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Chapter 3 : DEMAND THEORY I. Demand Function Demand function can be of different forms.

In this topic, we will focus on linear demand function. A basic linear demand function is in the form of Qx = a b1Px + b2Py + b3Y

From this demand function, we can see that quantity demanded for good x depends on factors like price of good x (P x), price of good y (P y) and income (Y), where a, b1, b2 and b3 are constant values. For many purposes, it is useful to focus on the relationship between quantity demanded and the price of good or service while holding other variables constant. Hence, the demand function can be written as Qx = a b1Px

This demand function can be rewritten so that P becomes the subject or in other words, the conventional way of writing the demand curve function: Qx b1Px Px Example: = = = Qx a a b1Px Qx (1Qx / b1) 2Px Qx 1/2Qx 0.5Qx

(a/ b1) = 20 20 20/2 10

II.

2Px = Px = Px = The Market Demand

If you are given individual demand functions and you want to develop the market demand function, you need to add those individual demand functions. Give three individual demand : Q1 = a1 b1P1 Q2 = a2 b2P2 Q3 = a3 b3P3 To get market demand, we must make the following assumption: Let Pm = P1 = P2 = P3 where Qm = Q1 + Q2 + Q3 Example: The followings are individual demand functions for books for three individuals. Q1 = 25 2.50P1 Q2 = 35 0.25P2

Q3

20

1.25P3

The market demand function, assuming that there are only three individuals in the market, so we let Pm = P1 = P2 = P3 where Qm Qm Qm Qm III. = = = = Q1 + Q2 + Q3

(25 - 2.50P1) + (35 - 0.25P2 ) + (20 - 1.25P3 ) (25 - 2.50Pm) + (35 - 0.25Pm) + (20 - 1.25Pm ) 80 4Pm

Total, Marginal and Average Revenue a) Total Revenue, TR = Example: P TR TR = = = 8.5 P 8.5Q x 0.5Q Q 0.5Q2 Price, P x Quantity, Q

(Total Revenue function must be in the form of Q) b) Marginal Revenue, MR Example: TR MR c) = = 8.5Q 0.5Q2 = = 8.5 TR/Q Q = dTR/dQ

dTR/dQ

Average Revenue, AR Example: TR AR = = 8.5Q TR/Q =

0.5Q2 8.5 0.5Q

IV.

Elasticity a) Price elasticity of demand It measures the responsiveness of demand when price changes. Ed = dQ dP x P Q

Ed Ed change) to Ed Ed Ed Example :

> < = = =

1 1 1 0

elastic (sensitive to price change) inelastic (not very sensitive to price

unitary elastic (proportionately sensitive price change) perfectly inelastic (not sensitive to price change) perfectly elastic (very sensitive to price change)

Given Q = 60 4P + 10Y and initial values P = 2.5 and Y = 5 Ed = Q P Find Q P Q P and Q= Q= Q= x P Q and Q :

= 4 60 4P + 10Y 60 4(2.5) + 10(5) 100 2.5_ 100 < 1 Demand is inelastic

Ey Ey

= ( 4 ) x

= 0.1 , since 0 < Ed

Elasticity Vs Total Revenue Change in Price P P P or change) 4. P 5. P 1. 2. 3. Elasticity Elastic Demand Elastic Demand Unitary Elastic Demand Inelastic Demand Inelastic Demand Change In TR TR TR TR(no TR TR

(Note: Further explanation on the relationship between Ed and TR , please refer to study manual, page 104 105.) b) Income Elasticity It measures the responsiveness of demand to changes in income. Ey Ey = < dQ dY 0 x Y Q the good is an inferior good

Ey 0 < Example :

> Ey

1 0

the good is a luxury good the good is a necessity good

Given Q = 60 4P + 10Y and initial values P = 2.5 and Y = 5 Ey Find = Q x Y Y Q Q and Q : Y Q = 10 Y Q = 60 4P + 10Y Q = 60 4(2.5) + 10(5) Q = 100 5_ 100

and

Ey Ey c)

= (10) x

= 0.5 , since 0 < Ey 0 it is a necessity good

Cross Elasticity It measures the responsiveness of demand to changes in price of other goods. Ec = dQx dPy 0 0 0 x Py Qx the two products x and y are substitutes the two products x and y are complements there is no relationship between two products.

Ec Ec Ec the Example :

> < =

Given Qx = 20 4Px + 5Py + 10Y and initial values Px = 2.5, Py = 3 and Y = 2 EC = Qx x Py0 Py Qx0 Find Qx and Q : Py Qx = 5 Py and Q = 20 4P + 5Py + 10Y Q = 20 4(2.5) + 5(3) + 10(2)

Q = 45 EC = (5 ) x 3_ 45 > 0 , products x and y are

Ey = 0.33 , since Ec substitutes

Exercise: 1. is The demand equation faced by DuMont Electronics for its personal computers given by P = 10,000 4Q. a) b) c) d) e) Derive the total revenue function. Derive the marginal revenue function. At what price and quantity will marginal revenue be zero? At what price and quantity will total revenue be maximized? If price, P = RM6,000, calculate the price elasticity of demand for the product.

2.

Golden Bake is involved with the production of pies. Its demand function has been estimated as follows: Qb Qb A Ps Pb a) b) = -28.60 + 0.24A + 45.20Ps 38.80Pb

= the demand for Golden Bake pies. = Advertising expenditure = the price of competitors pie per unit = the price of Golden-Bakes pie per unit Derive the conventional demand curve function in the form of Q = a bP, given that Ps = 0.85 and A = 210. Derive the total revenue function.

c) d)

Calculate the sales-revenue maximizing price for Golden Bake. What is the maximum total revenue it can earn? (APR 2002/ECO555/510/465/550)

3.

Demand for softback managerial economics text is given by Q = 20,000 300P. The book is initially priced at RM30. a) Compute the point price elasticity of demand at P = RM30.

b) If the objective is to increase total revenue, should the price be increased or decreased? Explain.