DEMAND THEORY

DEMAND THEORY (1)

Definition and Law of Demand
• The amount of a particular economic good or service that a consumer or group of consumers will want to
purchase at a given price in a given period of time.

Law of Demand: Other things being equal, the quantity demanded of a good falls when the
price of the good rises.
d=f(p); f'(p)<0

The demand curve is usually downward sloping.

Demand and quantity demanded

• Price and quantity demanded are negatively related, ceteris paribus.

• Demand for a good or service is determined by many different factors other than price, such as the income,
price of substitute goods and complementary goods, the size of the market, tastes and so on. In extreme
cases, demand may be completely unrelated to price, or nearly infinite at a given price.
Six main factors that change demand are

The prices of related goods

Expected future prices

Income

Expected future income and credit

Population

Preferences
DEMAND THEORY (2)

Exercise 1:
Show graphically and explain what will happen with
demand curves for cars and fuel if the price of cars
considerable increases.

Exercise 2:
Show graphically and explain what will happen in the
Pepsi Cola and Coca Cola markets if the price of Coca
Cola considerable increases.
DEMAND THEORY (3)

LAW OF DEMAND EXCEPTIONS:

1. Giffen good is a product that people consume more of as the

price rises (inferior goods).

2. Veblen good is a member of a group of commodities whose

demand is proportional to their price (positional goods).

3. Speculative effect.
PRICE ELASTICITY OF DEMAND (1)
The price elasticity of demand is a measure that captures the rresponsiveness of a
good's quantity demanded to a change in its price. More specifically, it is the
percentage change in quantity demanded in response to a one percent change in
price when all other determinants of demand are held constant.

dQ
Q dQp 
dpQ 
Ed    1
dp

p

Price elasticity of demand range of values

Ed = ∞ Perfectly Elastic Demand
∞ > Ed >1 Relatively Elastic Demand
0< Ed <1 Relatively Inelastic Demand
Ed = 1 Unitary Demand
Ed = 0 Perfectly Inelastic Demand
PRICE ELASTICITY OF DEMAND (2)

Exercise 3:
If a 2% increase in the price of flame throwers results in 3%
decline in quantity demanded, what is the elasticity of
demand for flame throwers.
TOTAL REVENUE AND ELASTICITY

The total revenue from the sale of a good equals the price of the good
multiplied by the quantity sold.

• If demand is elastic, a 1 percent price cut increases the quantity sold by

more than 1 percent and total revenue increases.

• If demand is unit elastic, a 1 percent price cut increases the quantity sold
by 1 percent and total revenue does not change.

• If demand is inelastic, a 1 percent price cut increases the quantity sold by

less than 1 percent and total revenue decreases.
INCOME ELASTICITY OF DEMAND
Income elasticity of demand measures the responsiveness of the demand
for a good to a change in the income of the people demanding the good,
ceteris paribus. It is calculated as the ratio of the percentage change in
demand to the percentage change in income.
dQ x
Qx dQ x I 
dIQ x 
I E x  dI  0

I

Example:
Income elasticity of demand for meat for different income levels
CROSS PRICE ELASTICITY
It is measured as the percentage change in quantity demanded for the
first good that occurs in response to a percentage change in price of the
second good.

dQy
Qy dQy p x 
px E y 
dpx

dpx Q y 0

px

• Positive coefficient means that observed goods are substitutes

• Negative coefficient means that observed goods are complementary
goods
• Zero – independent goods
Exercise 4:
Find the cross elasticity of demand between butter and
cheese for the data in the next table. What kind of goods
butter and cheese are?
Exercise 5:
Find the cross elasticity of demand between hamburger
and hotdogs for the data in the next table. What kind of
goods hamburger and hotdogs are?
Exercise 5:

Calculate the price and cross price elasticity of demand for

coconut oil. The coconut oil demand function is:

Q = 1 200 – 9.5p + 16.2pp + 0.2Y

Where Q is quantity of coconut oil demanded in thousands

of metric tones per year, p is the price of coconut oil in
cents per pound, pp is the price of palm oil in cents per
pound, and Y is the income of consumers. Assume that p is
initially 45 cents per pound, pp is 31 cents per pound, and
Q is 1 275 metric tones per year.