MANECON – MODULE 3: QUANTITATIVE DEMAND ANALYSIS

Professor: Prof. Cecilia Flores

Transcribed by: Tyrone Villena

Linear Demand, Elasticity, and Revenue Perfectly Elastic and Inelastic Demand

Linear Inverse Demand: P = 40 – 0.5Q

Demand: Q = 80 – 2P

Vertical Line: Perfectly Inelastic

Horizontal Line: Perfectly elastic

Revenue = P30 x 20 = P600 e > 1 = elastic

Elasticity = -2 x
20( )
P30
= -3 e < 1 = inelastic
e = 1 = unitary elastic
Conclusion: Demand is elastic. e = 0 = Perfectly inelastic
e -> ∞ = Perfectly elastic
Revenue = P10 x 60 = P600

Elasticity = -2 x ( P10
60 )
= -0.333
Factors Affecting the Own Price Elasticity
Conclusion: Demand is inelastic.
Three factors can impact the own price elasticity of
Revenue = P20 x 40 = P800 demand:

Elasticity = -2 x ( P20
40 )
= -1 -
-
Availability of consumption substitutes
Time/duration of purchase horizon
Conclusion: Demand is unitary elastic. - Expenditure share of consumers’ budgets

Total Revenue Test Marginal Revenue and the Own Price Elasticity of
Demand
When demand is elastic:
- The marginal revenue can be derived from a
- A price increase (decrease) leads to a decrease
market demand curve.
(increase) in total revenue.
o Marginal revenue measures the
When demand is inelastic: additional revenue due to a change in
output.
- A price increase (decrease) leads to an increase - This link relates marginal revenue to the own
(decrease) in total revenue. price elasticity of demand as follows:

When demand is unitary elastic: MR=P ( 1+EE )

- Total revenue is maximized.
When -∞ < E < -1, then MR > 0.
When E = -1, then MR = 0
When -1 < E < 0, then MR < 0.
MANECON – MODULE 3: QUANTITATIVE DEMAND ANALYSIS
Professor: Prof. Cecilia Flores
Transcribed by: Tyrone Villena

- Assessing the overall change in revenue from a

price change for one good when a firm sells two
Demand and Marginal Revenue goods is:
[
∆ R= R x ( 1+ EQ x d
, Px ) + R y EQ x , P ] x % ∆ P x
d
y

E.g.,

- Suppose a restaurant earns P4,000 per week in

revenues from hamburger sales (X) and P2,000 per week
from soda sales (Y).

- If the own price elasticity for burgers is EQ , P =−1.5 x x

and the cross-price elasticity of demand between sodas

and hamburgers is EQ , P =−4.0 , what would happen to
y x

the firm’s total revenues if it reduced the price of

hamburgers by 1 percent?

Cross-Price Elasticity ∆ R=[ P 4000 ( 1−1.5 ) + P 2000 (−4.0 ) ] (−1 %)

- Measures responsiveness of a percent change in = P100
demand for good X due to a percent change in
the price of good Y. = That is, lowering the price of hamburgers 1 percent
%∆ Q x d increases total revenue by P100.
EQ x P =
d
y
% ∆ Py

- If EQ x d
Py > 0, then X and Y are substitutes Elasticities for Linear Demand Functions

- If EQ x d
Py < 0, then X and Y are complements. - From a linear demand function, we can easily
compute various elasticities.
E.g., - Given a linear demand function:
d
- Suppose it is estimated that the cross-price elasticity of Q x =a0 +a x P x + a y P y + am M + a H P H
demand between clothing and food is -0.18. If the price
of food is projected to increase by 10%, by how much Px
o Own price elasticity: a x d
will demand for clothing change? Qx
Py
% ∆Q Clothing d o Cross price elasticity: a y d
−0.18= ⇒ % ∆ QClothing =−1.8
d Qx
10 M
o Income elasticity: a M d
- That is, demand for clothing is expected to decline by Qx
1.8% when the price of food increases by 10%.
E.g.,

The daily demand for Invigorated PED shoes is

- Cross-price elasticity is important for firms estimated to be:
selling multiple products. d
o Price changes for one product impact Q x =100−3 P x +4 P y −0.01 M + 2 P A x

demand for other products.

MANECON – MODULE 3: QUANTITATIVE DEMAND ANALYSIS
Professor: Prof. Cecilia Flores
Transcribed by: Tyrone Villena

Suppose good X sells at $25 a pair, good Y sells at $35, Regression Analysis
the company utilizes 50 units of advertising, and average
consumer income is $20,000. Calculate the own price, - How does one obtain information on the demand
cross-price and income elasticities of demand. function?
o Published studies
Q x d=100−3 ( $ 25 )+ 4 ( $ 35 )−0.01 ( $ 20,000 ) +2 ( 50 )=65 units o Hire consultant
o Statistical technique called regression
- Own price elasticity: −3 ( 2565 )=−1.15 analysis using data on quantity, price,
income and other important variables.

Cross-price elasticity: 4 ( ) =2.15

35
-
65

Income elasticity: −0.01 (

65 )
20,000
- =−3.08

One non-linear demand function is the log-linear

demand function:

In Q x d
= β 0 + β x ln P x + β y ln P y + β M ln M + β H ln H Job as an econometrician is to find a smooth curve or
line that does a good job at estimating the points
o Own price elasticity: β x
There are linear relations between x and y but there
o Cross price elasticity: β y is also some random variation in the relationship
o Income elasticity: β M
A and D lies above the line
E.g,

An analyst for a major apparel company estimates that

the demand for its raincoats is given by - True (or population) regression model
Y =a+bX + e
d
ln Q x =10−1.2 ln P x +3 ln R−2 ln A y a unknown population intercept
b unknown population slope parameter.
Where R denotes the daily amount of rainfall and A y the e random error term with zero mean and
level of advertising on good Y. What would be the standard deviation σ .
impact on demand of a 10% increase in the daily amount
of rainfall?

%∆Qx
d
%∆Qx
d - Least squares regression line
EQ x , R= β R=3. So , E Q x , R = ⇒3=
Y = a^ + b^ X
d d
%∆R 10

A 10% increase in rainfall will lead to a 30% increase in a^ least squares estimate of the unknown
the demand of raincoats. parameter a .
b^ least squares estimate of the unknown
parameter b .
- The parameter estimates a^ and b^ , represent the
values of a and b that result in the smallest sum
MANECON – MODULE 3: QUANTITATIVE DEMAND ANALYSIS
Professor: Prof. Cecilia Flores
Transcribed by: Tyrone Villena

of squared errors between a line and the actual - t ^a=|6.69|>2, the intercept is statistically
data. different from zero.
- t ^b=|−4.89|<2 , the intercept is statistically
different from zero.
- P values are a much more precise measure of
statistical significance
- 0.0012 = only 12 in 10000 chance that we’ll get
an estimate at least as big as -2.6 in absolute
value if the true coefficient is actually zero
- 0.05 = estimated coefficient is statistically
significant at the 5% level

Evaluating the Overall Fit of the Regression Line

Evaluating Statistical Significance
- R-Square
- Standard error o Also called the coefficient of
o Measure of how much each estimated
determination
estimate varies in regressions based on o Fraction of the total variation in the
the same true demand model using
dependent variable that is explained by
different data.
the regression.

- 95 Percent Confidence interval rule of thumb

Explained Variation SS Regression
o a^ ± 2 σ a^ R 2= =
Total Variation SS Total
o b^ ± 2 σ b^ o Ranges between 0 and 1.
 Values closer to 1 indicate “better”
- T-statistics rule of thumb fit
o When |t |>2, we are 95 percent
confident the true parameter is in the - Adjusted R-Square
regression is not zero. o A version of the R-Square that penalize
researchers for having few degrees of
freedom.
2 2 n−1
R =1−(1−R )
n−k

n is the total observations.

k is the number of estimated
coefficients.
n−k is the degrees of freedom for the
regression.

- When t stat is large we are confident that it is not - The F-Statistic

zero thus the standard error is small relative to
the absolute value of the parameter estimate
MANECON – MODULE 3: QUANTITATIVE DEMAND ANALYSIS
Professor: Prof. Cecilia Flores
Transcribed by: Tyrone Villena

o A measure of the total variation

explained by the regression relative to
the total unexplained variation.
 The greater the F-statistic, the better
the overall regression fit.
 Equivalently, the P-value is another
measure of the F-statistic.
 Lower P-values are associated
with better overall regression fit.

Regression for Nonlinear Functions and Multiple

Regression

- Regression techniques can also be applied to the

following settings:

o Nonlinear functional relationships:

 Nonlinear regression example:
ln Q= β0 + β p ln P+e

o Functional relationships with multiple

variables:
 Multiple regression example:
Q x d=a0 +a x P x + a y P y + am M + a H P H + e
d
ln Q x =¿ β 0 + β x ln Px + β y ln P y + β M ln M + β H ln H + e ¿