CHAPTER 3
Quantitative Demand Analysis
© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objectives
1. Apply various elasticities of demand as a quantitative tool
to forecast changes in revenues, prices, and/or units sold.
2. Illustrate the relationship between the elasticity of
demand and total revenues.
3. Discuss three factors that influence whether the demand
for a given product is relatively elastic or inelastic.
4. Explain the relationship between marginal revenue and
the own price elasticity of demand.
5. Show how to determine elasticities from linear and log-
linear demand functions.
6. Explain how regression analysis may be used to estimate
demand functions, and how to interpret and use the
© 2017 by McGraw-Hill Education. All Rights Reserved. 2
The Elasticity Concept
The Elasticity Concept
• Elasticity
– A measure of the responsiveness of one variable
to changes in another variable; the percentage
change in one variable that arises due to a given
percentage change in another variable.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-3
The Elasticity Concept
The Elasticity Concept
• The elasticity between two variables, and , is
mathematically expressed as:
• When a functional relationship exists, like , the
elasticity is:
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-4
The Elasticity Concept
Measurement Aspects of Elasticity
• Important aspects of the elasticity:
– Sign of the relationship:
• Positive
• Negative
– Absolute value of elasticity magnitude relative to
unity:
• is highly responsive to changes in .
• is slightly responsive to changes in .
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-5
Own Price Elasticity of Demand
Own Price Elasticity of Demand
• Own price elasticity of demand
– Measures the responsiveness of a percentage
change in the quantity demanded of good X to a
percentage change in its price.
– Sign: negative by law of demand.
– Magnitude of absolute value relative to unity:
• : Elastic.
• : Inelastic.
• : Unitary elastic.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-6
Own Price Elasticity of Demand
Linear Demand, Elasticity, and Revenue
Price Demand:
$40
• Elasticity:
$35 • Conclusion: Demand is elastic.
$30
$25
$20 Observation: Elasticity
varies along a linear
$15 (inverse) demand curve
$10
$5
Demand
0 10 20 30 40 50 60 70 80 Quantity
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-7
Own Price Elasticity of Demand
Total Revenue Test
• When demand is elastic:
– A price increase (decrease) leads to a decrease
(increase) in total revenue.
• When demand is inelastic:
– A price increase (decrease) leads to an increase
(decrease) in total revenue.
• When demand is unitary elastic:
– Total revenue is maximized.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-8
Own Price Elasticity of Demand
Perfectly Elastic and Inelastic Demand
Price
Demand
𝐸𝑄 𝑑
,𝑃𝑋
=0
𝑋
Perfectly Demand
elastic 𝐸𝑄 𝑑 =− ∞
𝑋
,𝑃𝑋
Perfectly Inelastic Quantity
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-9
Own Price Elasticity of Demand
Factors Affecting the Own Price
Elasticity
• Three factors can impact the own price
elasticity of demand:
– Availability of consumption substitutes
– Time/duration of purchase horizon
– Expenditure share of consumers’ budgets
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-10
Cross-Price Elasticity
Cross-Price Elasticity
• Cross-price elasticity
– Measures responsiveness of a percent change in
demand for good X due to a percent change in the
price of good Y.
– If , then and are substitutes.
– If , then and are complements.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-11
Cross-Price Elasticity
Cross-Price Elasticity in Action
• Suppose it is estimated that the cross-price
elasticity of demand between clothing and
food is -0.18. If the price of food is projected
to increase by 10 percent, by how much will
demand for clothing change?
– That is, demand for clothing is expected to decline
by 1.8 percent when the price of food increases 10
percent.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-12
Cross-Price Elasticity
Cross-Price Elasticity
• Cross-price elasticity is important for firms
selling multiple products.
– Price changes for one product impact demand for
other products.
• E.g. Movie theaters
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-13
Cross-Price Elasticity
Cross-Price Elasticity in Action
• Suppose a restaurant earns $4,000 per week
in revenues from hamburger sales (X) and
$2,000 per week from soda sales (Y).
• If the own price elasticity for burgers is and
the cross-price elasticity of demand between
sodas and hamburgers is , what would happen
to the firm’s total revenues if it reduced the
price of hamburgers by 1 percent?
– That is, lowering the price of hamburgers 1
percent increases total revenue by $100.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-14
Income Elasticity
Income Elasticity
• Income elasticity
– Measures responsiveness of a percent change in
demand for good X due to a percent change in
income.
– If , then is a normal good.
– If , then is an inferior good.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-15
Income Elasticity
Income Elasticity in Action
• Suppose that the income elasticity of demand for
transportation is estimated to be 1.80. If income
is projected to decrease by 15 percent,
• what is the impact on the demand for
transportation?
– Demand for transportation will decline by 27 percent.
• is transportation a normal or inferior good?
– Since demand decreases as income declines,
transportation is a normal good.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-16
Other Elasticities
Other Elasticities
• Own advertising elasticity of demand for good
X is the ratio of the percentage change in the
consumption of X to the percentage change in
advertising spent on X.
• Cross-advertising elasticity between goods X
and Y would measure the percentage change in
the consumption of X that results from a 1
percent change in advertising toward Y.
© 2017 by McGraw-Hill Education. All Rights Reserved. 2-17
Obtaining Elasticities From Demand Functions
Elasticities for Linear Demand
Functions
• From a linear demand function, we can easily
compute various elasticities.
• Given a linear demand function:
– Own price elasticity: .
– Cross price elasticity: .
– Income elasticity: .
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-18
Obtaining Elasticities From Demand Functions
Elasticities for Linear Demand
Functions In Action
The daily demand for Invigorated PED shoes is estimated
to be:
Suppose good X sells at $25 a pair, good Y sells at $35,
the company utilizes 50 units of advertising, and
average consumer income is $20,000. Calculate the
own price, cross-price and income elasticities of
demand.
– units.
– Own price elasticity: .
– Cross-price elasticity: .
– Income elasticity: .© 2017 by McGraw-Hill Education. All Rights Reserved. 3-19
Regression Analysis
Regression Analysis
• How does one obtain information on the
demand function?
– Published studies
– Hire consultant
– Statistical technique called regression analysis
using data on quantity, price, income and other
important variables.
© 2017 by McGraw-Hill Education. All Rights Reserved. 3-20