ( price, income,
etc)
iv) time interval

25