BUSINESS ECONOMICS
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Chapter 3:
DEMAND &
CONSUMER BEHAVIOR
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⚫ Required: Business Economics and
Managerial Decision Making, C.4-6
⚫ Recommend: Economics for
Business and Management, C.2
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STRUCTURE
1. Demand analysis
2. Demand function estimation
3. Consumer behavior
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1.Demand analysis
1.1 Market demand
1.2 Revenue
1.3 Elasticity
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Demand?
Desire of a consumer
Ability to pay
Willingness to part with purchasing power
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1.1 Market demand
Summation?
: quantity demanded of good X
: price of good X
: price of good Y
: advertising expenditure
Y: real disposable income
T: consumer tastes
O: other factors
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1.1 Market demand
For simplicity:
Inverse demand function?
i.e. Linear demand f.:
🡪 Q (P=0)
🡪 P (Q=0)
🡪 Slope
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1.2 Revenue
TR? MR?
i.e.
🡪A linear MR curve
🡪 A MR curve: slope is twice that of the demand
curve
🡪TR is maximized where MR is 0
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1.3 Elasticity
Responsiveness to changes
1.3.1. Own price elasticity
a. Formula:
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TR? MR?
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1.3 Elasticity
MR (0) Change in TR
(as P falls)
Inelastic
Elastic
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1.3 Elasticity
b. Factors affecting :
Price effect = substitution effect + income effect
- Substitution effect: Closer substitute 🡪 more or
less elastic?
- Income effect: Large proportion of income 🡪
more or less elastic?
- Time: Longer period 🡪 more or less elastic?
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1.3 Elasticity
c. Arc elasticity :
Non-linear, large change in price….
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1.3 Elasticity
1.3.2. Cross-price elasticity
Formula:
Substitute or complementary?
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1.3 Elasticity
1.3.2. Income elasticity
Formula:
Normal or inferior?
- Engel curve
- Factors affecting: initial income level,
status of the goods (necessities or
luxuries), age of the goods…
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1.3 Elasticity
1.3.2. Advertising elasticity
Formula:
A is informative or persuasive?
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2. Demand function estimation
Different methods:
- Interviews and surveys (using
questionnaires)
- Consumer experiments
- Market studies
- Statistical analysis (using regression)
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2. Demand function estimation
Statistical analysis (using regression)
2.1 Setting model:
Linear equation: not included in the final exam
Log-linear equation:
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2. Demand function estimation
2.2 Checking results:
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a. R and adjusted R
(overall explanatory power)
. Too low 🡪 misspecification of the model
. Too high 🡪 multi-collinearity
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2.2 Checking results:
b. F-test: dep. & a group of ind.
H0: no significant statistical rel.
F > Fb 🡪 reject H0
c. t-test: dep. & an ind.
H0: no significant statistical rel.
t > tb 🡪 reject H0
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2.2 Checking results:
d. Coefficients:
. Sign: if not the expected
🡪 Omission
🡪 Identification (simultaneous change between
the variable included and the one not included):
price and income
. Statistical significance (standard error)
95% probability of the actual value falls into
(estimated value +/- 2* standard errors)
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2.2 Checking results:
e. Auto-correlation:
Error terms: serially correlated
🡪 Overestimating/underestimating the
unexplained variation
🡪 Durbin-Watson statistic:
Ho: there is auto-correlation
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3. Consumer behavior
- Maximize utility with budget constraint
- Characteristic approach
(show the proliferation of similar but
different goods based on their
characteristics)
- Behavioral approach
(make use of rules of thumb and routines
🡪 imperfect information)
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Maximize utility
3.1 Indifference curve:
- A level of utility 🡪 intersect?
- A set of preferences and choices
Assume: 2 substitutes (more is better and
no durable characteristics)
- Convex to the origin
- Slope downward
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🡪 MRS (Marginal rate of substitution)
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3.2 Budget constraint:
Slope?
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3.3 Price effect (= Sub. + Inc.)
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3.4 Criticism of indifference curve:
- How to set preferences?
- Static
- The way that consumers make decisions?
- Ordering just based on utility?
- No interactions among individuals
- Private goods
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