Demand

Theory
B A 2 0 0 4 M A N AG E R I A L E C O N O M I C S

Presented by:
Fritzi Ruth B. Bendor
 Demand refers to the quantities that
people are or would be willing to buy at
different prices during a given time period,
assuming that other factors affecting these
quantities remain the same.
What
is Demand Theory is an economic theory that
concerns the relationship between the demand
Demand? for goods and their prices; it forms the core of
microeconomics.

The generation of demand can be shown below

as:
 • Demand is defined as the amount of goods the
consumers are ready to buy for a sustained
period and at a given price point.
• It is the relationship between price and quantity

Concept demanded other things remaining constant.

of • Quantity demanded is a flow concept thus

time dimension needs to be mentioned.

Demand
Consumer
Demand
Theory
 The general form of the demand function in
terms of price and quantity demanded is:

Q = f(P)

Demand In the two-variable case the demand function

Equation can be expressed in a linear form:

Q = a + bP

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.
 Linear:
Q = a + bP + cY

• b and other coefficients of variables are marginal

effects

Demand
• for every 1 unit P increases Q increases by b
units (b is normally negative)
• Linear – constant marginal effects, varying

Equation elasticities

Power:
Q = aP2

• 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)
• Power – varying marginal effects, constant
elasticities
Law
of
Demand
 ➢ Income Effect
When price of a commodity falls, the the individual can
purchase more units of that commodity, thus quantity
demanded for that commodity increases.

Reason
behind ➢ Substitution Effect
When price of a commodity falls, the quantity demanded

Demand for that product increases because the individual

substitutes in consumption the product with its
substitutes.
 Demand curve shows the relationship
between price and quantity demanded at a
given point of time holding everything else
constant. The movements along demand
Demand curve are a follows.

Curve ↑A rise in price causes upward movement

along a given demand curve.

↓A price decline causes downward movement

along a given demand curve.
Demand
Curve
 Why Demand Curve Slopes
Downward

Demand ✓ Cost- Utility Matching

Curve is ✓ Income Effect

Downward ✓ Substitution Effect

Slope ✓ Arrival of New Consumers

✓ Multiple Uses
Demand Schedule & Demand Curve
Demand Schedule:
A demand schedule is a
tabular presentation of the
amount of goods consumers
are willing and able to buy at
different level of prices over a
given period of time.

Demand Curve:
The graphical representation
of demand schedule is the
demand curve. The demand
curve is a downward sloping
curve from left to right. The
characteristic of the demand
curve is due to the inverse
relationship between price
and quantity demanded.
 The relevant factors determining demand

Factors
that
Affect
Demand
 Changes in the Quantity Demanded
Change in Demand

Demand “Ceteris Paribus” – all things equal

and ❑Changes in the price of a product

affect the quantity demanded per
Quantity period.
Demanded ❑Changes in any other factor, income
or preferences, affect demand.
 Elasticity in general terms is concerned
with the responsiveness or sensitivity of
one variable to changes in another.

Concept ELASTICITY OF DEMAND

• It is the measure of the degree of change in the

of
demand for a product, in response to a given
change in the price, income and change in price
of other related products.

Elasticity • Law of demand shows the direction of the

demand in response to price change whereas,
elasticity of demand gives the extent of change in
demand for the given change in the influencing
factor.
• Elasticity of demand is measured by comparing
proportionate change in demand and
proportionate change in price.
 In terms of degree of elasticity, demand and
supply, may be described as:

• Elastic – when a change in a determinant

leads to proportionately greater change in

Concept quantity of demand for supply

of
• Inelastic – when a change in a determinant
results in a proportionately lesser change in
the quantity of demand and supply. The
Elasticity coefficient of elasticity is less than 1.

• Unitary elastic – when a change in a

determinant leads to proportionately equal
change in the quantity of demand or supply.
The coefficient of elastic is equal to 1.
1. Price Elasticity Demand (PED)
is the percentage change in quantity
demanded in response to a 1 percent
change in price.

• a measure of the relationship

between a change in the
quantity demanded of a
particular good and a change in
its price
• a term in economics often used
when discussing price
sensitivity

Different Elasticities of Demand

 Range of Values
PED Demand Interpretation

Consumers responsive to price

>1 Elastic change

Types <1 Inelastic

Consumers not very
responsive to price change

of =1 Unit Elastic
Perfectly Elastic
Intermediate case
Infinitely responsive (buy

Price
1
nothing if price rises)
Totally unresponsive (buy the
0 Perfectly Inelastic
Elasticity same if price rises)

Demand
2. Promotional Elasticity or
Advertising Elasticity Demand (AED)
can be defined in a very similar way to PED; AED
refers to the percentage change in quantity
demanded in response to a 1 percent change in
advertising.

• it also refers to the proportionate change in

demand of a commodity due to
proportionate change in advertising
expense
• it is a measure of an advertising campaigns
effectiveness in generating sales

Different Elasticities of Demand

3. Income Elasticity Demand (YED) is defined similarly
to the above elasticities; it is the percentage change in quantity
demanded in response to a 1 percent change in income.

• it is the responsiveness of demand to the change in

income
• it is calculated as the percentage in demand to the
percentage in income

Different Elasticities of Demand

Types YED
Range of Values
Demand Interpretation

of >1 Income elastic Luxury products

Income 0<YED<1 Income inelastic Staple products

<0 Negative elasticity Inferior products
Elasticity
Demand
4. Cross-Elasticity Demand (CED) refers to the
percentage change in the quantity demanded of one product in
response to a 1 per cent change in the price of another product.

• measures the responsiveness of a quantity demanded of

one good to a change in the price of another good.

Different Elasticities of Demand

Types
of
Elasticity
based on
Demand
Determinant
 There are four methods of measuring elasticity of demand:
1. Percentage (or Ratio) Method
• The most popular method used to
measure elasticity.
• Elasticity of demand is expressed
as the ratio of proportionate
change in quantity demanded
and proportionate change in the
price of the commodity.
• It helps in deciding how big a
change in price or quantity is.

Ways of Measuring Elasticity

 There are four methods of measuring elasticity of demand:

2. Point Elasticity Method

• Elasticity measured at a pint of
demand curve is referred as point
elasticity of demand
• As changes in price become smaller
and approach zero, the ratio
becomes equivalent to the first
order derivative of the demand
function with respect to price.

Ways of Measuring Elasticity

 There are four methods of measuring elasticity of demand:
3. Arc Elastic Method
• Used when the available figures on price and
quantity are discrete, and it is possible to
isolate and calculate the incremental changes.
• It is used to find the elasticity at the midpoint
of an arc between any two points on a demand
curve, by taking the average of the prices and
quantities.
• This method finds wider applications, as it
reflects a movement along a portion (arc) of a
demand curve.

Ways of Measuring Elasticity

 There are four methods of measuring elasticity of demand:
4. Total Outlay Method
• Elasticity is measures by comparing expenditure
levels before and after any change in price, i.e.
whether the new expenditure is more than or less
than or equal to the initial expenditure level.
• Helps a seller in taking decision to raise price
only if:
➢ Reduction in quantity demanded does not
reduce total revenue or
➢ Reduction in price increases the quantity
demanded to the extent that total revenue
also increases.

Ways of Measuring Elasticity

 Uses and Applications of
Different Elasticities
Firms want to know the PED for their products in
Price Elasticity
order to charge the right price and to make forecasts.
Firms want to know the AED for their products in
Promotion Elasticity order to spend the right amount on promotion and to
make forecasts.
Firms want to know the income elasticities for their
Income Elasticity products in order to select target markets and make
forecasts
Firms want to know the CED for their products in
Cross Elasticity order to see what their main competition is and
determine strategy accordingly.
1. Managerial Economics: A Problem Solving Approach by
Nick Wilkinson, Cambridge University Press.
➢ http://www.railassociation.ir/Download/Article/Books/Managerial%20Economics-
%20A%20Problem%20Solving%20Approach.pdf

2. Economics for Business, 2005/2006 edition, the CIMA

Study System ( E Book from 4shared.com)
➢ https://documents.pub/document/economics-for-business.html

Sources
Case Study 3.4: Oil Production
OPEC’s oil shock
OPEC has surprised the markets with an output cut of 900,000 barrels per day, to take effect at the beginning
of November. Observers had expected the oil producers’ cartel to hold its quotas steady because production
in Iraq has been hit by sabotage. Before the regular meeting of the Organization of Petroleum Exporting
Countries (OPEC) in Vienna on Wednesday September 24th, most of the drama was provided by Hugo
Chavez, the Venezuelan president, who opined that the Iraq representative should not have been at the get-
together because he was an illegitimate stooge of American occupiers. If that is so, Ibrahim Bahr al-Uloum
behaved very oddly. His bullish predictions that Iraq could produce at least 3.5m barrels per day (bpd) by 2005
seem to have been among the factors that persuaded the ten members of OPEC’s quota system to approve a
surprise production cut of 900,000 bpd, to 24.5m bpd.

The effect of the cut was to send oil prices sharply higher. Equities in America retreated on fears that a higher
oil price could stymie the incipient economic recovery: the Dow Jones Industrial Average of 30 leading shares
fell by 1.57% that day. In their official communique´, OPEC’s oil ministers pointed to their expectation of a
‘contra-seasonal stock build-up’ at the end of this year and the beginning of next year. Normally, oil stocks
decline over the winter in the northern hemisphere, thanks to heavy use of heating oil. But this year, demand
for oil, according to OPEC, will grow merely at its ‘normal, seasonal’ level, despite an improving world
economy. OPEC expects supply to grow faster than demand, thanks to continued increases in production
from Iraq and non-OPEC countries (of which Russia, the world’s second-biggest oil exporter, is the most
important). OPEC expects this supply–demand mismatch to translate into a stock increase of 600,000 bpd in
the final quarter of this year. This contrasts with an estimated stock reduction of 500,000 bpd in the final
quarter of 2001, and 1m bpd in the last quarter of 2002. Larry Goldstein, president of the Petroleum Industry
Research Foundation, believes OPEC has got its sums wrong. In remarks to the Wall Street Journal, he said
he thought stocks would be flat over the coming three months. Although the communique´ did not explicitly
say so, OPEC members are keen to keep worldwide oil stocks below their ten-year average. That would give
the cartel more power to determine the price. American oil stocks have been creeping up again after hitting
26-year lows earlier this year. America’s energy secretary, Spencer Abraham, was clearly disappointed by
OPEC’s move, saying: ‘Sustained global economic growth requires abundant supplies of energy.
The US believes oil prices should be set by market forces in order to ensure adequate supplies.’ America’s
opposition Democrats have been even more outspoken. Last month, they publicly rebuked Saudi Arabia,
OPEC’s (and the world’s) leading producer, for reducing exports in August, thus causing an unpopular rise in
American petrol prices. Some observers are also speculating that OPEC may be sneakily trying to shift its
price target above the current $22–28 range (per barrel, for a basket of Middle Eastern crudes, which tend to
trade a couple of dollars below West Texas crude). After all, the oil price has been well within that range for the
past few months. Why cut production when current supply levels are achieving their aim? In fact, the oil price
has stayed higher than many expected: it was widely expected to fall well below $20 per barrel after the end of
the Iraq war. However, unrest in Nigeria, a big producer, and the continuing attacks on Iraq’s oil facilities put
paid to that. OPEC’s fears about non-OPEC production may be well-founded. After decades of communism,
the industry in Russia is ramping up output: so far this year, it has been pumping an average of 800,000 bpd
more than last year. Oil and gas are the country’s biggest exports, earning hard currency that is seen as a key
ingredient of economic revival. Moreover, the oil industry is in private hands, so even if the government in
Moscow wanted to put a lid on production, it has less influence over its oil companies than OPEC governments
have over theirs.
The president of OPEC, Abdullah bin Hamad al-Attiyah, told the Wall Street Journal that the cartel would not
cut production below 24m bpd unless big oil exporters outside OPEC, including Mexico and Norway as well as
Russia, were prepared to cut production too. OPEC’s stance on Iraq is very different. Here, the cartel seems to
be taking an overly rosy view. Iraq says it is currently producing around 1.8m bpd, well below the 2.5m bpd
that it was pumping before the country was invaded in the spring (and even that was well below its potential,
owing to years of sanctions). Moreover, exports, which are a crucial source of revenue for reconstruction, are
still running at only about 500,000 bpd, compared with 2m bpd before the war. These have been seriously
disrupted, and continue to be threatened by sabotage. Currently, oil is being exported mainly through the
north: the southern ports on the Gulf coast are operating far below capacity. For those who take OPEC’s
optimistic view of Iraqi production at face value, the cartel’s move should not have come as a surprise. But the
sharp reaction from oil markets and stockmarkets suggests it did. Many speculators had sold oil in the futures
market, or ‘shorted’ it, expecting the price to fall in the short term – they clearly weren’t expecting a big cut in
output quotas any time soon. According to the Commodity Futures Trading Commission, the American
regulator for commodity futures markets, the increase in short positions over September was equivalent to
470,000 barrels of oil.
OPEC’s decision led to a scramble to ‘cover’ such positions by buying oil. Whether prices stay higher will
depend on two key factors. Will OPEC members stick to their new quotas? (They have a history of
cheating.) And will Iraqi militants continue to destroy their own country’s wells and pipelines?

Link: pp116-118
http://www.railassociation.ir/Download/Article/Books/Managerial%20Economics-%20A%20Problem%20Solving%20Approach.pdf

Questions:

1. Describe the factors currently driving the world demand for oil.
2. Comment on the effects of OPEC’s actions on the market.
 News Articles

Link: https://www.bworldonline.com/laptop-demand-surges-but-supply-cant-keep-up/

Link: https://economictimes.indiatimes.com/markets/commodities/news/opec-sees-steeper-oil-
demand-drop-as-virus-remains-challenging/articleshow/78109549.cms
end
Thank You.