WRITTEN REPORT ON

DEMAND THEORY
(Part 1)

ADVANCED MANAGERIAL ECONOMICS

 In this chapter we will discuss the factors that determine demand, both those that are
controllable by the firm and those that are uncontrollable, or environmental. The sensitivity of
demand to these factors is examined, and how knowledge of this sensitivity is useful to
managers.

Demand is simply the quantity of a good or service that consumers are willing and able
to buy at a given price in a given time period. People demand goods and services in an economy
to satisfy their wants or needs, such as food, healthcare, clothing, entertainment, shelter, etc.
The demand for a product at a certain price reflects the satisfaction that an individual expects
from consuming the product. Though, this satisfaction differs from one consumer to another,
depending on one’s satisfaction of want or need and ability to pay for the product.

Demand theory is an economic principle relating to the relationship between consumer

demand for goods and services and their prices in the market. It forms the basis for the demand
curve, which relates consumer desire to the amount of goods available. Evaluating demand in
an economy is one of the most important decision-making variables that a business must
analyze if it is to survive and grow in a competitive market. The market system is governed by
the laws of supply and demand, which determine the prices of goods and services. When supply
equals demand, prices are said to be in a state of equilibrium. When demand is higher than
supply, prices increase to reflect scarcity. Conversely, when demand is lower than supply, prices
fall due to the surplus.

Tables, graphs and equations. These are the forms of representation commonly use in
analyzing demand in economics.
 Tables - the simplest method of representation. Below is an example of demand
table which shows the general law of demand, that less is demanded at higher
prices. Tables are simple to understand; however, they are not very useful for
analytical purposes.
 Price per Apple Quantity of Apple
10 500
20 400
30 300
40 200
50 100

 Graphs – are much more useful for analysis. A demand curve is a graph depicting the
relationship between the price of a certain commodity (the y-axis) and the quantity
of that commodity that is demanded at that price (the x-axis). It is generally
assumed that demand curves are downward sloping, as shown on below graph
image. This is again because of the law of demand: for most goods, the quantity
demanded will decrease in response to an increase in price and will increase in
response to a decrease in price. The main disadvantage of using graphical analysis is
that it only involves two-dimensional framework, thus it is limited to examining only
two variable relationships, while demand relationship often involves many variables.

 Equations - the most useful method of representation for analytical purposes since
they explicitly show the effects of all the variables affecting quantity demanded, in a
concise form and at the same time reveals important information regarding the
nature of the relationship.
 The general form of the demand function in terms of price and quantity
demanded is: Q = f (P)
  The demand function can be expressed in a linear form: Q = a + bP
Using the demand table above, coefficients a and b can be calculated. First,
calculate the value of b, by using mathematical equation: b = ∆Q / ∆P. Any
two pairs of values in the table can be used to find the value of b. Thus, b =
-100/10 = -10.
Then, to calculate the value of a, let us take the first pair of values in the
table; Q = a + bP
500 = a - 10(10)
Thus, a = 600 and the demand equation can now be expressed as:
Q = 600 - 10(P)
 The advantage of this approach is that the value of b can more easily be
interpreted as a slope coefficient. The value of a in turn can be interpreted as
an intercept and the vertical axis.

In using the equation, the quantity demanded is depending on the price and other
variables if we want to include these in the equation on the righthand side. All the
independent variables in the situation are on the righthand side of the equation.
Whereas, in graphical representation, for Marshall, the first economist to develop this
method, the price is the dependent variable. Marshall and other neoclassical
economists were primarily concerned with price determination, since the price
mechanism was the key to allocating resources in the economy. In conclusion we can
say that either method of representing the graph or equation is correct, meaning that
either price or quantity can be treated as the dependent variable.
Interpretation of Equations. The economic interpretations of the two-variable equation
above is that the value of a represents the maximum sales that will occur if the price is
zero while b represents the marginal effect of price on quantity demanded. It means
that for every unit the price rises, the quantity demanded will rise by b units. In the
context of the demand equation the value of b will normally be negative.
In reality, the demand relationship may take a few mathematical forms, but a
particularly common form is the power form. The two-variable expression of this is:
Q = aPb . As seen on graph below, the slope of the demand curve decreases from left to
right, as quantity increases. The shape is the same if the axes are reversed, with the
slope decreasing as price increases.

This function can also be extended to include other variables; in this case the
function is multiplicative: Q = aPbYc
The values of b and c represent elasticities; b represents the price elasticity of demand,
and c represents the income elasticity of demand. In the case of the price elasticity of
demand, this means that for every 1 per cent the price rises the quantity demanded will
rise by b per cent. In the case of the income elasticity of demand this means that for
every 1 per cent the income rises the quantity demanded will rise by c per cent. To
summarize the interpretations of the linear and power forms:
Linear: Q = a + bP + . . .
 b and other coefficients of variables are marginal effects.
For every 1-unit P increases Q increases by b units (b is normally negative).
Power: Q = aPb . . .
b and other coefficients of variables are elasticities.
For every 1 per cent P increases Q increases by b per cent (again b is negative).
Demand and Revenue. The demand curve for a firm automatically determines its
revenue function, since revenue is simply price multiplied by quantity. The table is
rearranged because revenue and marginal revenue are normally considered as functions
of quantity rather than price. It should be noted that marginal revenue can be calculated
in two different ways:
 ∆R=∆Q – when quantity changes from 100 to 200
MR = (8,000-5,000) / (200-100) = 30
These values are given in bold in the Table and inserted between the
quantities
of 100 and 200, and so on for the other values.

 dR / dQ - the derivative of the revenue function.

Returning to the graphical interpretation of the coefficients, if we switch the
equation around, we obtain: P = a+b(Q), where b = ∆P / ∆Q. The value of b
represents the slope of the demand curve and the value of a represents the
vertical intercept if the graph is drawn in the customary way, with P on the
vertical axis. First, compute for the value of b: b = (40-50) / (200-100) = -0.10
Then, we proceed in the computation of P = a+b(Q)
50 = a – 0.10 (100)
P = 60 – 10
Since P = 60 – 0.10 (Q)
R = PQ = (60 – 0.10 Q) Q = 60Q - 0.10 Q 2
MR = 60 - Q
These values are given by substituting the value of Q into the MR function
and
are written directly opposite the relevant values of Q in the table.