Managerial Economics ECO555

CHAPTER 3 : DEMAND ANALYSIS

I. Demand
II. Law of Demand
III.Determinants of Demand
IV. Demand Function
1.
Linear Function
2.
Multiplicative Function
V. Demand Curve Function
1.
How to derive the demand curve function
from a demand function
VI.

Relationship Among Total Revenue, Average

Revenue and Marginal Revenue
1.
Total, Marginal and Average Revenue
Functions
2.
Total Revenue, Marginal Revenue and
Average Revenue Curves

VII. The Individual Demand and Market Demand

VIII. Determining
Quantity
IX.

Market

Equilibrium

Price

and

Elasticities of Demand :
1.
Price Elasticity of Demand
2.
Income Elasticity of Demand
3. Cross Elasticity of Demand
4. Advertising Elasticity of Demand
CHAPTER 3 : DEMAND ANALYSIS
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Managerial Economics ECO555

I.

Demand
It is the quantity of a good or service that customers are willing and able
to buy

II.

Law of Demand
There is an inverse/negative relationship between price and quantity
demanded for a product, ceteris paribus.
When price increases, quantity demanded decreases and vice versa.

Price, P

Demand

Quantity, Q
Diagram 1 : Demand Curve

III.

Determinants of Demand
There are factors that influence demand for a product.
Examples of determinants of demand are:
1.
2.
3.
4.
5.
6.

IV.

Price of the product,

Price of another related product
Consumer income
Advertising expenditure
Expectations of price changes, and others
Government policy

Demand Function

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Demand function shows the relationship between quantity demanded and

all determinants of demand.

where,

QX

f(PX, A, I, T, .)

PX
A
I
T

=
=
=
=

price of product x
advertising expenditure
income per capita
taste of consumers

Demand function can be of different forms.

1.

Linear Function
QX = a - b1PX

+ b2PY

+ b3Y

a = constant and b = coefficient

b indicates the marginal impact of each independent variable on
the quantity demanded.
if b1 = 5, means 1 unit change in price of good x, quantity
demanded for good x change by 5 units.
2.

Multiplicative Function
QX

aPXb1PYb2Yb3

b measures the percentage change in the dependent variable

relative to % change in the respective independent variable.
if b1 = -5, then a 1% increase in price, quantity demanded will
decrease by 5%.
V.

Demand Curve Function

1.

How to derive the demand curve function from a demand

function
A demand function shows quantity demanded for good x depends
on factors such as price of good x (P X), price of good y (P Y) and
income (Y).
A demand curve function shows the relationship between quantity
demanded and the price of good or service while holding other
variables constant.

Hence, the demand curve function can be written as:

QX

b1PX

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This demand curve function can be rewritten so that P becomes the

subject
QX
b1 PX
PX

=
a
b1PX
=
a
QX
=
(a/ b1)
(QX / b1)
(conventional demand curve function)

Example:
Assume the estimated demand function is
QX = 2 - 3PX + 2I + 3PY + T
Given PX = 2, I = 4, PY = 3 and T = 1
i)

To derive a demand curve function, substitute all the values

except for PX
QX = 2 - 3PX + 2(4) + 3(3) + (1)
QX = 20 3 PX

ii)

To derive to a conventional demand curve function,

rearrange the above function so that PX will be the
dependent variable and QX the
independent variable.
QX
3 PX
PX

VI

Relationship among
Marginal Revenue
1.

= 20 3 PX
= 20 - QX
= 20/3 - QX /3
Total

Revenue,

Average

Revenue

and

Total, Marginal and Average Revenue Functions

Q
P

= a bP
= a/b 1/b Q

Table 1 : Total Revenue, Average Revenue and Marginal Revenue

Functions

From Table 1, the slope of marginal revenue is twice the slope of average
revenue or price.
Total Revenue
TR = P x Q
TR = (a/ b - 1/ b Q) x Q
TR = a/b Q 1/b Q2

i)

Average Revenue
AR
AR
AR
AR

=
=
=
=

TR/Q
(P x Q) / Q
P
a/b 1/b Q

Marginal Revenue
MR = dTR/dQ
MR=d(a/b Q1/b Q2) /dQ
MR = a/b 2/b Q

Total Revenue, TR = Price (P) x Quantity (Q)

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Example:
P
TR
TR
TR
ii)

=
=
=
=

6.5 - 0.5Q
PxQ
(6.5 0.5Q) x Q
6.5Q - 0.5Q2

Marginal Revenue, MR = d(TR)/dQ

Example:
TR
MR

iii)

=
=

6.5Q d(TR)/dQ

0.5Q2
=
6.5 - Q

Average Revenue, AR = TR/Q

Example:
TR
AR
AR

=
=
=

6.5Q - 0.5Q2
TR/Q = (6.5Q
6.5 - 0.5Q

- 0.5Q2)/ Q

Note:
Total Revenue, marginal revenue and average revenue
functions must be in the form of Q

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2.
Curves

Total Revenue, Marginal Revenue and Average Revenue

P, MR
6.5

P = AR = D
MR
6.5

13

TR

TR is max; MR = 0
TR is increasing; MR +ve
TR is decreasing; MR -ve

TR

Diagram 2 : Total
and Marginal
6.5Revenue, Average Revenue
13
Q
Revenue Curves

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VII

The Individual Demand and Market Demand

Market demand is the aggregate of individual demand. It shows the total
quantity demanded in the market at various prices.
Given individual demand functions, a market demand function is derived
by adding the individual demand curve functions.
Example:
The followings are individual demand curve functions for books for three
individuals.
Q1
Q2
Q3

=
=
=

30
22.5
37.5

P
0.75P
1.25P

The market demand curve function, assuming that there are only three
individuals in the market, is
QM
QM
QM
VIII

=
=
=

Q1
+
Q2
+
Q3
(30 P) + (22.5 0.75P) + (37.5 1.25P)
90
3P

Determining Market Equilibrium Price and Quantity

A market is in equilibrium if quantity demanded is equal to quantity
supplied at some price.
The price at which equilibrium occurs is called equilibrium price.
When demand or supply or both of them change, market equilibrium
changes.
Conditions:
PA = PB

OR

Q D = QS

Example:
Given QD = 10 PA and QS = 2 + PB
Market equilibrium price & quantity:
QP
D
10 PA
2P
P

4
substitute

= QS

= 2 + PB
=8
=4
P = 4 into QD or QS
Q = 10 4 = 6

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Diagram 3 : Market Equilibrium Price and Quantity for a

Good
IX.

Elasticities of Demand
Elasticity is the measurement of the percentage change in one variable
that results from a 1% change of another variable.
Elasticity of demand measures the sensitivity of quantity demanded to
changes in its determinants.
Two ways of measuring elasticity:
Arc elasticity - measures over a range of output
Point elasticity- measures over very small range of output
1.

Price Elasticity of Demand

It measures the responsiveness of quantity demanded when price
changes. Price elasticity coefficient can help managers in making
decision.
Formulas:
Point Elasticity:
dQ x P
dP
Q
Arc Elasticity:
Q2 Q 1 x
P2 P1
i)

P2 + P1
Q 2 + Q1

Degrees of Price Elasticity of Demand

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lEpl

>

elastic (sensitive to price change)

lEpl

<

inelastic (not very sensitive to price

change)

lEpl

unitary
elastic
(proportionately
sensitive to price change)

lEpl

perfectly inelastic (not sensitive to

change)

lEpl

perfectly elastic
change)

price

price

(very

sensitive

to

Example on price elasticity:

QX = 1 2PX + 2Y + 3T + PY
given
PX = 2, Y = 4, T = 1 and PY = 3
QX

= 1 2(2) + 2(4) + 3(1) + (3)

= 11

lEpl

= dQX x PX
dPX
QX
= -2 x (2 / 11)
= 4/11 (inelastic)

ii)

Elasticity along a linear demand curve

In a linear demand curve function, the elasticity along the
demand curve varies from zero to infinity.

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Managerial Economics ECO555

Diagram 4 : Elasticity Along a Linear Demand Curve

iii)
Relationship
revenue:

between

price

elasticity

and

total

If demand is elastic, it is better to reduce price to increase

total revenue.
If demand is inelastic, it is better to increase price to
increase total revenue.
If demand is unitary elastic, a price increase or decrease will
not change total revenue.
iv)

Determinants of price elasticity of demand

a)

availability of substitutes
many substitutes more elastic

b)

proportion of income spend on a product

small proportion of income spend more inelastic

c)

time period period of analysis

longer period of time more elastic

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d)

2.

types of goods
necessity more inelastic
luxury more elastic

Income Elasticity of Demand

It measures the responsiveness of quantity demanded to changes
in income.
It is useful to determine the types of goods.
Formulas:
Point Elasticity:
dQ x Y
dY
Q
Arc Elasticity:
Q2 Q 1 x
Y2 Y1
i)

Y2 + Y1
Q 2 + Q1

Interpretation of Income Elasticity Coefficient

Ey < 0 (-ve)
Ey 0 (+ve)
good
0 Ey < 1

Ey 1

the product is an inferior good

the product is a normal

the product is necessity
the product is a luxury good

Example on income elasticity:

QX = 1 2PX + 2Y + 3T + PY
given PX = 2, Y = 4, T = 1 and PY = 3
QX

= 1 2(2) + 2(4) + 3(1) + (3)

= 11

Ey

= dQX x Y
dY
QX
= 2 x (4 / 11)
= 8/11

Good X is a normal good since 0< EY < 1

OR
Good X is a necessity because EY is close to zero

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Managerial Economics ECO555

ii)

Uses of income elasticity

a)

Forecasting future demand

Forecast the business
recession, expansion)

cycle

(peak,

contraction,

If the economy is at the peak, demand for luxury

good will increase.
b)

Promotional strategies
Normal product can be advertised in daily media but
expensive products should be advertised in a media
that reaches the rich people.

3.

Cross Price Elasticity of Demand

It measures the responsiveness of quantity demanded to changes
in price of other goods.
Formulas:
Point Elasticity:
dQX x PY
dPY
QX
Arc Elasticity:
QX2 QX1 x
PY2 + PY1
PY2 PY1
QY2 + QX1
i)

Interpretation of Cross Elasticity Coefficient.

Cross price elasticity shows the relationship between two
goods
EXY = +ve the two products x and y are substitutes
EXY = -ve the two products x and y are
complements
EXY = 0
there is no relationship between the
two products.
Example on cross price elasticity:
QX = 1 2PX + 2Y + 3T + PY
given PX = 2, Y = 4, T = 1 and PY = 3
QX

= 1 2(2) + 2(4) + 3(1) + (3)

= 11

EXY

= dQX x PY
dPY
QX

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Managerial Economics ECO555

= 1 x (3 / 11)
= 3/11
the 2 goods are substitutes because E XY > 0 (weak
substitutes)
OR
the 2 goods are not related because EXY is very close to zero
4.

Advertising Elasticity of Demand

It measures the sensitiveness/responsiveness of the quantity
demanded due to a change in advertising.
It plays an important role in marketing activities for a broad range
of good and services.
Formulas:
Point Elasticity:
dQ x A
dA
Q
Arc Elasticity:
Q2 Q 1 x
A2 + A1
A2 A1
Q 2 + Q1
i)

Interpretation of Advertising Elasticity

EA > 0
EA < 0

direct relation between advertising and

quantity
indirect relation between advertising
and quantity.

PRACTICE QUESTIONS

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Managerial Economics ECO555

1.

The McKnight company is a major producer of steel. Management

estimates that the demand for the companys steel is given by the
equation
Qs

= 5,000 1,000Ps + 0.1Y + 100Pa

Where Qs is steel demand in thousands of tons per year, Ps is the price of

steel in RM per kg, Y is income per capita, and Pa is the price of aluminium
in RM per kilo. Initially, the price of steel is RM1 per kg, income per capita
is RM20,000, and price of aluminium is RM0.80 per kg.
a)
b)
c)
d)
e)
f)

2.

Calculate income elasticity? Interpret the answer.

Calculate icross elasticity between steel and aluminium? Interpret
the answer
Calculate price elasticity of demand? Should the company increase
or decrease price to increase its revenue?
Calculate the price and quantity if firms objective is to maximize
total revenue.
Discuss 3 determinants of price elasticity.
State the relationship between the total revenue of a firm and the
price elasticity of demand for a price increase along a linear
demand curve. Use graph to illustrate.

A market consists of three people, A, B, and C, whose individual demand

equations are as follows:
A
B
C

:
:
:

P
P
P

= 35 0.5QA
= 50 0.25QB
= 40 2.00QC

The industry supply equation is given by Qs = 40 + 3.5P

a)
b)
c)
d)
e)

Determine the market demand curve function.

Determine the market equilibrium price and quantity.
Determine the amount that will be purchased by each individual at
the market equilibrium price.
At what price will the market fail to sell any output?
If the government set the price at RM20, will there be a shortage or
surplus? Calculate the surplus or shortage.

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