Taken from: Online Materials for the book: Sloman, John and Mark Sutcliffe (2004), Economics for

Business, 3rd ed., Prentice Hall

The Demand for Butter

A real-world demand function

The following is an estimate of the UKs market demand curve for butter. It has been estimated (using a computer regression package) from actual data for the years 19929. Qd = 21.39 10.88Pb + 12.36Pm + 0.29Y where: Qd is the quantity of butter sold in grams per person per week. Pb is the real price of butter: i.e. the price of butter in pence per kg, divided by the retail price index (RPI) (1990 = 100). Pm is the real price of margarine (calculated in the same way as butter). Y is the real personal disposable income of households: i.e. household income after tax, expressed as an index (1990 = 100). From this economists could forecast what would happen to the demand for butter if any of three variables the price of butter, the price of margarine or income changed.

Question From this equation, calculate what would happen to the demand for butter if: (a) The price of butter went up by 1p per kg and the RPI was 100. (b) The price of margarine went up by 1p per kg and the RPI was 200. (c) The index of personal disposable incomes went up by 1 point.

There is a serious problem with estimated demand functions like these: they assume that other determinants of demand have not changed. In the case of this demand-for-butter function, one of the other determinants did change. This was tastes during the 1980s and 1990s there was a massive shift in demand from butter and margarine to low fat spreads, partly for health reasons, and partly because of an improvement in the taste for these products and a greater range available. The following table shows this shift. Consumption of butter, margarine and spreads (grams per person per week) Butter 1986 1992 1997 64 41 38 Margarine 116 79 26 Low-fat spreads 30 51 77

Source: Based on National Food Survey (MAFF) various years.

Assuming that this shift in taste took place steadily over time, a new demand equation was estimated for the same years: Qd = 16.4 8.63Pb + 6.67Pm + 0.5Y 1.16TIME where the TIME term is as follows: 1992 = 1, 1993 = 2, 1994 = 3, etc. Because of the large changes, over just a few years, in the nature and variety of low fat spreads, it is not possible to include the price (or prices) of these products in an equation in any meaningful way. But clearly, their presence on the market has shifted the demand curve for butter, and continues to do so, and hence makes the estimated equations less reliable for forecasting the demand for butter.

Questions 1. How does the introduction of the TIME term affect the relationship between the demand for butter and (a) the price of margarine and (b) personal disposable income? 2. Is butter a normal good or an inferior good?

Calculations by W. Thurlow.