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Quantitative Demand Analysis

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Overview
I. The Elasticity Concept

Own Price Elasticity

Elasticity and Total Revenue
Cross-Price Elasticity
Income Elasticity

II. Demand Functions

Linear
Log-Linear

III. Regression Analysis

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The Elasticity Concept

How responsive is variable G to a change
in variable S

EG , S

%G

%S

If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.

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The Elasticity Concept Using

Calculus
An alternative way to measure the elasticity
of a function G = f(S) is

EG , S

dG S

dS G

If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.

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Own Price Elasticity of

Demand
EQX , PX

%QX

%PX

Negative according to the law of demand.

Elastic:

EQX , PX 1

Inelastic: EQ X , PX 1
Unitary:

EQX , PX 1

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Perfectly Elastic &

Inelastic Demand
Price

Price
D
D

Quantity
Perfectly Elastic ( EQ X ,PX )

Quantity
Perfectly Inelastic ( EQX , PX 0)

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Own-Price Elasticity
and Total Revenue
Elastic

Increase (a decrease) in price leads to a decrease (an

increase) in total revenue.

Inelastic

Increase (a decrease) in price leads to an increase (a

decrease) in total revenue.

Unitary

Total revenue is maximized at the point where demand is

unitary elastic.

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Elasticity, Total Revenue and Linear

Demand
P
100

TR

10

20

30

40

50

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Elasticity, Total Revenue and Linear

Demand
P
100

TR

80

800

10

20

30

40

50

10

20

30

40

50

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Elasticity, Total Revenue and Linear

Demand
P
100

TR

80
1200

60

800

10

20

30

40

50

10

20

30

40

50

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Elasticity, Total Revenue and Linear

Demand
P
100

TR

80
1200

60
40

800

10

20

30

40

50

10

20

30

40

50

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Elasticity, Total Revenue and Linear

Demand
P
100

TR

80
1200

60
40

800

20

10

20

30

40

50

10

20

30

40

50

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Elasticity, Total Revenue and Linear

Demand
P
100

TR
Elastic

80
1200

60
40

800

20

10

20

30

40

50

10

20

Elastic

30

40

50

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Elasticity, Total Revenue and Linear

Demand
P
100

TR
Elastic

80
1200

60
Inelastic

40

800

20

10

20

30

40

50

10
Elastic

20

30

40
Inelastic

50

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Elasticity, Total Revenue and Linear

Demand
P
100

TR
Elastic

80

Unit elastic
Unit elastic
1200

60
Inelastic

40

800

20

10

20

30

40

50

10
Elastic

20

30

40
Inelastic

50

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Demand, Marginal Revenue (MR)

and Elasticity
P
100

Elastic

80

For a linear inverse

demand function,
MR(Q) = a + 2bQ,
where b < 0.
When

Unit elastic

60
Inelastic

40

20

10

20

40
MR

50

MR > 0, demand is
elastic;
MR = 0, demand is unit
elastic;
MR < 0, demand is
inelastic.

Factors Affecting
Own Price Elasticity

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Available Substitutes
The more substitutes available for the good, the more elastic
the demand.

Time
Demand tends to be more inelastic in the short term than in
the long term.
Time allows consumers to seek out available substitutes.

Expenditure Share
Goods that comprise a small share of consumers budgets
tend to be more inelastic than goods for which consumers
spend a large portion of their incomes.

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Cross Price Elasticity of

Demand
EQX , PY

%QX

%PY

If EQX,PY > 0, then X and Y are substitutes.

If EQX,PY < 0, then X and Y are complements.

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Predicting Revenue Changes

from Two Products
Suppose that a firm sells to related goods. If the price of
X changes, then total revenue will change by:

R RX 1 EQX , PX RY EQY , PX %PX

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Income Elasticity
EQX , M

%QX

%M

If EQX,M > 0, then X is a normal good.

If EQX,M < 0, then X is a inferior good.

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Uses of Elasticities

Pricing.
Managing cash flows.
Impact of changes in competitors prices.
Impact of economic booms and recessions.
Impact of advertising campaigns.
And lots more!

Example 1: Pricing and Cash

Flows
According to an FTC Report by Michael
Ward, AT&Ts own price elasticity of
demand for long distance services is -8.64.
AT&T needs to boost revenues in order to
meet its marketing goals.
To accomplish this goal, should AT&T raise
or lower its price?

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Answer: Lower price!

Since demand is elastic, a reduction in price
will increase quantity demanded by a
greater percentage than the price decline,
resulting in more revenues for AT&T.

Example 2: Quantifying the

Change
If AT&T lowered price by 3 percent, what
would happen to the volume of long
distance telephone calls routed through
AT&T?

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Answer
Calls would increase by 25.92 percent!

EQX , PX

%QX
8.64
%PX
d

%QX
8.64
3%
d
3% 8.64 %QX
d

%QX 25.92%

Example 3: Impact of a change

in a competitors price
According to an FTC Report by Michael
Ward, AT&Ts cross price elasticity of
demand for long distance services is 9.06.
If competitors reduced their prices by 4
percent, what would happen to the demand
for AT&T services?

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Answer
AT&Ts demand would fall by 36.24 percent!

EQX , PY

%QX
9.06
%PY
d

%QX
9.06
4%
d
4% 9.06 %QX
d

%QX 36.24%

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Interpreting Demand Functions

Mathematical representations of demand curves.
Example:
d

QX 10 2 PX 3PY 2 M

Law of demand holds (coefficient of PX is negative).

X and Y are substitutes (coefficient of PY is positive).

X is an inferior good (coefficient of M is negative).

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Linear Demand Functions and

Elasticities
General Linear Demand Function and Elasticities:

QX 0 X PX Y PY M M H H
d

P
EQX , PX X X
QX
Own Price
Elasticity

EQX , PY

PY
Y
QX

Cross Price
Elasticity

M
EQX , M M
QX
Income
Elasticity

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Example of Linear Demand

Qd = 10 - 2P.
Own-Price Elasticity: (-2)P/Q.
If P=1, Q=8 (since 10 - 2 = 8).
Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25.

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Log-Linear Demand
General Log-Linear Demand Function:
ln Q X d 0 X ln PX Y ln PY M ln M H ln H

X
Cross Price Elasticity : Y
Income Elasticity :
M

Own Price Elasticity :

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Example of Log-Linear
Demand
ln(Qd) = 10 - 2 ln(P).
Own Price Elasticity: -2.

Graphical Representation of
Linear and Log-Linear Demand
P

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D
Linear

D
Q

Log Linear

Conclusion
Elasticities are tools you can use to quantify
the impact of changes in prices, income,
and advertising on sales and revenues.
Managers can quantify the impact of
changes in prices, income, advertising, etc.

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