Lecture 1
Demand
Topics Covered
▪ The Demand Curve – Price and Demand
▪ Substitution and Income Effects
▪ Price Elasticity of Demand
▪ Price and Revenue
▪ Shifts in Demand
▪ Income Elasticity of Demand
▪ Inferior Vs Normal Goods
▪ Cross-Price Elasticity of Demand
Optimisation and Equilibrium
▪ The optimisation principle: People try to choose the
best patterns of consumption that they can afford
▪ The equilibrium principle: Prices adjust until the
amount that people demand of something is equal to the
amount that is supplied
Understanding Demand
▪ A customer’s choice of buying your product over a
competitor’s product depends on several factors
▪ The factors that managers can directly influence
include;
➢ Price
➢ Product
➢ Promotion
➢ Place
Price and Demand
Price and Quantity demanded combinations
Price and Demand
▪ The significance of price in relation to a customers’
buying decisions can be analysed using a demand
curve
▪ The demand curve depicts how much customers are
willing and able to buy at each and every price level in
a given time period, assuming all other factors are
unchanged
Price and Demand
Effects of a change in price on the demand curve
Price and Demand
▪ The movement along the curve can be analysed by dividing it
into two parts;
➢ The Substitution Effect – With a lower price the product is now
relatively cheaper compared to rival products. Consumers
substitute the cheaper product for more expensive alternatives
➢ The Income Effect – A fall in the price of a product, with the
consumers income remaining constant, implies a rise in real
income and purchasing power. Quantity demanded of a product
increases with increasing purchasing power
Price Elasticity of Demand
▪ The price elasticity of demand (PED) measures the
extent to which the quantity demanded of a product
changes following a change in price, all other things
constant
▪ PED = Percentage change in the quantity demanded of
the product/Percentage change in price
▪ PED = 1 in absolute value implies unit elasticity i.e. a
change in price has the same proportional effect on
quantity demanded
Price Elasticity of Demand
▪ PED = 0 – Perfectly price inelastic: A change in price has
no effect on quantity demanded
▪ PED < 1 in absolute value – Price inelastic: A change in
price has a less than proportional effect on quantity
demanded
▪ PED >1 in absolute value – Price elastic: A change in price
has a more than proportion effect on quantity demanded
▪ PED = infinity – Perfectly price elastic: A change in price
leads to an infinite change in quantity demanded
Price and Demand
Price elasticity of demand
Price and Revenue
▪ If demand is price elastic, an increase in price will decrease
the total revenue earned by the business
Original revenue = 65
x 110 = £7,150
New revenue = 80 x
50 = £4,000
Price and Revenue
▪ If demand is price inelastic, an increase in price will
increase the total revenue earned by the business
Original revenue = 8 x 90 =
£720
New revenue = 12 x 80 = £960
Determinants of Price Elasticity of
Demand
▪ The product itself
▪ Availability of substitutes
▪ Switching costs
▪ Time
▪ Who actually pays for the product
▪ Percentage of income spent on a product
Shifts in Demand
▪ The income levels of the target market
▪ The population size
▪ Seasonality
▪ Competitors’ actions
▪ Changes in prices of substitutes and compliments
▪ Changes in law or government policy
Shifts in Demand
▪ A shift in the demand curve implies a rise/fall in quantity
demanded at every price level
Income Elasticity of Demand
▪ The extent to which demand is affected by a change in
income is measured by the income elasticity of demand
▪ IED = Percentage change in quantity demanded/Percentage
change in income
▪ Income elastic - If the percentage change in quantity
demanded is greater than the percentage change in income
▪ Income inelastic – If the percentage change in quantity
demanded is less than the percentage change in income
Inferior Vs Normal Good
▪ If the demand falls with a rise in income, the product is
known as an inferior good
▪ If the demand increases with an increase in income, the
product is known as a normal good
Product Income elasticity of demand
Normal Product Positive
Inferior Product Negative
Necessity and normal Value positive and < 1
Luxury and normal Value positive and > 1
Cross-Price Elasticity of Demand
▪ The extent to which your demand is sensitive to change in the
price of another product is measured by cross-price elasticity of
demand (CPED)
▪ Percentage change in the quantity demanded of product
A/Percentage change in the price of product B
▪ If the price of another product increases and the quantity
demanded of your product increases, the two products are
substitutes – CPED is positive
▪ If the price If the price of another product increases and the
quantity demanded of your product decreases, the two products
are compliments – CPED is negative
Seminar Questions
Last year you were selling membership of your health club at £400 a
year. You had 500 members. This year, you wanted to boost sales
revenue and so you decided to reduce your membership fee to £360.
The number of members has risen to 525. Calculate;
a) The price elasticity of demand
b) Calculate change in total revenue
c) Explain the link between price elasticity of demand and total
revenue.
Seminar Questions
The Crown and Kings Arms are two restaurants on high street
Egham. Last week the Crown introduced a special mid-week
discount that reduced the average price of a meal from £20 to £18 per
person. The number of customers that evening at Kings Arms fell by
20 percent.
a) What is the price change at the Crown?
b) What is the cross-price elasticity of demand for Kings Arms?
c) What can you comment about these products being substitutes or
compliments?
Seminar Solutions
a) Price elasticity of demand.
The percentage change in quantity demanded is:
Change in quantity/Original quantity x 100 = 25/500 x 100 = +5%
The percentage change in price is:
Change in price/Original price x 100 = -40/400 x100 = -10%
The price elasticity of demand is:
Percentage change in quantity demanded/Percentage change in price
= +5%/-10% = -0.5%, hence this is price inelastic
Seminar Solutions
b) Change in total revenue
Total revenue last year = £400 x 500 = £200,000
Total revenue this year = £360 x 525 = £189,000
The total change in revenue = £200,000 - £189,000 = £11,000
c) Link between price elasticity and total revenue
A fall in price has led to a fall in total revenue, because demand is
price inelastic. The hike in membership numbers does not
compensate for the lower membership fee
Seminar Solutions
a) The price change at the Crown is = -2/20 x 100 = -10%
b) The cross-price elasticity of demand for Kings Arms is:
-20%/-10% = +2
c) This means the products are substitutes, decrease in the price of
one decreases demand for another
Recommended Reading
Chapters 2 - Begg, D. and Ward, D., 2013. Economics for
Business, 4th Edition. McGraw Hill
Email – sharik.essa@uwl.ac.uk
