NOT FOR QUOTATION

BASICS OF DEMAND ANALYSIS

Reference texts: A. Koutsoyiannis, Modern Microeconomics

Nicholson, Microeconomic Theory

Demand may be defined as the amount of a good or a service a customer may

purchase given prices, his/her income, taste and other factors that may influence
his/her acquisition of the good or service. Note that prices refer to market prices,
in other words, prices determined by the market. This qualification is often
mentioned because a good is anything that gives a person a utility or satisfaction.
This definition of a good covers things that give us satisfaction but are not sold in
the market. This type of good belongs to what is called public goods, and has a
different form of demand function. This module will not deal with public goods.

In economics, the theory of demand starts with the examination of the behavior
of the consumer. A demand function is an abstraction or a model of the behavior
of a consumer. Once the demand of a consumer is determined, we can also
determine the market demand, since the latter is just a summation of individual
demand.

To enable us to examine the behavior of a consumer, we have to assume that

the consumer is rational. What is meant by rational is, the consumer is a
maximizer. That is, given his/her income and prices of commodities (plus other
factors), the consumer will spend his/her income to attain the highest possible
satisfaction or utility. Note that when a consumer spends his/her income to obtain
the highest possible satisfaction there is a decision making process involved, and
making the right decision requires information. Thus, in examining how a rational
consumer spends his/her income, it is assumed that the consumer has a
complete knowledge of all information relevant to his/her decision, and a
complete knowledge of all available commodities and their prices, and his/her
income. These will enable the consumer to compare goods or basket of goods
which he/she can buy with his/her income to maximize his/her utility or
satisfaction. Comparing goods or basket of goods is basically the same as
comparing utilities or satisfaction that goods or services could give to the
consumer. To be able to compare requires the ability to measure utility of
satisfaction.

There are two basic approaches on how to compare utilities of goods or basket
of goods, namely: the cardinalist approach, and the ordinalist approach. We will
not go into the details of these approaches. The position of cardinalist approach
however is that utility or satisfaction can be measured, while the position of the
ordinalist approach is that utility or satisfaction is not measurable, but the
consumer could rank the utility or satisfaction he/she gets from goods or basket
of goods. In other words, a consumer could rank or determine his/her order of
preference among different bundles of goods. We will use later one of the
approaches under the ordinalist approach to derive the demand function.

One of the purposes of the theory of demand is to predict how a consumer

behaves. This knowledge is invaluable in policy making. For entrepreneurs of
course knowing how a consumer will behave will have an immense impact on
his/her profit.

1. Factors Affecting Demand

Demand is a multivariate relationship, i.e. it is determined by many factors

simultaneously. Some of the most important determinants of market demand for
a particular good are:

 Own price of the good

 Consumer’s income
 Prices of other commodities or goods
 Consumer’s taste
 Income distribution
 Total population
 Consumer’s wealth
 Credit availability
 Government policy
 Past levels of demand
 Past levels of income

The traditional theory of demand focused on four of the above determinants,

namely: price of the commodity, other prices, income and taste. Note that in the
above formulation, demand is seen at a point in time, and basically on
consumption or non-durable goods. These are goods which we consume at one
time. The demand function for durable goods, although follows the same theory,
has a different formulation. The other characteristics of the traditional theory of
demand are:

 It is a partial equilibrium approach, i.e. it examines the demand

in one market in isolation from the conditions of demand in other
markets.
 It has an implicit assumption that the firms sell their products
directly to final consumers.
 It does not deal with the demand for investment goods, nor the
demand for intermediate products.

Inclusion of time in the demand function makes the demand function dynamic
and it is this formulation that makes it relevant to forecasting or projection of
demand. Note that we usually make distinction between a forecast and a
projection. A forecast is the prediction of future values of a variable with an
accompanying distribution function. For example, when the weather man says
that there is a 25% probability that it will rain tomorrow that is a forecast. Note
that the distinguishing term there is the probability that an even will occur.

On the other hand, prediction is associated with the prediction of future values of
a variable under certain set of assumptions. For example, when a government
planner says that the gross domestic product of the Philippines will 6.5% for the
next three years if the economic fundamentals of the country will remain strong,
the peso – dollar exchange rate will be stable, the flow of investments will remain
constant, etc., the pronounced GDP growth rate in this case is a projection.

Note that it is easier to project than to forecast, also you can easily get away with
the projection than with a forecast. This is because if what you project did not
happened, you can always say that the assumptions were not realized. However,
if you made a mistake with your forecast, you really made a mistake. In other
words the model that you used was not good enough.

Demand relationship is usually expressed in terms of functional relationship.

Thus, in a static demand function, if we let:

Qd = the quantity demanded

Po = own price
Pno = other prices
M = income
T = taste
N = population
W = wealth
D = income distribution
Xi = other variables

Then the functional relationship is simply;

Qd = f(Po, Pno, M, T, N, W, D, Xi) (1)

The dynamic form of this demand function may be obtained by placing a

subscript t for time on the variables, thus:

Qd,t = f(Po,t, Pno,t, Mt, Tt, Nt, W t, Dt, Xi,t) (2)

This is the form of the demand function that we will be devoting a major portion of
our time in this short course in modeling and forecasting. Notice that it is also the
most difficult form of the demand function. This is because as you can probably
see in Equation 2, it is usually necessary to forecast also the values of P o,t,;
Pno,t,; Mt, ; Tt, ; Nt,; W t,; Dt,, and Xi,t to enable us to forecast Qd,t.

2. Derivation of Demand Function

The derivation of a demand function is based on the assumption that a consumer
maximizes his/her satisfaction given prices of goods and services, his/her income
and a number of other factors. We will use the indifference curve theory which is
one of the two approaches under the ordinalist approach to derive the demand
function.

The Indifference Curve Theory

The indifference curve theory has the following assumptions:

(a) Rationality. The consumer aims at the maximization of his utility given his
income and market prices. It is assumed that he has full knowledge of all
relevant information.
(b) Utility is ordinal. It is taken as axiomatically true that the consumer can
rank his preferences according to the satisfaction of each basket. He need
not know precisely the amount of satisfaction. Only his expressed
preference is necessary.
(c) Diminishing marginal rate of substitution. Preference are ranked in terms
of indifference curves, which are assumed to be convex to the origin. The
slope of the indifference curves is called the marginal rate of substitution
of the commodities.
(d) The total utility of the consumer depends on the quantities of commodities
consumed, thus:

U = f( q1, q2, q3, …, qn)

(e) Consistency and transitivity of choice. It is assumed that the consumer is

consistent in his choice, if in one period he chooses bundle A over bundle
B, he will not choose bundle B over bundle a in the next period if both
bundles are available to him. Symbolically, we can express this as : if A >
B, then B  A. Similarly, consumer choices are characterized by transitivity,
that is, if A is preferred to B, and B is preferred to C, then A is preferred to
C. Or in symbol:

if A > B, and B > C, then A > C

Equilibrium of the Consumer.

To find or determine the equilibrium of the consumer, we need to introduce the

concepts of (1) indifference-curves, (2) the marginal rate of substitution, and (3)
the budget line.

The indifference – curve is defined as the locus of points of a particular

combination or bundles of goods which yields the same level of satisfaction to
the consumer. The consumer in this situation is indifferent to the particular
combination he consumes. We can express the indifference curve equation as:

(4) U = f( x 1 , x 2 , …, x n ) = K = constant

Graphically, the indifference – curves may presented as:

I2
I 1 Indifference curve
x
Indifference map shows all the indifference curves which rank the preferences of
the consumer. Higher indifference curve from the origin has higher level of
satisfaction.

It is assumed that the commodities y and x can substitute one another to a

certain extent, but are not perfect substitutes. The indifference curve of a perfect
substitute is a straight line.

x
Indifference curve of perfect substitute
Perfect substitutes give a corner solution, i.e. the consumer spends all his
income in one commodity.

On the other hand, if the commodities are complements, the indifference curve
takes the shape of a right angle, as shown below.

Note that in the case of complementary goods, the indifference curve breaks
down because there is no possibility of substitution between commodities.

Marginal rate of substitution (MRS) of x for y. The marginal rate of substitution of

x for y is defined as the number of units of commodity y that must be given up in
exchange for an extra unit of commodity x so that one maintains the same level
of satisfaction. MRS xy is equal to the negative of the slope of an indifference
curve at any one point, that is:
dy
MRS xy = -
dx

This is equal also equal to

MUx
MRS xy = -
MUy

This can be proved as follows: let the utility function be

(5) U = f(x, y)

then, the indifference curve function is:

(6) U = f(x, y ) = K

where K is a constant.
The total differential of the utility function is
U U
(7) dU = dy + dx
y x

= MUy dy + MUx dx

U U
Where: MUy = and MUx =
y x

The total differential of the utility function shows the total change in utility as the
quantities of both commodities change. In this case, the total change in U caused
by changes in y and x is equal to the change in y multiplied by its marginal utility,
plus the change in x multiplied by its marginal utility.

By definition, however, along any indifference curve, the total differential is equal
to zero, thus

(8) dU = MUy dy + MUx dx = 0

therefore

(9) MUy dy = - MUx dx

Or
MUy dx
=- = MRSy,x
MUx dy

Properties of the Indifference Curves

(1) It has a negative slope which means that if the quantity of one commodity
(y) decreases, the quantity of the other commodity (x) must increase, if the
consumer is to stay on the same level of satisfaction.
(2) The further away from the origin an indifference curve lies, the higher level
of utility it denotes.
(3) Indifference curves do not intersect.
(4) Indifference curves are convex to the origin. This implies that the slope of
an indifference curve decreases (in absolute terms) as we move along the
curve from the left downwards to the right, i.e. the MRS of the
commodities is diminishing. The Axiom of Decreasing MRS expresses the
observed behavioral rule that the number of units of x the consumer is
willing to sacrifice in order to obtain an additional unit of y increases as the
quantity of y decreases. Note that it becomes increasingly difficult to
substitute x for y as we move along the indifference curve.
 y

y4

y3

y2
y1

x
x1 x2 x3 x4

The Budget Constraint of the Consumer

The income of the consumer sets the limits to his maximizing behavior. The
income constraint for two commodities is:

(12) Y = Px qx + Py qy

Where: Y = income
Px = price of x
Py = price of y
qx = quantity of x
qy = quantity of y

The budget constraint may be presented by the budget line define as follows:

1 P
(13) qy = Y - x qx
Py Py

The slope of the budget line is the derivative

q y Px
(14) =
q x Py

Derivation of the Equilibrium of the Consumer

The consumer is in equilibrium when he maximizes his utility, given his income
and market prices. There are two conditions that must be fulfilled for the
consumer to be in equilibrium, namely:
(a) The marginal rate of substitution should be equal to the ratio of commodity
prices, i.e.
MU x P
MRSx,y = = x
MU y Py

Note that this is necessary, but not a sufficient condition for equilibrium.

(b) The second condition is that the indifference curves be convex to the
origin. This condition is fulfilled by the Axiom of Diminishing MRS.

Mathematical Derivation of Equilibrium of the Consumer.

Let us assume that there are n commodities available to the consumer with given
market prices, Pi, where i = 1, to n. The consumer has money income Y which
he spends on available commodities. We can then state formally the
maximization problem as:

Maximize: U = f( q i )
n
Subject to:  qipi = Y
i 1

Where: i = 1, 2, …, n

To solve this maximization problem, we use the Langrangean Multiplier method.

To do this, we follow the following steps:

Step 1: Rewrite the constraint equation to

n

 qipi - Y = 0
i 1

or
q1 p1 + q 2 p 2 + … + q n p n - Y = 0

Step 2: Multiply the constraint by a constant  , which the Langrangean

Multiplier
 ( q1 p1 + q 2 p 2 + . . . + q n p n - Y ) = 0

Step 3: Subtract the constraint from the utility function (objective function)
to
obtain the composite function:

 = U -  ( q1 p1 + q 2 p 2 + . . . + q n p n - Y )
Step 4: Differentiate  with respect to q i and  and equate the partial
Derivatives to zero, thus

 U
= -  (p 1 ) = 0
q1 q1
.
.
 U
= -  (p n ) = 0
q n q n


= - ( qi pi - Y ) = 0


Rearranging these equations, we have

U
=  pi
qi
but

U
= MU i
qi
Therefore:

MU i
 =
pi

If we divide the preceding equation corresponding to commodity X by the

equation which refers to commodity Y, we have the equilibrium condition

MU X px
= = MRS x, y
MU y py

Note that the equilibrium conditions are identical with the cardinalist approach
and the indifference curve approach. Note also that although in the indifference
curve approach cardinality of utility is not required, the MRS requires knowledge
of the ratio of marginal utilities. Given that the first order condition for any two
commodities may be written as:

MUx/Muy = Px/Py = MRSx,y

Thus, the concept of marginal utility is implicit in the definition of the slope of the
indifference curves, although its measurement is not required by this approach.
What is needed is a marginal rate of substitution which of course does not
require (the assumption) diminishing utilities of the commodities involved in the
utility function. What was done by the Indifference –Curves theorists is to
substitute the assumption of diminishing marginal utility with the assumption that
the indifference curves are convex to the origin, which implies diminishing MRS
of the commodities.

Derivation of the Demand Curve Using the Indifference Curves Approach.

1. Graphical approach

B B’ B’’’ X

Given an income I and the prices Px and Py of goods X and Y, the budget line of
a consumer is defined by line AB. As the price of x falls, however, the budget line
shifts to the right, to a new position AB’, due to the higher purchasing power of
the consumer from a given money income, the consumer can now buy more X
than before. The consumer also shifts to a higher indifference curve than before,
i.e. from I to II, indicating a higher satisfaction or utility. The point where the
budget line is tangent to indifference curve II is the new equilibrium. If the price of
X falls further, the same process is repeated, the budget line shifts further to the
right, i.e. to AB’’, and the consumer attains an equilibrium at the tangent of the
budget line AB’’ to the indifference curve III.

If we plot the resulting price-quantity pairs defined by the points of equilibrium,

we will obtain a demand curve for x.
 p

p1
p2

p3

x1 x2 x3 qx

The demand for normal goods will always have a negative slope, denoting the
Law of Demand, i.e. the quantity purchase increases as the price falls.

The Law of Demand in the indifference-curves approach is derived from what is

known as the Slutsky’s Theorem which states that the substitution effect of a
price change is always negative, relative to the price: if the price increases, the
quantity demanded decreases and vice versa.

Mathematical Derivation of the Demand Curve Using the Indifference- Curves

Approach
.
We start with the equilibrium condition

(1) MUx/Px = MUy/Py = . . . = MUn/Pn

Let the budget constraint be

(2) Y= Piqi

Suppose we have the following two-commodity system with total utility defined as

(1) U = ¼ qxqy

Then
(2) MUx = 1/4qy

And
 (3) MUy = ¼ qx

At equilibrium the marginal utilities for X and Y are equal, therefore

(4) ¼ qy/Px = ¼ qxPx

or
(5) ¼ qyPy = ¼ qxPx

From (2), the budget constraint for the two-commodity system is:

(6) Y = qyPy + qxPx

For commodity X therefore, we have

(10) Y = 2 qxPx since qxPx = qyPy from (7)

or
qx = (1/2Px) Y

which the demand function for commodity X. Likewise, the demand for
commodity y is

(10) qy = (1/2Py) Y

Critique of the Indifference-Curves Approach

Advantages:

 A major advance in the field of consumer demand, only ordinality of

preferences is required.
 The assumption of constant utility of money is dropped.
 Provided a framework for the measurement of consumer surplus which is
important in welfare economics and in designing government policies.
 Established a better criterion for the classification of goods into substitutes
and complements.

Shortcomings:

 The weakness of the theory is its axiomatic assumption of the existence and
the convexity of the indifference curves. The theory does not establish either
the existence or the shape of the indifference curves. It just assumes that
they exist and have the required shape of convexity.
  It is also questionable whether the consumer is able to order his preferences
as precisely and rationally as the theory implies. Also, the preferences of the
consumers change continuously under the influence of various factors, hence
any ordering of these preferences even if possible should be considered as
valid for the very short run.
 Rules out the influence of advertisement, habit persistence and
interdependence of preferences of consumers which could lead to irrational
behavior.
 Speculative demand and random behavior are ruled out, but these are
considered important in pricing and output decision of the firm.

3. Functional Forms

The linear demand function

This is probably the most common type of demand function that we see in
economics text books. Its simplest form is:

Qd = a – bP

Qd = the amount of the good demanded

P = the price of the good
a = a constant
b = the slope or the regression coefficient

The multiple explanatory variable version of this model is done simply by adding
the other explanatory variables. The signs of the regression coefficients of some
of these variables may be predetermined according to the theory. For example,
for a normal good, the sign of the coefficient of own price should be negative.
Why? What is its implication if the coefficient of own price is positive? Also, for a
normal good the sign of the coefficient of income should be positive. Why? What
does it mean if the coefficient of income is negative?

The constant-elasticity demand function

This is the most commonly used form of demand function in applied research.
The specific form of this function is:

Q x = b 0 P bx1 P bo 2 Y b 3 e b 4 t

Where: Qx = the quantity demanded of commodity X

Px = price of commodity X
Po = price of other commodities
Y = consumers’ aggregate income
e b 4 t = a trend factor for taste with e as the base of natural logarithm
 b 1 = price elasticity of demand
b 2 = cross price elasticity of demand
b 3 = income elasticity of demand

To prove that b 1 is the constant price elasticity of demand, we express the

demand function in natural logarithms, thus:

log Qx = log bo + b1 log Px + b2 log Po + b3 log Y + b4t

getting the partial derivative of log Qx with respect to Px, we have:

 log Qx
= b1
 log Px

But
Qx
 log Qx =
Qx
and
Px
 log Px =
Px
Therefore

 log Qx Qx / Qx Qx Px

= = * = b1
 log Px Px / Px Px Qx

A variant of this model is

Px b1 Po b 2 Y b 3
Qx = bo ( ) ( ) ( )
P P P

This model expresses demand as a homogeneous function of degree zero, and

incorporates the assumption of no money illusion.

Homogeneous function of degree zero means that if prices and income change
by the same proportion say k percent, the quantity demanded of X will not
change because k will appear in both the numerator and denominator of relative
prices and real income, and hence its effect will cancel out.

Dynamic version of demand functions: the distributive – lag models of

demand

Dynamic demand functions include lagged values of the quantity demanded and
of income as separate variables influencing demand in any particular period. The
dynamic function expresses the idea that current purchasing decisions are
influenced by past behavior.
Models, including lagged values of demand, of income or of other variables are
called distributed-lag models. Their general form may be expressed as:

Qx(t) = f{ Px(t), Px(t-1), . . . , Qx(t-1), Qx(t-2), . . . , Y(t), Y(t-1), . . . }

Where the number of lags depend on the particular relationship being studied.

Nerlove’s Stock Adjustment Model

This model is applied consumer durable and is derived as follows: let

Q*t = bYt

Where Q*t = the desired level of durable

The consumer, however, cannot immediately acquire the desired level of durable
due to limited income, credit limitations, etc. Thus, in each period, the consumer
acquires only a portion of desired level.

Since the consumer buys a certain quantity Qt at current period, the actual
change from the quantity bought in the previous period is denoted by

Qt – Qt-1

This change in actual purchases is only a fraction k of the desired change

Q*t – Qt-1

Accordingly:

Qt – Qt-1 = k( Q*t – Qt-1 )

Where Qt – Qt-1 = actual change

Q*t – Qt-1 = desired change

k = the coefficient of stock adjustment

but Q*t = bYt

therefore

Qt – Qt-1 = k( bYt – Qt-1 )

Or
 Qt = kbYt – kQt-1 + Qt-1

Which simplifies to

Qt = kbYt + ( 1 – k )Qt-1

Now let: kb = a1

( 1 – k ) = a2

then

Qt = a1Yt + a2Qt-1

Which is the final form of the stock adjustment model.

Houthakker’s and Taylor’s (HT) Dynamic model

This model is based on Nerlove’s model. What HT did is extend the idea of stock
adjustment to include non-durables. The model assumes the following:

 Current demand for durables depends on, among others, the stock of
such commodities (stock adjustment process)
 Current demand for non-durables depends on, among others, the
purchases of commodities in the past, because by consuming a certain
commodity we get accustomed to it.

The demand function is derived as follows, let the demand in any particular
period depends on price, stocks of commodity and on current level of income,
then we have:

Qt = bo + b1Pt + b2St + b3Yt

Where: St = stocks of durables if the function refers to such good

St = “stocks of habits” if the function refers to non-durables.

The sign of the coefficient of S will be negative for durables, i.e. the more we
have furniture, electrical appliances, etc. the less our demand for such
commodities.

The sign of the coefficient of S will be positive for non-durables, i.e. the higher
our purchases of non-durables the stronger our habit becomes.
Stocks St however cannot be measured because:

(a) The stocks of durables is composed of heterogeneous items of

various ages, i.e. some are old, some are new, some need
replacing. Their heterogeneity makes direct measurement difficult.
What we ideally want for stocks is the sum of depreciated
inventories of durables, but appropriate depreciation rate is not
known.
(b) The “stocks of habits” is a psychological variable and cannot be
quantified.

We can however eliminate algebraically stocks St from the demand function and
replace it with other measurable variables by making reasonable assumptions.

For durables, the elimination process may be done as follows:

(a) The net change in stocks realized in any period t is equal to our purchases
in that period minus the depreciation of our old possessions:

(1) St – St-1 = Qt – depreciation

(b) Let depreciation be equal in the periods of life of the durables, i.e.

Depreciation = St

Hence:

(2) St – St-1 = Qt - St

(c) From the demand function

(3) Qt = bo + b1Pt + b2St + b3Yt

Solve for St, thus

(4) St = 1/b2 ( Qt – bo – b1Pt –b3Yt )

Substituting (2), we have

(5) St – St-1 = Qt - (1/b2) { Qt – bo – b1Pt – b3Yt}

(d) Since the relation Qt = bo + b1Pt + b2St + b3Yt holds for period t, it should
also hold for period t-1,

(6) Qt-1 = bo + b1Pt-1 + b2St-1 + b3Yt-1

Subtracting Qt-1 from Qt, we have

(7) Qt – Qt-1 = b1(Pt – Pt-1) + b2( St – St-1) + b3( Yt – Yt-1 )

Substituting the value of St – St-1 to (7), we have

(8) Qt – Qt-1 = b1( Pt – Pt-1) + b2{ Qt - /b2( Qt – bo – b1Pt – b3Yt )}

+ b3( Yt – Yt-1)

Rearranging the terms, we have:

(9) Qt = Qt-1 + b1(Pt – Pt-1) + b2Qt - ( Qt – bo – b1Pt – b3Yt)

+ b3(Yt – Yt-1)

(10) Qt (1 – b2 +  ) = (bo) + (b1)Pt + b1Pt + (b3)Yt + b3Yt + Qt-1

Solving for Qt we have:

(11) Qt = (bo)/(1 – b2 +  ) + {(b1)/(1 – b2 + )}Pt +

{(b1)/(1 – b2 +  )}(Pt) + {(b3)/(1- b2 + )}Yt +
{(b3)/(1 – b2 + )}(Yt) + {1/(1 – b2 + )}Qt-1

Let ao, a1, a2, a3, a4, and a5 be equal to the corresponding coefficient of the
term in the equation, then we have:

(12) Qt = ao + a1Pt + a2(Pt) + a3Yt + a4(Yt) + a5Qt-1

Which is the final form of the HT dynamic model formulation of the demand
function.

4. Market Demand

Derivation of Market Demand

Market demand is the horizontal summation of the demands of individual

consumers. Thus, the quantity demanded in the market by a given price is the
sum of individual demands of consumers at that price. We illustrate the market
demand below.
Table .1. Hypothetical Individual and market demand

Pric Quantity Quantity Quantity Quantity Market

e demanded demanded demanded demanded by demand
by by B by C D
A

2 40 4 45 18 107
4 30 2 35 16 83
6 24 5 30 13 72
8 18 7 20 12 57
10 14 10 15 11 50
12 10 7 13 8 38
14 8 5 10 6 29
16 6 3 8 4 21
18 4 2 0 0 6
20 3 0 0 0 3

The form of market demand is not defined by economic theory. Thus, the
demand of the demand curve is generally dictated by the response of the
quantity demanded to the change in price and of the type of good. One thing we
say, however, is that the quantity demanded is inversely related to price in
normal goods, i.e. the quantity demanded decreases as the price increases.
Nevertheless, two general form of demand curves may by advanced, namely:
(a) linear demand curve, and (b) curvilinear demand curve.

Linear demand curve:

The linear demand curve takes the form of

Q = a – bP

Where: Q = quantity demanded

a = the intercept
b = the slope of the demand curve
P = price

This linear demand curve exhibits constant slope but changing elasticity at
various prices.

Non-linear demand curve.

An example of the non-linear demand curve is:

 Q = aPb

This is a common non-linear form of demand curve, also known as the constant-
elasticity-demand curve. Note that b is the constant elasticity of demand.

Determinants of demand

The most common and important determinants of the market demand are: the
price of the commodity in question; prices of other commodities; consumers’
income, and taste.

The changes in price results in the movement along the same demand curve,
while changes in other determinants of demand results to a shift of the demand
curve. Accordingly, they are considered the shift factors (prices of other
commodities; income and taste). It should be noted that the demand curve is
drawn under the assumption of constant shift factors.

The market demand is also affected by distribution of income, total population

and its composition; wealth, credit availability, stocks and habit.

Elasticity of Demand

Price elasticity of demand.

Price elasticity of demand measures the responsiveness of demand to changes

in the commodity’s own price. If the change in price is very small, the measure of
responsiveness used is the point elasticity of the demand, i.e. when the
change in price is given as the first derivative of the function, otherwise, the
measure of responsiveness used is the arc elasticity of demand.

Price elasticity of demand ranges from 0 to infinity. The following are the
classification of values of price elasticity of demand.

Price elasticity Types of Demand

0 The demand is perfectly inelastic

1 The demand has unitary elasticity

 The demand is perfectly elastic

0<e<1 The demand is inelastic

1< e < The demand is elastic

Basic determinants of elasticity of demand of a commodity with respect to its
price are:

(a) The demand for a commodity is more elastic if there are close substitutes for
it.
(b) In general luxury goods are price elastic while necessities are price inelastic.
(c) Demand is more elastic in the long run
(d) The more possible uses of the commodity the greater is its price elasticity.
(e) The proportion of income spent on the commodity.

The Income Elasticity of Demand.

The income elasticity of demand is defined as the proportionate change in

quantity demanded resulting from a proportionate change in income.

Income elasticity is positive for normal goods. Some classify goods according to
their income elasticity. Thus, a commodity is considered to be a luxury if its
income elasticity is greater than one. On the other hand, a good is a necessity if
its income elasticity is less than one.

The main determinants of income elasticity of demand are:

(a) The nature of need the need that the commodity covers: the percentage of
income spent on food declines as income increases ( Engel’s Law)
(b) The initial level of income of a country. For example, a TV set is a luxury in
an underdeveloped, poor country, but a necessity in a country with high
per capita income.
(c) The time period, because consumption patterns adjust with time-lag to
changes in income.

The Cross Elasticity of Demand

The cross elasticity of demand is defined as the proportionate change in the

quantity demanded of commodity X resulting from a proportionate change in the
price of commodity Y. The formula for cross – elasticity of demand is:

dQx/Qx divided dPy/Py

The sign of the cross-elasticity is negative if X and Y are complementary goods,

and positive if X and Y are substitutes. The higher the value of cross-elasticity
the stronger is will be the degree of substitutability or complementarity of X and
Y.

The main determinant of cross – elasticity is the nature of the commodity and
their uses. If two commodities can satisfy equally well the same need, the cross –
elasticity is high and vice versa.
Market Demand, Total Revenue and Marginal Revenue.

Demand and Total Revenue

The market demand curve can be used to derived the total expenditure of the
consumers which forms the total revenue of the firms selling that particular
commodity.

Total revenue (TR) is found by multiplying the quantity (Q) sold or demand by its
price (P). Thus,

TR = P*Q

Note that if the demand curve is linear, then TR is a curve which initially curves
upwards, reaches its maximum, then starts declining.

Marginal Revenue

Marginal revenue is defined as the change in total revenue resulting from selling
additional unit of the commodity. It is also the slope of the total revenue curve at
any level of output.

Mathematically, the marginal revenue is the derivative of the TR function, thus:

MR = d(TR)/dQ = d(PQ)/dQ
Or
MR = P + Q(dP/dQ)

If the demand curve is linear, e.g.

Q = b0 – b1P

Then solving for P, we have

P = a0 - a1Q

Where: a0 = b0/b1

a1 = 1/b1

Substituting P in the total revenue function, we have:

TR = P*Q = Q ( a0 – a1 Q) = a0 Q – a1Q2

Taking the derivative of TR with respect to Q, we have:

 MR = d(TR)/dQ = a0 – 2a1 Q

This proves that the MR curve starts from the same point (a 0) of the demand
curve, and that the MR is a straight line with a negative slope twice as steep as
the slope of the demand curve.

Marginal Revenue and Price Elasticity

The marginal revenue is related to the price elasticity of demand with the formula

MR = P{ 1 – 1/e}

The proof of this is as follows:

Assume that the demand function is:

P = f(Q)

The total revenue is

TR = PQ = Q[f(Q)]

The MR is

MR = d(PQ)/dQ = P(dQ/dQ) + Q(dP/dQ)

= P + Q(dP/dQ)

Now, price elasticity of demand is

e = - (dQ/dP)(P/Q)

Rearranging the terms of the equation we have:

e (Q/P) = dQ/dP

(P/eQ) = dP/dQ

Substituting dP/dQ in the expression of the MR we have

MR = P + Q(dP/dQ) = P – Q(P/eQ) = P – (P/e)

Or

MR = P ( 1 – 1/e )
Total Revenue, Marginal Revenue and Price Elasticity

The following conclusions may be advanced on the shape of total revenue curve
and MR, P and e.

The total revenue curve reaches its maximum when e = 1, since MR = 0 when e
= 1.
If e > 1 the total revenue curve has a positive slope, i.e, it is still increasing hence
has not reached its maximum point.

Given P > 0 and (1 – 1/e ) > 0, hence MR > 0

If e < 1 the total revenue curve has a negative slope, i.e. it is falling

Given P > 0, ( 1 – 1/e ) < 0, hence MR < 0

In summary:

(a) If demand is inelastic, an increase in price leads to an increase in total

revenue, and a decrease in price leads to a fall in total revenue.
(b) If demand is elastic, an increase in price will result to a decrease of total
revenue, while a decrease in price leads to an increase in total revenue.
(c) If demand has unitary elasticity, total revenue is not affected by changes
in price, since if e = 1, then MR = 0.