1. Principles and Worldwide Applications, 7th Edition
Managerial Economics
Principles and Worldwide Applications, 7th Edition
Dominick Salvatore &
Ravikesh Srivastava

3. Chapter 3:
Demand Theory

4. Law of Demand
Holding all other things constant (ceteris paribus), there is an inverse relationship between the price of a good and the quantity of the good demanded per time period.
Substitution Effect
Income Effect

5. Components of Demand: The Substitution Effect
Assuming that real income is constant:
If the relative price of a good rises, then consumers will try to substitute away from the good. Less will be purchased.
If the relative price of a good falls, then consumers will try to substitute away from other goods. More will be purchased.
The substitution effect is consistent with the law of demand.

6. Components of Demand: The Income Effect
The real value of income is inversely related to the prices of goods.
A change in the real value of income:
will have a direct effect on quantity demanded if a good is normal.
will have an inverse effect on quantity demanded if a good is inferior.
The income effect is consistent with the law of demand only if a good is normal.

7. Individual Consumer’s Demand QdX = f(PX, I, PY, T)
quantity demanded of commodity X by an individual per time period
price per unit of commodity X
consumer’s income
price of related (substitute or complementary) commodity
tastes of the consumer

8. QdX = f(PX, I, PY, T)
QdX/PX < 0
QdX/I > 0 if a good is normal
QdX/I < 0 if a good is inferior
QdX/PY > 0 if X and Y are substitutes
QdX/PY < 0 if X and Y are complements

11. Market Demand Curve
Horizontal summation of demand curves of individual consumers
Exceptions to the summation rules
Bandwagon Effect
collective demand causes individual demand
Snob (Veblen) Effect
conspicuous consumption
a product that is expensive, elite, or in short supply is more desirable

13. Market Demand Function QDX = f(PX, N, I, PY, T)
quantity demanded of commodity X
price per unit of commodity X
number of consumers on the market
consumer income
price of related (substitute or complementary) commodity
consumer tastes

14. Demand Curve Faced by a Firm Depends on Market Structure
Market demand curve
Imperfect competition
Firm’s demand curve has a negative slope
Monopoly - same as market demand
Oligopoly
Monopolistic Competition
Perfect Competition
Firm is a price taker
Firm’s demand curve is horizontal

15. Demand Curve Faced by a Firm Depends on the Type of Product
Durable Goods
Provide a stream of services over time
Demand is volatile
Nondurable Goods and Services
Producers’ Goods
Used in the production of other goods
Demand is derived from demand for final goods or services

17. Linear Demand Function
QX = a0 + a1PX + a2N + a3I + a4PY + a5T PX
Intercept: a0 + a2N + a3I + a4PY + a5T
Slope: QX/PX = a1 QX

18. Linear Demand Function Example Part 1
Demand Function for Good X
QX = PX + 2N + 0.5I + 2PY + T
Demand Curve for Good X
Given N = 58, I = 36, PY = 12, T = 112
Q = P

19. Linear Demand Function Example Part 2
Inverse Demand Curve
P = 43 – 0.1Q
Total and Marginal Revenue Functions
TR = 43Q – 0.1Q2
MR = 43 – 0.2Q

24. Price Elasticity of Demand
Point Definition
Linear Function

25. Price Elasticity of Demand
Arc Definition

26. Marginal Revenue and Price Elasticity of Demand

27. Marginal Revenue and Price Elasticity of DemandPX QX
MRX

28. Marginal Revenue, Total Revenue, and Price ElasticityTR
MR>0
MR<0 QX
MR=0

29. Determinants of Price Elasticity of Demand
The demand for a commodity will be more price elastic if:
It has more close substitutes
It is more narrowly defined
More time is available for buyers to adjust to a price change

30. Determinants of Price Elasticity of Demand
The demand for a commodity will be less price elastic if:
It has fewer substitutes
It is more broadly defined
Less time is available for buyers to adjust to a price change

32. Income Elasticity of Demand
Point Definition
Linear Function

33. Income Elasticity of Demand
Arc Definition
Normal Good
Inferior Good

35. Cross-Price Elasticity of Demand
Point Definition
Linear Function

36. Cross-Price Elasticity of Demand
Arc Definition
Substitutes
Complements

38. Example: Using Elasticities in Managerial Decision Making
A firm with the demand function defined below expects a 5% increase in income (M) during the coming year. If the firm cannot change its rate of production, what price should it charge?
Demand: Q = – 3P + 100M
P = Current Real Price = 1,000
M = Current Income = 40

39. Solution Elasticities Price Q = Current rate of production = 1,000
P = Price = - 3(1,000/1,000) = - 3
I = Income = 100(40/1,000) = 4
Price
%ΔQ = - 3%ΔP + 4%ΔI
0 = -3%ΔP+ (4)(5) so %ΔP = 20/3 = 6.67%
P = ( )(1,000) = 1,066.67

41. Other Factors Related to Demand Theory
International Convergence of Tastes
Globalization of Markets
Influence of International Preferences on Market Demand
Growth of Electronic Commerce
Cost of Sales
Supply Chains and Logistics
Customer Relationship Management

43. Chapter 3 Appendix

44. Indifference Curves Utility Function: U = U(QX,QY)
Marginal Utility > 0
MUX = ∂U/∂QX and MUY = ∂U/∂QY
Second Derivatives
∂MUX/∂QX < 0 and ∂MUY/∂QY < 0
∂MUX/∂QY and ∂MUY/∂QX
Positive for complements
Negative for substitutes

45. Marginal Rate of Substitution
Rate at which one good can be substituted for another while holding utility constant
Slope of an indifference curve
dQY/dQX = -MUX/MUY

47. Indifference Curves: Complements and Substitutes
Perfect Complements
Perfect Substitutes QY QX QY QX

48. The Budget Line Budget = M = PXQX + PYQY Slope of the budget line
QY = M/PY - (PX/PY)QX
dQY/dQX = - PX/PY

49. Budget Lines: Change in Price
GF: M = $6, PX = PY = $1
GF’: PX = $2
GF’’: PX = $0.67

51. Budget Lines: Change in Income
GF: M = $6, PX = PY = $1
GF’: M = $3, PX = PY = $1

52. Consumer Equilibrium
Combination of goods that maximizes utility for a given set of prices and a given level of income
Represented graphically by the point of tangency between an indifference curve and the budget line
MUX/MUY = PX/PY
MUX/PX = MUY/PY

54. Mathematical Derivation
Maximize Utility: U = f(QX, QY)
Subject to: M = PXQX + PYQY
Set up Lagrangian function
L = f(QX, QY) + (M - PXQX - PYQY)
First-order conditions imply
 = MUX/PX = MUY/PY