Lecture 2: REVIEW OF MICROECONOMIC TOOLS
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
1
The Demand Function


A demand function is a causal relationship:

Relationship between a dependent variable (i.e., quantity
demanded) and various independent variables (i.e., factors
which are believed to influence quantity demanded).

Remember, this is just a behavior function.
Let’s consider a market demand function, and list the
factors.
Independent Variables in the Demand
Function

Quantity demand is a function of:




Price of good
Income (normal goods, inferior goods)
Price related goods (substitutes, complements)
#Buyers


Tastes



Note: Can depend on ADVERTISING
Note: Can depend on ADVERTISING
Expectations (price changes, income changes)
As always, we have to abstract.
General Function Form
Red Variables are
constant for a given
demand curve
QDX=f(PX,PY,I,Tastes(A),Expect.,Buyers(A), )
 is a random term.
•
•
Human beings have random element to behavior.
There are random events (disasters, etc.) which influence
demand.
Lets Systematically Derive the Demand
Curve Graphically


The demand curve holds all the factors that shift demand
curves constant.
Only the own price changes.
Demand
Suppose that the
consumers in this market
are willing and able to
purchase Q1 units per
period of time when the
price of each unit is P1.
P/unit
P1
Q1
Q
A Change in Demand


The demand curve
shows consumers’
willingness and ability to
purchase these
alternative units at
alternative prices when
everything else remains
constant.
Suppose something else
does change!
P/unit
P1
P2
Q1
Q2
D
Q
A Change in Demand
• If one of the ceteris paribus
assumptions changes, this
shifts the entire demand
curve.
• Suppose advertising
affects tastes positively, or
increases number of
buyers.
•
•
P/unit
P1
P2
D’
Demand increases or shifts
right!
Q increases at every price.
D
Q1 Q’1 Q2
Q’2
Q
The Supply Function

A supply function is a causal relationship between a
dependent variable (i.e., quantity supplied) and various
independent variables (i.e., factors which are believed to
influence quantity supplied)

Again, this is just a behavior function.

Lets consider a market supply function, and list the
factors.
Factors which you believe influence quantity
supplied

Your list:




Price of good
Technology
Price of inputs
Price related goods




Other goods which could be produced
Number of suppliers
Expectations
Government through excise taxes or subsidies, regulation
General Function Form
Red Variables are constant
for a given supply curve
QSX=f(PX,Pinput,POther,Tech.,Expect.,#Sellers,Govt,)
 is a random term.


Suppliers may behave randomly.
There are random events (disasters, etc.) which influence supply.
Elasticity of Supply and Demand

Not only are we concerned with what direction price and quantity
will move when the market changes, but we are concerned about
how much they change.

Elasticity gives a way to measure by how much a variable will change
with the change in another variable.

Specifically, it gives the percentage change in one variable resulting
from a one percent change in another.
Price Elasticity of Demand
Definition

Measures the sensitivity of
quantity demanded to price
changes

The percentage change in
the quantity demanded of a
good that results from a one
percent change in price
Formula
% Q D
E 
% P
D
P
Price Elasticity of Demand

The percentage change in a variable is the absolute
change in the variable divided by the original level of
the variable.

Therefore, elasticity can also be written as:
Q Q P Q
E 

P P Q P
D
P
Price Elasticity of Demand
Definition
Usually a negative number
 As price increases, quantity decreases
 As price decreases, quantity increases
|EP| > 1
The good is price elastic
 |%Q| > |%P|
|EP| < 1
The good is price inelastic
 |%Q| < |% P|
Determinants of Price Elasticity of Demand

The primary determinant of price elasticity of demand is
the availability of substitutes

Many substitutes, demand is price elastic


Can easily move to another good with price increases
Few substitutes, demand is price inelastic
Price Elasticity of Demand

Price elasticity of demand
must be measured at a
particular point on the
demand curve
P/unit
QD
Elasticity
60
0.9
0.8
50
0.7
40
0.6
0.5
30

Looking at a linear demand
curve, as we move along the
curve Q/P is constant, but
P and Q will change
0.4
20
0.3
0.2
10
0.1
0
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Quantity
Example: Price Elasticities of Demand for
Automobile Makes (1990)
Model
Price
Mazda 323 $5,039
Estimated
Q,P
-6.358

Nissan
Sentra
$5,661
-6.528
Ford
Escort
$5,663
-6.031
Lexus
LS400
$27,544
-3.085
BMW 735i
$37,490
-3.515
Source: Berry, Levinsohn
and Pakes, "Automobile
Price in Market Equilibrium,"
Econometrica 63 (July 1995),
841-890.
Price Elasticity of Demand
Elastic

The steeper the
demand curve, the
more inelastic the
demand for the good
becomes
QD
QD
Elasticity
Elasticity
60
0.9
0.8
50
0.7
40
0.6
0.5
30

The flatter the demand
curve, the more elastic
the demand for the
good becomes
0.4
20
0.3
0.2
10
0.1
0
0
1
2
3
4
5
6
Inelastic
7
8
9
10
11
Look at the Extremes
Perfectly Elastic D
Perfectly Inelastic D
P
P
D
  0
D
  -infinite
Q
Q
Relatively Elastic vs. Relatively
Inelastic Demand Curves
P
D’ is relatively more elastic
than D
P1
P2
D
D’
Q
Q1 Q 2
Q2 ’
Price Elasticities of Demand
Market Level
Firm Level

Price elasticity of market
demand for automobiles is
between -1 and -1.5.

Price elasticity of demand
for BMW 325 is on the
order of -4 to -6.

Price elasticity of demand
for ready-to-eat breakfast
cereal in the U.S. is on the
order of -0.25 to -0.5.

Price elasticity of demand
for individual brands, such
as Captain Crunch, is on
the order -2 to -4.
Price Elasticity and Revenues
• Suppose we look at P increase along D curve.
• Revenues = P*Q
• Impact on expenditure (revenue) depends on which effect
is greater.
• For elastic responses, |EP| > 1 so %Q>%P
• Thus, when P increases, Q decreases by more!
• Revenues = P*Q falls
• For inelastic response, |EP| < 1 so %Q<%P
• Thus, when P increases, Q decreases by less!
• Revenues = P*Q rises
Quick Example: mathematical demand
function
• Assume equilibrium P and Q:
•
Q=13,750 and P=190
• Demand function
•
•
QDX=15000 - 25PX + 10PY+2.5*I
Derive demand curve by holding PY and I constant (e.g., at PY=100,
and I=1000) giving: QDX=18500-25PX
• Derive Q/P)* P1 /Q1
•
What is P1 and Q1?
•
What is Q/P?
Elasticity calculation
Q/P)* P1 /Q1
 -25*190/13750 = -0.34


What is the interpretation?
Look at an Example
•

Suppose the price elasticity of demand is -3.6, and
you expect a 5% price increase next year.
What do you expect would happen to the quantity
demanded?
Look at an Example
•
•
•
•
Suppose the price elasticity of demand is -3.6, and
you expect a 5% price increase next year.
What should happen to the quantity demanded?
Answer:  Q/P
-Q/(+)
Solving for Q=5*(-3.6)=-18%
Comments


Don’t forget the economics behind your calculations.
Know how to calculate these, and how to manipulate
them.