1. Lecture 2 Review of Microeconomic Tools

2. 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.

3. 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
Note: Can depend on ADVERTISING
Tastes
Note: Can depend on ADVERTISING
Expectations (price changes, income changes)
As always, we have to abstract.

4. General Functional Form
Red Variables are constant for a given demand curve
 is a random term.
Human beings have random element to behavior.
There are random events (disasters, etc.) which influence demand.
QDX=f(PX,PY,I,Tastes(A),Expect.,Buyers(A), )

5. Lets Systematically Derive the Demand Curve Graphically
The demand curve holds all the factors that shift demand curves constant.
Only the own price changes.

6. 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 Q P1 Q1

7. A Change in Demand P/unit P1 P2 D Q Q1 Q2
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 D Q Q1 Q2

8. A Change in Demand P/unit P1 P2 D’ D Q Q1 Q2 Q’1 Q’2
If one of the ceteris paribus assumptions changes, this shifts the entire demand curve.
Suppose advertising affects tastes positively, or increases number of buyers.
Demand increases or shifts right!
Q increases at every price.
P/unit P1 P2 D’ D Q Q1 Q2
Q’1
Q’2

9. 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.

10. Empirical Uber Demand
Using Big Data to Estimate Consumer Surplus: The Case of Uber (2016)
Focus on UberX
Data covers NYC, LA, SF and Chicago
Jan 1, 2015 to June 17, 2015
48 million observations in the base sample
Uber generates a continuous measure of surge, actual prices charged are limited to a discrete set of points: 1.0, 1.2, 1.3, …, 4.8, 4.9, etc.

11. Empirical Uber Demand
Using Big Data to Estimate Consumer Surplus: The Case of Uber (2016)
Purchase is an indicator variable for whether or not a session ends in a purchase,
Wait is the expected wait time,
Generator is the continuous measure of surge produced by the Uber algorithm.
Fixed effects for city and eight “Hour and day” categories

12. Empirical Uber Demand

13. Empirical Uber Demand

14. 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

15. General Function Form  is a random term.
Red Variables are constant for a given supply curve
 is a random term.
Suppliers may behave randomly.
There are random events (disasters, etc.) which influence supply.
QSX=f(PX,Pinput,POther,Tech.,Expect.,#Sellers,Govt,)

16. 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. 69

17. Price Elasticity of Demand
Definition
Formula
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 70

18. 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: 72

19. Price Elasticity of Demand
Definition
Usually a negative number
As price increases, quantity decreases
As price decreases, quantity increases
|EP| > 1
This good is price elastic
|%Q| > |%P|
This good is price inelastic
|%Q| < |%P|
|EP| < 1

20. 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 75

21. Example: Price Elasticities of Demand for Automobile Makes (1990)
Source: Berry, Levinsohn and Pakes, "Automobile Price in Market Equilibrium," Econometrica 63 (July 1995),

22. Uber Price Elasticity Findings
Interestingly, demand is estimated to be substantially less elastic in Los Angeles (-0.33, se=.05) than in the other three cities.
Demand is estimated to be most elastic during the day on weekends (-0.66, se=0.05) and least elastic during non-rush hour times of the day on weekdays (-0.46, se=0.06).
When the consumers are divided by prior experience with Uber, the more frequent users (e.g., those taking more than 8 rides in a period) are the most elastic.

23. Price Elasticity of Demand
Price elasticity of demand must be measured at a particular point on the demand curve
Looking at a linear demand curve, as we move along the curve Q/P is constant, but P and Q will change
Elasticity will change along the demand curve
P/unit Q

24. Price Elasticity of Demand
The steeper the demand curve, the more inelastic the demand for the good becomes
The flatter the demand curve, the more elastic the demand for the good becomes
Elastic
Inelastic

25. Look at the Extremes Perfectly Elastic D Perfectly Inelastic D P P D DQ Q

26. Relatively Elastic vs. Relatively Inelastic Demand CurvesP
D’ is relatively more elastic
than D P1 P2 D’ D Q Q1 Q2
Q2’

27. 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 ready-to-eat breakfast cereal in the U.S. is on the order of to -0.5.
Price elasticity of demand for BMW 325 is on the order of -4 to -6.
Price elasticity of demand for individual brands, such as Captain Crunch, is on the order to -4.

28. 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

29. Quick Example: mathematical demand function
Assume equilibrium P and Q:
Q=13,750 and P=190
Demand function
QDX= PX + 10PY+2.5*I
Derive demand curve by holding PY and I constant (e.g., at PY=100, and I=1000) giving: QDX= PX
Derive eQ/P)* P1 /Q1
What is P1 and Q1?
What is Q/P?

30. Elasticity calculation
eQ/P)* P1 /Q1
e-25*190/13750 = -0.34
What is the interpretation?

31. Look at an Example
Suppose the price elasticity of demand is e-3.6, and you expect a 5% price increase next year.
What should happen to the quantity demanded?

32. Look at an Example
Suppose the price elasticity of demand is e-3.6, and you expect a 5% price increase next year.
What should happen to the quantity demanded?
Answer: eQ/P
Q/(+)
Solving for Q=5*(-3.6)=-18%

33. Comments Don’t forget the economics behind your calculations.
Know how to calculate these, and how to manipulate them.