Mba1014 consumers markets elasticity 040513

Go Global !Go Global !Managerial Economics :Managerial Economics :Consumers, Markets & Elasticity

By

Stephen OngStephen OngVisiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City UniversityVisiting Professor, College of Management, Visiting Professor, College of Management,

Shenzhen UniversityShenzhen UniversityMay 2013May 2013

AgendaAgenda

1.1. Consumer BehaviourConsumer Behaviour

2.2. Elasticity of DemandElasticity of Demand

3.3. Demand Analysis & Demand Analysis & PricingPricing

Learning ObjectivesLearning Objectives

To identify and explain the factors To identify and explain the factors that influence consumer behaviourthat influence consumer behaviourTo explain the decision-making To explain the decision-making process and how marketeers can process and how marketeers can influence buyer behaviourinfluence buyer behaviourTo understand To understand elasticity and apply elasticity and apply concepts of price elasticity, cross-concepts of price elasticity, cross-elasticity, and income elasticityelasticity, and income elasticityTo understand determinants of To understand determinants of elasticity and how elasticity affects elasticity and how elasticity affects business revenuebusiness revenue

11Consumer BehaviourConsumer Behaviour

To Which To Which Segment ofSegment ofConsumers Will Consumers Will This Ad Appeal?This Ad Appeal?

A Segment of Consumers Who A Segment of Consumers Who are Environmentally Concernedare Environmentally Concerned

Consumer BehaviourConsumer BehaviourThe behaviour that The behaviour that

consumers display consumers display in searching for, in searching for, purchasing, using, purchasing, using, evaluating, and evaluating, and disposing of disposing of products and products and services that they services that they expect will satisfy expect will satisfy their needs.their needs.

Two Consumer Entities

Consumers

Consumers use products to help them define their identities

Consumer BehaviourConsumer Behaviour

Consumer behaviour is a Consumer behaviour is a process.process.

Consumer BehaviourConsumer Behaviour

Theory of consumer behaviour Theory of consumer behaviour •Description of how consumers allocate Description of how consumers allocate incomes among different goods and incomes among different goods and services to maximize their well-being.services to maximize their well-being.

Consumer behaviour is best understood Consumer behaviour is best understood in 3 distinct steps:in 3 distinct steps:

1.1. Consumer PreferencesConsumer Preferences2.2. Budget ConstraintsBudget Constraints3.3. Consumer ChoicesConsumer Choices

Consumer Tastes & Preferences Consumer Tastes & Preferences Effect on DemandEffect on Demand

Video : Domino’s Pizza Turn Video : Domino’s Pizza Turn AroundAroundhttp://www.youtube.com/watch?v=AH5R56jILag

Consumer PreferencesConsumer Preferences

Market basket (or bundle) List with specific quantities Market basket (or bundle) List with specific quantities of one or more goods.of one or more goods.

TABLE 1TABLE 1 ALTERNATIVE MARKET BASKETSALTERNATIVE MARKET BASKETS

AA 2020 3030

BB 1010 5050

DD 4040 2020

EE 3030 4040

GG 1010 2020

HH 1010 4040

MARKET BASKET UNITS OF FOOD UNITS OF CLOTHING

To explain the theory of consumer behaviour, we will ask whether To explain the theory of consumer behaviour, we will ask whether consumers consumers prefer prefer one market basket to another.one market basket to another.

Some Basic Assumptions about Some Basic Assumptions about PreferencesPreferences

Completeness: Completeness: Preferences are assumed to Preferences are assumed to be be completecomplete. In other words, . In other words, consumers can compare and consumers can compare and rank all possible baskets. rank all possible baskets. Thus, for any two market Thus, for any two market baskets baskets A A and and BB, a consumer , a consumer will prefer will prefer A A to to BB, will prefer , will prefer B B to to AA, or will be indifferent , or will be indifferent between the two. By between the two. By indifferentindifferent we mean that a we mean that a person will be equally person will be equally satisfied with either basket.satisfied with either basket.

Note that these preferences Note that these preferences ignore costs. A consumer might ignore costs. A consumer might prefer steak to hamburger but prefer steak to hamburger but buy hamburger because it is buy hamburger because it is cheaper.cheaper.

Some Basic Assumptions Some Basic Assumptions about Preferencesabout Preferences

Transitivity:Transitivity:Preferences are Preferences are transitivetransitive. . Transitivity means that if a Transitivity means that if a consumer prefers basket consumer prefers basket A A to to basket basket B B and basket and basket B B to to basket basket CC, then the consumer , then the consumer also prefers also prefers A A to to CC. .

Transitivity is normally Transitivity is normally regarded as necessary for regarded as necessary for consumer consistency.consumer consistency.

More is better than More is better than less: less: Goods are assumed to be Goods are assumed to be desirable—i.e., to be desirable—i.e., to be goodgood. . Consequently, Consequently, consumers consumers always prefer more of any always prefer more of any good to lessgood to less. .

In addition, consumers are In addition, consumers are never satisfied or satiated; never satisfied or satiated; more is always better, even if more is always better, even if just a little betterjust a little better. .

Consumer Tastes and PreferencesConsumer Tastes and Preferences

Preference orderings are Preference orderings are completecomplete..

MoreMore of the goods are preferred to less of the goods are preferred to less of the goods.of the goods.

Consumers are Consumers are selfishselfish..

The goods are continuously The goods are continuously divisibledivisible so so that consumers can always purchase that consumers can always purchase one more or one less unit of the goods.one more or one less unit of the goods.

Indifference CurvesIndifference Curves

A consumer’s A consumer’s indifference curve indifference curve that that shows alternative shows alternative combinations of the combinations of the two goods that two goods that provide the same provide the same level of satisfaction or level of satisfaction or utility.utility.

ΔY

ΔX

Y1

Y2

X1 X2

U2U1

DESCRIBING DESCRIBING INDIVIDUAL INDIVIDUAL PREFERENCESPREFERENCESBecause more of each Because more of each good is preferred to less, good is preferred to less, we can compare market we can compare market baskets in the shaded baskets in the shaded areas. areas.

Basket Basket AA is clearly is clearly preferred to basket preferred to basket GG, while , while EE is clearly preferred to is clearly preferred to AA..

However, However, AA cannot be cannot be compared with compared with BB, , DD, or , or HH without additional without additional information.information.

Indifference Curves

IIndifference curve ndifference curve Curve representing all combinations of market baskets that Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction.provide a consumer with the same level of satisfaction.

The indifference curve The indifference curve UU11

that passes through that passes through market basket market basket AA shows shows all baskets that give the all baskets that give the consumer the same level consumer the same level of satisfaction as does of satisfaction as does market basket market basket AA; these ; these include baskets include baskets BB and and DD. .

AN INDIFFERENCE AN INDIFFERENCE CURVECURVE

Our consumer prefers Our consumer prefers basket basket EE, which lies , which lies above above UU11, to , to AA, but , but

prefers prefers AA to to HH or or GG, which , which lie below lie below UU11..

An Indifference CurveAn Indifference Curve

An indifference map is a set of indifference curves that describes a person's preferences.

AN INDIFFERENCEINDIFFERENCE MAP

Indifference MapsIndifference MapsIIndifference Map ndifference Map Graph containing a set of indifference curvesGraph containing a set of indifference curvesshowing the market baskets among which a consumer is indifferent.showing the market baskets among which a consumer is indifferent.

Any market basket on indifference curve U3, such as basket A, is preferred to any basket on curve U2 (e.g., basket B), which in turn is preferred to any basket on U1, such as D.

If indifference curves U1 and U2 intersect, one of the assumptions of consumer theory is violated.

INDIFFERENCE CURVES CANNOT INTERSECTINDIFFERENCE CURVES CANNOT INTERSECT

According to this diagram, the consumer should be indifferent among market baskets A, B, and D. Yet B should be preferred to D because B has more of both goods.

The magnitude of the The magnitude of the slope of an indifference slope of an indifference curve measures the curve measures the consumer’s marginal consumer’s marginal rate of substitution rate of substitution (MRS) between two (MRS) between two goods.goods.

THE MARGINAL THE MARGINAL RATE OF RATE OF

SUBSTITUTIONSUBSTITUTION

In this figure, the MRS In this figure, the MRS between clothing (between clothing (CC) ) and food (and food (FF) falls from 6 ) falls from 6 (between (between AA and and BB) to 4 ) to 4 (between (between BB and and DD) to 2 ) to 2 (between (between DD and and EE) to 1 ) to 1 (between (between EE and and GG).).

The Shape of Indifference CurvesThe Shape of Indifference Curves

Marginal Rate of SubstitutionMarginal Rate of Substitution

The ratio The ratio ΔΔY/Y/ΔΔX, X, which shows which shows the rate at which the consumer the rate at which the consumer

is willing to is willing to trade off trade off one one good for another and still good for another and still maintain a constant utility level, maintain a constant utility level, is called the is called the marginal rate of marginal rate of substitution (MRSsubstitution (MRSxyxy).).

The Marginal Rate of SubstitutionThe Marginal Rate of Substitution

MMarginal rate of substitution (MRS) arginal rate of substitution (MRS) Maximum amount of a good that a consumer is Maximum amount of a good that a consumer is willing to give up in order to obtain one willing to give up in order to obtain one additional unit of another good.additional unit of another good.

CONVEXITYCONVEXITYObserve that the MRS falls as we move down the Observe that the MRS falls as we move down the indifference curve. The decline in the MRS reflects our indifference curve. The decline in the MRS reflects our fourth assumption regarding consumer preferences: a fourth assumption regarding consumer preferences: a

diminishing marginal rate of substitutiondiminishing marginal rate of substitution . . When the MRS diminishes along an indifference curve, When the MRS diminishes along an indifference curve, the curve is convex.the curve is convex.

Perfect Substitutes and Perfect Perfect Substitutes and Perfect ComplementsComplements

PPerfect substitutes erfect substitutes Two goods for which the marginal rate of Two goods for which the marginal rate of substitution of one for the other is a substitution of one for the other is a constant.constant.

PPerfect complements erfect complements Two goods for which the MRS is zero or Two goods for which the MRS is zero or infinite; the indifference curves are infinite; the indifference curves are shaped as right angles.shaped as right angles.

BBadsads Good for which less is preferred rather than more.Good for which less is preferred rather than more.

In (In (aa), Bob views orange juice ), Bob views orange juice and apple juice as perfect and apple juice as perfect substitutes: He is always substitutes: He is always indifferent between a glass of indifferent between a glass of one and a glass of the other.one and a glass of the other.

In (In (bb), Jane views left shoes and right ), Jane views left shoes and right shoes as perfect complements: An shoes as perfect complements: An additional left shoe gives her no extra additional left shoe gives her no extra satisfaction unless she also obtains the satisfaction unless she also obtains the matching right shoe.matching right shoe.

Perfect Substitutes Perfect Substitutes & & Perfect ComplementsPerfect Complements

Preferences for automobile attributes can Preferences for automobile attributes can be described by indifference curves. Each be described by indifference curves. Each curve shows the combination of curve shows the combination of acceleration and interior space that give the acceleration and interior space that give the same satisfaction.same satisfaction.

PREFERENCES FOR AUTOMOBILE ATTRIBUTESPREFERENCES FOR AUTOMOBILE ATTRIBUTES

Owners of Ford Mustang coupes (Owners of Ford Mustang coupes (aa) are ) are willing to give up considerable interior willing to give up considerable interior

space for space for additional accelerationadditional acceleration..

The opposite is true for owners of The opposite is true for owners of Ford Explorers. They prefer Ford Explorers. They prefer

interior space interior space to acceleration to acceleration ((bb).).

DESIGNING NEW AUTOMOBILES (I)DESIGNING NEW AUTOMOBILES (I)

A utility function can be represented by a set of indifference curves, each with a numerical indicator.

This figure shows three indifference curves (with utility levels of 25, 50, and 100, respectively) associated with the utility function:

UTILITY AND UTILITY FUNCTIONSUTILITY AND UTILITY FUNCTIONS

UtilityUtility Numerical score representing the satisfaction that a Numerical score representing the satisfaction that a consumer gets from a given market basket.consumer gets from a given market basket.

Utility function Utility function Formula that assigns a level of utility to Formula that assigns a level of utility to individual market baskets.individual market baskets.

UTILITY FUNCTIONS AND UTILITY FUNCTIONS AND INDIFFERENCE CURVESINDIFFERENCE CURVES

u (F,C ) = FC

A cross-country A cross-country comparison comparison shows that shows that individuals living individuals living in countries with in countries with higher GDP per higher GDP per capita are on capita are on average happier average happier than those living than those living in countries with in countries with lower per-capita lower per-capita GDP.GDP.

INCOME AND HAPPINESSINCOME AND HAPPINESS

CAN MONEY BUY HAPPINESS?CAN MONEY BUY HAPPINESS?

Income and Income and Happiness: Happiness: Comparing Comparing CountriesCountries

The Budget ConstraintThe Budget Constraint

The consumer’s The consumer’s budget constraint budget constraint shows all the shows all the combinations of two combinations of two goods that can be goods that can be purchased with a purchased with a given income and given income and given the prevailing given the prevailing prices of the two prices of the two goods.goods.

Market baskets associated with the budget lineMarket baskets associated with the budget line F F + 2 + 2CC = $80 = $80

Budget constraints Budget constraints Constraints that consumers face as a result of limited Constraints that consumers face as a result of limited incomes.incomes.

BBudget line udget line All combinations of goods for which the total amount All combinations of goods for which the total amount of money spent is equal to incomeof money spent is equal to income..

Budget ConstraintsBudget Constraints

TABLE 2 MARKET BASKETS AND THE BUDGET LINE

MARKET MARKET BASKETBASKET

FOOD FOOD ((FF))

CLOTHING CLOTHING ((CC))

TOTAL TOTAL SPENDINGSPENDING

AA 00 4040 $80$80

BB 2020 3030 $80$80

DD 4040 2020 $80$80

EE 6060 1010 $80$80

GG 8080 00 $80$80

A budget line describes the combinations of goods that can be purchased given the consumer’s income and the prices of the goods.

Line AG (which passes through points B, D, and E) shows the budget associated with an income of $80, a price of food of PF = $1 per unit, and a price of clothing of PC = $2 per unit.

The slope of the budget line (measured between points B and D) is −PF/PC = −10/20 = −1/2.

FPPPIC CFC )/()/(

A BUDGET LINEA BUDGET LINE

Shifts in the Budget Shifts in the Budget ConstraintConstraint

Increase in incomeIncrease in income Increase in price of good XIncrease in price of good X

Y1

B1

B2

INCOME CHANGESINCOME CHANGES

A change in income (with A change in income (with prices unchanged) prices unchanged) causes the budget line to causes the budget line to shift parallel to the shift parallel to the original line (original line (LL11).).

When the income of $80 When the income of $80 (on(on L L11) is increased to ) is increased to

$160, the budget line $160, the budget line shifts outward to shifts outward to LL22..

If the income falls to $40, If the income falls to $40, the line shifts inward to the line shifts inward to LL33..

EFFECTS OF A EFFECTS OF A CHANGE IN INCOME CHANGE IN INCOME ON THE BUDGET LINEON THE BUDGET LINE

The Effects of Changes in Income The Effects of Changes in Income and Pricesand Prices

PRICE CHANGESPRICE CHANGES

A change in the price of A change in the price of one good (with income one good (with income unchanged) causes the unchanged) causes the budget line to rotate budget line to rotate about one intercept.about one intercept.

When the price of food When the price of food falls from $1.00 to $0.50, falls from $1.00 to $0.50, the budget line rotates the budget line rotates outward from outward from LL11 to to LL22..

However, when the price However, when the price increases from $1.00 to increases from $1.00 to $2.00, the line rotates $2.00, the line rotates inward from Linward from L11 to to L L33..

EFFECTS OF A EFFECTS OF A CHANGE IN PRICE ON CHANGE IN PRICE ON THE BUDGET LINETHE BUDGET LINE

EFFECTS OF A CHANGE IN PRICE ON THE EFFECTS OF A CHANGE IN PRICE ON THE BUDGET LINEBUDGET LINE

Consumer ChoiceConsumer Choice

The consumer The consumer maximizes utility maximizes utility by choosing a by choosing a combination of combination of good X and Y, lying good X and Y, lying on the budget on the budget constraint and constraint and simultaneously simultaneously lying on the lying on the indifference curve indifference curve furthest from the furthest from the origin.origin.

Consumer ChoiceConsumer Choice

The maximizing market basket must satisfy The maximizing market basket must satisfy two conditions:two conditions:

1.1. It must be located on the budget lineIt must be located on the budget line..

2.2. ItIt must give the consumer the most must give the consumer the most preferred combination of goods and servicespreferred combination of goods and services..

A consumer maximizes A consumer maximizes satisfaction by choosing satisfaction by choosing market basket market basket AA. At this . At this point, the budget line and point, the budget line and indifference curve indifference curve UU22 are are

tangent.tangent.

No higher level of No higher level of satisfaction (e.g., market satisfaction (e.g., market basket basket DD) can be attained.) can be attained.

At At AA, the point of , the point of maximization, the MRS maximization, the MRS between the two goods between the two goods equals the price ratio. At equals the price ratio. At BB, however, because the , however, because the MRS [− (−10/10) = 1] is MRS [− (−10/10) = 1] is greater than the price greater than the price ratio (1/2), satisfaction is ratio (1/2), satisfaction is not maximized.not maximized.

MAXIMIZING CONSUMER MAXIMIZING CONSUMER SATISFACTIONSATISFACTION

MAXIMIZING CONSUMER SATISFACTIONMAXIMIZING CONSUMER SATISFACTION

MMarginal Benefit arginal Benefit Benefit from the consumption of one additional unit of Benefit from the consumption of one additional unit of a good.a good.

Marginal Cost Marginal Cost Cost of one additional unit of a good.Cost of one additional unit of a good.

So, we can then say that satisfaction is maximized when So, we can then say that satisfaction is maximized when the marginal benefit—the benefit associated with the the marginal benefit—the benefit associated with the consumption of one additional unit of food—is equal to consumption of one additional unit of food—is equal to the marginal cost—the cost of the additional unit of food. the marginal cost—the cost of the additional unit of food. The marginal benefit is measured by the MRS.The marginal benefit is measured by the MRS.

Satisfaction is maximized (given the budget Satisfaction is maximized (given the budget constraint) at the point where constraint) at the point where

MRS = MRS = PPFF//PPCC

The consumers in (The consumers in (aa) are willing to ) are willing to trade off a considerable amount of trade off a considerable amount of interior space for some additional interior space for some additional acceleration.acceleration.

CONSUMER CHOICE OF AUTOMOBILE ATTRIBUTESCONSUMER CHOICE OF AUTOMOBILE ATTRIBUTESGiven a budget constraint, they Given a budget constraint, they will choose a car that emphasizes will choose a car that emphasizes acceleration. The opposite is true acceleration. The opposite is true for consumers in (for consumers in (bb).).

Different preferences of consumer groups for automobiles can affect their Different preferences of consumer groups for automobiles can affect their purchasing decisions. Following up on Example 1, we consider two purchasing decisions. Following up on Example 1, we consider two groups of consumers planning to buy new cars. groups of consumers planning to buy new cars.

DESIGNING NEW AUTOMOBILES (II)DESIGNING NEW AUTOMOBILES (II)

Corner solutionCorner solutionSituation in which the marginal rate of substitution for one good in a Situation in which the marginal rate of substitution for one good in a

chosen market basket is not equal to the slope of the budget linechosen market basket is not equal to the slope of the budget line..

A CORNER SOLUTIONA CORNER SOLUTION

Corner SolutionsCorner Solutions

When a corner solution When a corner solution arises, the consumer arises, the consumer maximizes satisfaction by maximizes satisfaction by consuming only one of the consuming only one of the two goods.two goods.

Given budget line Given budget line ABAB, the , the highest level of highest level of satisfaction is achieved at satisfaction is achieved at BB on indifference curve on indifference curve UU11, ,

where the MRS (of ice where the MRS (of ice cream for frozen yogurt) is cream for frozen yogurt) is greater than the ratio of greater than the ratio of the price of ice cream to the price of ice cream to the price of frozen yogurt.the price of frozen yogurt.

CONSUMER PREFERENCES FOR HEALTH CARE VERSUS CONSUMER PREFERENCES FOR HEALTH CARE VERSUS OTHER GOODSOTHER GOODSThese indifference curves show the These indifference curves show the trade-off between consumption of health trade-off between consumption of health care (H) versus other goods (O). Curve care (H) versus other goods (O). Curve UU11

applies to a consumer with low income; applies to a consumer with low income; given the consumer’s budget constraint, given the consumer’s budget constraint, satisfaction is maximized at point A. satisfaction is maximized at point A.

As income increases the budget line As income increases the budget line shifts to the right, and curve shifts to the right, and curve UU22 becomes becomes

feasible. The consumer moves to point B, feasible. The consumer moves to point B, with greater consumption of both health with greater consumption of both health care and other goods. care and other goods.

Curve Curve UU33 applies to a high-income applies to a high-income

consumer, and implies less willingness consumer, and implies less willingness to give up health care for other goods. to give up health care for other goods. Moving from point B to point C, the Moving from point B to point C, the consumer’s consumption of health care consumer’s consumption of health care increases considerably (from increases considerably (from HH22 to to HH33), ),

while her consumption of other goods while her consumption of other goods increases only modestly (from increases only modestly (from OO22 to to OO33).).

CONSUMER CHOICE OF HEALTH CARECONSUMER CHOICE OF HEALTH CARE

When given a college When given a college trust fund that must trust fund that must be spent on be spent on education, the student education, the student moves from moves from AA to to BB, a , a corner solution.corner solution.

If, however, the trust If, however, the trust fund could be spent fund could be spent on other consumption on other consumption as well as education, as well as education, the student would be the student would be better off at better off at CC..

A COLLEGE TRUST FUND

A COLLEGE TRUST FUNDA COLLEGE TRUST FUND

If an individual facing budget line l1 chose market basket A rather than market basket B, A is revealed to be preferred to B.

Likewise, the individual facing budget line l2 chooses market basket B, which is then revealed to be preferred to market basket D.

Whereas A is preferred to all market baskets in the green-shaded area, all baskets in the pink-shaded area are preferred to A.

REVEALED PREFERENCE:TWO BUDGET LINES

If a consumer chooses one market basket over another, and if the If a consumer chooses one market basket over another, and if the chosen market basket is more expensive than the alternative, then chosen market basket is more expensive than the alternative, then the consumer must prefer the chosen market basket.the consumer must prefer the chosen market basket.

Revealed PreferenceRevealed Preference

Facing budget line l3, the individual chooses E, which is revealed to be preferred to A (because A could have been chosen).

Likewise, facing line l4, the individual chooses G, which is also revealed to be preferred to A.

Whereas A is preferred to all market baskets in the green-shaded area, all market baskets in the pink-shaded area are preferred to A.

REVEALED PREFERENCE:FOUR BUDGET LINES

Revealed PreferencesRevealed Preferences

REVEALED PREFERENCE FOR RECREATION

When facing budget line When facing budget line ll11, an individual chooses to use a health club for 10 , an individual chooses to use a health club for 10

hours per week at point hours per week at point AA..

When the fees are altered, she faces budget line When the fees are altered, she faces budget line ll22..

She is then made better off because market basket She is then made better off because market basket AA can still be purchased, as can still be purchased, as can market basket can market basket BB, which lies on a higher indifference curve., which lies on a higher indifference curve.

REVEALED PREFERENCE FOR RECREATIONREVEALED PREFERENCE FOR RECREATION

MMarginal utility (MU)arginal utility (MU) Additional satisfaction obtained from Additional satisfaction obtained from consuming one additional unit of a good.consuming one additional unit of a good.

DDiminishing marginal utilityiminishing marginal utilityPrinciple that as more of a good is consumed, Principle that as more of a good is consumed, the consumption of additional amounts will the consumption of additional amounts will yield smaller additions to utility.yield smaller additions to utility.

Equal marginal principleEqual marginal principlePrinciple that utility is maximized when the consumer Principle that utility is maximized when the consumer has equalized the marginal utility per dollar of has equalized the marginal utility per dollar of expenditure across all goods.expenditure across all goods.

Marginal Utility and Consumer ChoiceMarginal Utility and Consumer Choice

Changes in Consumer ChoiceChanges in Consumer Choice

Increase in incomeIncrease in income Increase in priceIncrease in price

B

MARGINAL UTILITY AND HAPPINESSMARGINAL UTILITY AND HAPPINESSA comparison of mean levels of satisfaction with life across A comparison of mean levels of satisfaction with life across income classes in the United States shows that happiness income classes in the United States shows that happiness increases with income, but at a diminishing rate.increases with income, but at a diminishing rate.

MARGINAL UTILITY AND HAPPINESSMARGINAL UTILITY AND HAPPINESSWhat, if anything, does research on consumer satisfaction What, if anything, does research on consumer satisfaction tell us about the relationship between happiness and the tell us about the relationship between happiness and the concepts of utility and marginal utility?concepts of utility and marginal utility?

INEFFICIENCY OF GASOLINE RATIONINGINEFFICIENCY OF GASOLINE RATIONINGWhen a good is rationed, less is When a good is rationed, less is available than consumers available than consumers would like to buy. Consumers would like to buy. Consumers may be worse off. may be worse off.

Without gasoline rationing, up Without gasoline rationing, up to 20,000 gallons of gasoline to 20,000 gallons of gasoline are available for consumption are available for consumption (at point (at point BB).).

The consumer chooses point The consumer chooses point CC on indifference curve on indifference curve UU22, ,

consuming 5000 gallons of consuming 5000 gallons of gasoline.gasoline.

However, with a limit of 2000 However, with a limit of 2000 gallons of gasoline under gallons of gasoline under rationing, the consumer moves rationing, the consumer moves to to DD on the lower indifference on the lower indifference curve curve UU11..

RationingRationing

Some consumers will be worse Some consumers will be worse off, but others may be better off off, but others may be better off with rationing. With rationing with rationing. With rationing and a gasoline price of $1.00, and a gasoline price of $1.00, she buys the maximum she buys the maximum allowable 2000 gallons per year, allowable 2000 gallons per year, putting her on indifference putting her on indifference curve curve UU11..

Had the competitive market Had the competitive market price been $2.00 per gallon with price been $2.00 per gallon with no rationing, she would have no rationing, she would have chosen point chosen point FF, which lies , which lies below indifference curve below indifference curve UU11..

However, had the price of However, had the price of gasoline been only $1.33 per gasoline been only $1.33 per gallon, she would have chosen gallon, she would have chosen point point GG, which lies above , which lies above indifference curve indifference curve UU11..

COMPARING GASOLINE RATIONING TO COMPARING GASOLINE RATIONING TO THE FREE MARKETTHE FREE MARKET

CCost-of-living index ost-of-living index Ratio of the present cost of a typical Ratio of the present cost of a typical bundle of consumer goods and services bundle of consumer goods and services compared with the cost during a base compared with the cost during a base period.period.

IIdeal cost-of-living index deal cost-of-living index Cost of attaining a given level of utility at current Cost of attaining a given level of utility at current prices relative to the cost of attaining the same prices relative to the cost of attaining the same utility at base-year prices.utility at base-year prices.

Cost-of-Living IndexesCost-of-Living Indexes

The initial budget The initial budget constraint facing Sarah constraint facing Sarah in 2000 is given by line in 2000 is given by line ll11; ;

her utility-maximizing her utility-maximizing combination of food and combination of food and books is at point books is at point AA on on indifference curve indifference curve UU11..

Rachel requires a budget Rachel requires a budget sufficient to purchase the sufficient to purchase the food-book consumption food-book consumption bundle given by point bundle given by point BB on line on line ll22 (and tangent to (and tangent to

indifference curve indifference curve UU11).).

TABLE 3 IDEAL COST-OF-LIVING INDEX

Price of booksPrice of books $20/book$20/book $100/bk$100/bk

Number of booksNumber of books 1515 66

Price of foodPrice of food $2.00/lb.$2.00/lb. $2.20/lb.$2.20/lb.

Pounds of foodPounds of food 100100 300300

ExpenditureExpenditure $500$500 $1260$1260

2010 (RACHEL)2000 (SARAH)

COST-OF-LIVING INDEXES 1COST-OF-LIVING INDEXES 1

A price index, which A price index, which represents the cost of represents the cost of buying bundle buying bundle AA at at current prices relative current prices relative to the cost of bundle to the cost of bundle AA at base-year prices, at base-year prices, overstates the ideal overstates the ideal cost-of-living index.cost-of-living index.

TABLE 3 TABLE 3 IDEAL COST-OF-LIVING INDEX

Price of booksPrice of books $20/book$20/book $100/bk$100/bk

Number of booksNumber of books 1515 66

Price of foodPrice of food $2.00/lb.$2.00/lb. $2.20/lb.$2.20/lb.

Pounds of foodPounds of food 100100 300300

ExpenditureExpenditure $500$500 $1260$1260

2010 (RACHEL)2000 (SARAH)

COST-OF-LIVING INDEXES 2COST-OF-LIVING INDEXES 2

Fixed-weight index Fixed-weight index Cost-of-living index in which the quantities of goods and services Cost-of-living index in which the quantities of goods and services remain unchanged.remain unchanged.

CChain-weighted price index hain-weighted price index Cost-of-living index that accounts for changes in quantities of goods Cost-of-living index that accounts for changes in quantities of goods and services.and services.

A commission chaired by Stanford University professor A commission chaired by Stanford University professor Michael Boskin concluded that the CPI overstated inflation Michael Boskin concluded that the CPI overstated inflation by approximately 1.1 percentage points—a significant by approximately 1.1 percentage points—a significant amount given the relatively low rate of inflation in the United amount given the relatively low rate of inflation in the United States in recent years. Approximately 0.4 percentage points States in recent years. Approximately 0.4 percentage points of the 1.1-percentage-point bias was due to the failure of the of the 1.1-percentage-point bias was due to the failure of the Laspeyres price index to account for changes in the current Laspeyres price index to account for changes in the current year year mix of consumption of the products mix of consumption of the products in the base-year in the base-year bundle.bundle.

THE BIAS IN THE CPITHE BIAS IN THE CPI

A Simple Model of Consumer Decision Making - Figure 1.4

Segmenting Consumers: Demographics

Demographics:

Age

Gender

Family structure

Social class/income

Race/ethnicity

Geography

1-58Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

Redneck Bank Targets by Social Class

Popular Culture

Music

Movies

Sports

Books

Celebrities

Entertainment

Marketers influence preferences for movie and music heroes, fashions, food, and decorating choices.

Consumer-Brand RelationshipsConsumer-Brand Relationships

Self-concept attachment

Nostalgic attachment

Interdependence

Love

1-60

1.1. Live on the Coke side of Life.Live on the Coke side of Life.2.2. Smarter together.Smarter together.3.3. Your potential. Our passion.Your potential. Our passion.4.4. Don’t do evil.Don’t do evil.5.5. Imagination at work.Imagination at work.6.6. I’m lovin’ it.I’m lovin’ it.7.7. Leap ahead.Leap ahead.8.8. Think different.Think different.9.9. Where dreams come true.Where dreams come true.10.10.Invent.Invent.11.11.It’s not the destination, it’s It’s not the destination, it’s

the journey.the journey.

Who are you?Who are you?

The Best Global BrandsThe Best Global Brands

1.1. Coca-ColaCoca-Cola2.2. IBMIBM3.3. MicrosoftMicrosoft4.4. GEGE5.5. NokiaNokia6.6. ToyotaToyota7.7. IntelIntel8.8. McDonald’sMcDonald’s9.9. DisneyDisney10.10.GoogleGoogle

Top 10 Top 10 Ranked U.S. Companies in Terms of Ranked U.S. Companies in Terms of Consumers’ Trust and Respect of PrivacyConsumers’ Trust and Respect of Privacy

Top 10 Companies• American Express • eBay• IBM• Amazon• Johnson & Johnson• Hewlett-Packard• U.S. Postal Service• Procter and Gamble• Apple• Nationwide

The Mobile ConsumerThe Mobile Consumer• Wireless Media Wireless Media

Messages will Messages will expand as:expand as:– Flat-rate data Flat-rate data

traffic increasestraffic increases– Screen image Screen image

quality is quality is enhancedenhanced

– Consumer-user Consumer-user experiences experiences with web with web applications applications improveimprove

Penetration of Internet Usage Among Penetration of Internet Usage Among Mobile Subscribers in 16 Countries - Mobile Subscribers in 16 Countries -

FIGURE 1.3FIGURE 1.3

Consumer and the InternetConsumer and the Internet

The Web The Web is is

changing changing consumer consumer behaviour.behaviour.

Social MediaSocial Media

Social media are the online means of communication, conveyance, Social media are the online means of communication, conveyance, collaboration, and cultivation among interconnected and collaboration, and cultivation among interconnected and interdependent networks of people, communities, and interdependent networks of people, communities, and organizations enhanced by technological capabilities and mobility. organizations enhanced by technological capabilities and mobility.

1-66

For ReflectionFor Reflection

Did you know If you were paid $1 for every time an article was If you were paid $1 for every time an article was

posted on posted on WikipediaWikipedia, you’d earn $156.23/hour?, you’d earn $156.23/hour?80% of companies use 80% of companies use LinkedInLinkedIn as their primary as their primary

recruiting tool?recruiting tool?More than 1.5 billion pieces of content are shared on More than 1.5 billion pieces of content are shared on

FacebookFacebook daily? daily?

Do Marketers Promise Miracles?Do Marketers Promise Miracles?

Advertisers simply do not know enough about people to manipulate them

22Elasticity of DemandElasticity of Demand

OverviewOverview

The economic concept of The economic concept of elasticityelasticity

The price elasticity of demandThe price elasticity of demand

The cross-elasticity of demandThe cross-elasticity of demand

Income elasticityIncome elasticity

Other elasticity measuresOther elasticity measures

Elasticity of supplyElasticity of supply

How sticky is

How long ago since How long ago since the price changed ?the price changed ?

MonthsMonths MonthsMonths

Dry cleaningDry cleaning McDonald’s McDonald’s MealMeal

NewspaperNewspaper Small CarSmall Car

HaircutHaircut MilkMilk

Taxi fareTaxi fare ElectricityElectricity

Medical servicesMedical services AirfareAirfare

MagazineMagazine PetrolPetrol

Personal ComputerPersonal Computer Teh tarikTeh tarik

Sticky PricesSticky Prices• Average months between price Average months between price

changes (USA)changes (USA)

MonthsMonths MonthsMonths

Coin-operated Laundry Coin-operated Laundry MachineMachine

46.446.4 BeerBeer 4.34.3

NewspaperNewspaper 29.929.9 Microwave Microwave OvensOvens

3.03.0

HaircutHaircut 25.525.5 MilkMilk 2.42.4

Taxi fareTaxi fare 19.719.7 ElectricityElectricity 1.81.8

Vet servicesVet services 14.914.9 AirfareAirfare 1.01.0

MagazineMagazine 11.211.2 GasolineGasoline 0.60.6

PC SoftwarePC Software 5.55.5

Why Should Managers Study Why Should Managers Study Elasticity?Elasticity?

Own-price elasticity Own-price elasticity helps managers helps managers understand the impact that price understand the impact that price changes will have on their revenue.changes will have on their revenue.

Income elasticity Income elasticity can help managers can help managers understand what income groups to understand what income groups to target their product to.target their product to.

Cross-price elasticity Cross-price elasticity can help can help managers understand who their managers understand who their closest competitors are.closest competitors are.

Demand ElasticityDemand Elasticity

Demand elasticity is the Demand elasticity is the responsiveness of quantity responsiveness of quantity demanded to changes in the demanded to changes in the factors that influence factors that influence demand, product price, demand, product price, income, or prices of related income, or prices of related products.products.

The economic concept of The economic concept of elasticityelasticity

Elasticity: the Elasticity: the percentage percentage changechange in one variable in one variable relative to a percentage relative to a percentage change in another.change in another.

Bin changepercent

Ain changepercent Elasticity oft Coefficien

Price elasticity of demandPrice elasticity of demand

Price elasticity of demand: Price elasticity of demand: the percentage change in the percentage change in quantity demanded caused quantity demanded caused by a by a 1 percent change in 1 percent change in priceprice

Price %

Quantity %E

p

Own Price Elasticity Own Price Elasticity of Demandof Demand

Measured as the percentage change in Measured as the percentage change in

quantity demanded of a given good, quantity demanded of a given good,

relative to a percentage change in its relative to a percentage change in its

price, all else constant.price, all else constant.

eepp = %ΔQ = %ΔQxx ÷ %ΔP ÷ %ΔPxx


Elasticity varies Elasticity varies

along a linear along a linear

demand curvedemand curve

Own Price Elasticity of Demand – Own Price Elasticity of Demand – Graphical RepresentationGraphical Representation

P

Q

P1

P2

Q1 Q2

%∆P

%∆Q

A

B

Examples of Own-Price Examples of Own-Price ElasticityElasticity

Cereal: -0.55Cereal: -0.55

Fish: -0.29Fish: -0.29

Neuman’s Own Pasta Sauce: Neuman’s Own Pasta Sauce: -2.32 -2.32

Orange juice: -1.39Orange juice: -1.39


Categories of elasticityCategories of elasticity

Relative elasticity of demand: Relative elasticity of demand: EEpp > 1 > 1

Relative inelasticity of demand: Relative inelasticity of demand: 0 < E0 < Epp < 1 < 1

Unitary elasticity of demand: Unitary elasticity of demand: EEpp = 1 = 1

Perfect elasticity: Perfect elasticity: EEpp = = ∞∞

Perfect inelasticity: Perfect inelasticity: EEpp = = 00

Own Price Elasticity and Total RevenueOwn Price Elasticity and Total Revenue

Value of price Value of price elasticity elasticity

coefficientcoefficientElasticity Elasticity definitiondefinition

Relationship Relationship among variablesamong variables Impact on revenueImpact on revenue

|e|epp| > 1| > 1Elastic Elastic

demanddemand %%ΔΔQQdd > % > %ΔΔPPxx

Price increase results in Price increase results in lower total revenue.lower total revenue.Price decrease results Price decrease results in higher total revenue.in higher total revenue.

|e|epp| < 1| < 1Inelastic Inelastic demanddemand %%ΔΔQQdd < % < %ΔΔPPxx

Price increase results in Price increase results in higher total revenue.higher total revenue.Price decrease results Price decrease results in lower total revenue.in lower total revenue.

|e|epp| = 1| = 1Unit or Unit or unitary unitary elasticelastic

%%ΔΔQQdd = % = %ΔΔPPxx

Price increase or Price increase or decrease has no impact decrease has no impact on total revenue.on total revenue.

If demand is elastic,a decrease in price If demand is elastic,a decrease in price results in an increase in total revenue, results in an increase in total revenue, and an increase in price results in a and an increase in price results in a decrease in total revenue.decrease in total revenue.

If demand is inelastic,a If demand is inelastic,a decrease In price results decrease In price results in a decrease in total in a decrease in total revenue, and an revenue, and an increase in price results increase in price results in a increase in total in a increase in total revenue.revenue.

Graphical Representation of Relationship Graphical Representation of Relationship Between Price Elasticity and Total RevenueBetween Price Elasticity and Total Revenue

P

Q

P1

P2

Q1 Q2

A

BY

X

P

Q

P1

P2

Q1 Q2

A

BY

X

Determinants of Own Price ElasticityDeterminants of Own Price Elasticity

The number of The number of

substitute goods.substitute goods. The percent of a The percent of a

consumer’s income consumer’s income

that is spent on the that is spent on the

product.product. The time period The time period

under under

consideration.consideration.

Demand is generally more Demand is generally more inelastic:inelastic:

The fewer the number The fewer the number of substitutes or of substitutes or perceived substitutes perceived substitutes available.available.

The smaller the percent The smaller the percent of the consumer’s of the consumer’s income that is spent on income that is spent on the product.the product.

The shorter the time The shorter the time period under period under consideration.consideration.

Perfectly Elastic Perfectly Elastic and and Inelastic DemandInelastic Demand


Factors affecting demand Factors affecting demand elasticityelasticity

ease of ease of substitutionsubstitutionproportion of total proportion of total expendituresexpendituresdurabilitydurability of product of product

possibility of postponing possibility of postponing purchasepurchase

possibility of repairpossibility of repairused product marketused product market

length of length of timetime period period


Derived demandDerived demand: the : the demand for products or factors demand for products or factors that are not directly consumed, that are not directly consumed, but go into the production of a but go into the production of a another (final) productanother (final) product

The demand for such a product The demand for such a product or factor exists because there is or factor exists because there is

demand for the final demand for the final productproduct

Price elasticity of Price elasticity of demanddemandThe derived demand curve will be more The derived demand curve will be more inelastic:inelastic:

the more the more essentialessential is the is the componentcomponent

the more inelastic is the demand the more inelastic is the demand curve for the curve for the final productfinal product

the smaller is the fraction of total the smaller is the fraction of total costcost going to this component going to this component

the more inelastic is the the more inelastic is the supplysupply curve of cooperating factorscurve of cooperating factors


A long-run demand A long-run demand curve will generally curve will generally be more elastic than be more elastic than a short-run curvea short-run curve

As the time period As the time period lengthens consumers lengthens consumers find ways to adjust to find ways to adjust to the price change, via the price change, via substitution or substitution or shifting shifting consumptionconsumption


The relationship between price and The relationship between price and

revenue revenue depends on elasticitydepends on elasticity

Why? By itself, a price fall will reduce receipts Why? By itself, a price fall will reduce receipts … …

BUT because the demand curve is downward BUT because the demand curve is downward sloping, the drop in price will also sloping, the drop in price will also

increase quantity demandedincrease quantity demanded

Q: which effect will be stronger?Q: which effect will be stronger?


As price decreasesAs price decreasesrevenue rises when revenue rises when

demand is elasticdemand is elasticrevenue falls when it revenue falls when it

is inelasticis inelasticrevenue reaches it revenue reaches it

peak if peak if elasticity =1 elasticity =1 the lower chart the lower chart

shows the shows the effect of effect of elasticity on total elasticity on total revenuerevenue


Marginal revenue: the Marginal revenue: the change in total revenue change in total revenue resulting from changing resulting from changing quantity by one unitquantity by one unit

QuantityMR

Revenue Total


Marginal Marginal revenue curve revenue curve is twice as is twice as steep as the steep as the demanddemand

curvecurve


at the point at the point where marginal where marginal revenue crosses revenue crosses the X-axis, the the X-axis, the demand curve is demand curve is unitary elastic unitary elastic and total and total revenue reaches revenue reaches a maximuma maximum


ExamplesExamples: some real world elasticities: some real world elasticities

coffee: short run -0.2, long run -0.33coffee: short run -0.2, long run -0.33

kitchen and household appliances: kitchen and household appliances:

-0.63-0.63

meals at restaurants: -2.27meals at restaurants: -2.27

airline travel in U.S.: -1.98airline travel in U.S.: -1.98

beer: -0.84, Wine: -0.55beer: -0.84, Wine: -0.55


ExamplesExamples: some real world elasticities: some real world elasticities

white pan bread:-0.69white pan bread:-0.69

cigarettes: short run -0.4, long run cigarettes: short run -0.4, long run -0.6-0.6

wine imports: -0.15wine imports: -0.15

crude oil: -0.06crude oil: -0.06

internet services: -0.6/-0.7 internet services: -0.6/-0.7

Cross-Price Elasticity of DemandCross-Price Elasticity of Demand

The percentage change in the quantity The percentage change in the quantity demanded of a given good, demanded of a given good, X, relative to a X, relative to a percentage percentage change in the price of good Ychange in the price of good Y, , assuming all other factors constant.assuming all other factors constant.

eexyxy = %ΔQ = %ΔQxx ÷ %ΔP ÷ %ΔPyy

Cross-elasticity of demandCross-elasticity of demand

Cross-elasticity of demand: the Cross-elasticity of demand: the percentage change in quantity percentage change in quantity consumed of one product as a consumed of one product as a result of a 1 percent change in result of a 1 percent change in the price of a related productthe price of a related product

B

Ax P

QE

%

%

Cross-elasticity of demandCross-elasticity of demand

The sign of cross-elasticity for The sign of cross-elasticity for

substitutes is positivesubstitutes is positive

The sign of cross-elasticity for The sign of cross-elasticity for

complements is negativecomplements is negative

Two products are considered good Two products are considered good substitutes or complements when the substitutes or complements when the

coefficient is coefficient is larger than 0.5 larger than 0.5 (in ab. value)(in ab. value)

SubstitutesSubstitutes

Two goods with Two goods with a a positive positive cross-price cross-price elasticity elasticity of of demand demand coefficient are coefficient are said to said to be be substitute substitute goods.goods.

Boiler chickens and Boiler chickens and beefbeefeexyxy = 0.20 = 0.20

Boiler chickens and Boiler chickens and porkporkeexyxy = 0.28 = 0.28

ComplementsComplements

If two goods have If two goods have a a negative negative cross-cross-price elasticity price elasticity of of demand demand coefficient, they coefficient, they are called are called ccomplementary omplementary goods.goods.

Bread Bread and eggsand eggseexyxy = - = -0.030.03

Income Elasticity of DemandIncome Elasticity of Demand

The percentage change in the quantity The percentage change in the quantity demanded of a given good, demanded of a given good, X, relative X, relative to a percentage to a percentage change in consumer change in consumer income(Y), assuming all other factors income(Y), assuming all other factors constant.constant.

eeii = %ΔQ = %ΔQx x ÷ %ΔY÷ %ΔY


Income elasticity of demand: the Income elasticity of demand: the percentage change in quantity demanded percentage change in quantity demanded caused by a caused by a 1 percent change in 1 percent change in incomeincome

Y is shorthand for incomeY is shorthand for income

Y

QEY

%

%


Categories of income Categories of income elasticityelasticitysuperior goods: superior goods: EEYY > 1 > 1

normal goods: 0 normal goods: 0 ≤≤ E EY Y ≤ ≤ 11

inferior goods: inferior goods: EEYY < 0 < 0

Normal GoodNormal Good

Good X is a Good X is a normal good if normal good if the demand for the demand for good X moves good X moves in the in the same same direction direction as a as a change in change in income.income.

CreamCreameeii = 1.72 = 1.72

ApplesAppleseeii = 1.32 = 1.32

PotatoesPotatoeseeii = 0.15 = 0.15

Inferior GoodInferior GoodGood X is an Good X is an

inferior good if inferior good if the demand for the demand for good X moves in good X moves in

the the opposite opposite direction direction of a of a change in change in income.income.

ChickenChickeneeii = -0.106 = -0.106

Other demand elasticitiesOther demand elasticities

ExamplesExamples: elasticity is encountered : elasticity is encountered every time a change in some variable every time a change in some variable affects demandaffects demand

advertising expenditureadvertising expenditure

interest ratesinterest rates

population sizepopulation size

Elasticity of supplyElasticity of supplyPrice elasticity of supply: the Price elasticity of supply: the

percentage change in quantity percentage change in quantity supplied as a result of a supplied as a result of a 1 percent 1 percent change in pricechange in price

The coefficient of supply elasticity is The coefficient of supply elasticity is a normally a a normally a positive numberpositive number

Price %

SuppliedQuantity %E

S

Elasticity of supplyElasticity of supply

When the supply curve is When the supply curve is moremore elastic elastic, , the effect of a change in demand will the effect of a change in demand will be be greater on quantitygreater on quantity than on the than on the price of the productprice of the product

When the supply curve is When the supply curve is lessless elastic elastic, a , a change in demand will have a change in demand will have a

greater effect on price greater effect on price than on quantitythan on quantity

Global applicationGlobal application ExampleExample: price elasticities in Asia: price elasticities in Asia

importsimports almost always almost always price inelasticprice inelastic

if if exportsexports price inelastic, price inelastic, export earnings will rise as export earnings will rise as prices riseprices rise

if if exportsexports price elastic, price elastic, export earnings will rise with export earnings will rise with world incomesworld incomes

33Demand Analysis & PricingDemand Analysis & Pricing

Not Just for Lunch Anymore…Not Just for Lunch Anymore…

Percent of revenues and profits Percent of revenues and profits McDonald’s gets from breakfast.McDonald’s gets from breakfast.

Revenues: 25%Revenues: 25% Profits: 50%Profits: 50% Opportunity relates toOpportunity relates to usage situation usage situation

and is driven by time pressure and and is driven by time pressure and other factors.other factors.

Portability is key Portability is key as many eat in as many eat in their cars or at their desk.their cars or at their desk.

Consumer Behaviour In The Consumer Behaviour In The News…News…

Source: K. Macarthur, “Rise and Shine,” Advertising Age, July 31, 2006, p. 3 and 26.13-112

DEMAND ANALYSISDEMAND ANALYSISA firm’s quantity of sales dependsA firm’s quantity of sales dependson multiple economic factors.on multiple economic factors.

For instance, an airline’s seat demandFor instance, an airline’s seat demandmight be described by the equation:might be described by the equation:

Q = 25 + 3Y + PQ = 25 + 3Y + P – 2P. – 2P.

Here, demand depends on:Here, demand depends on: customer income (Y),customer income (Y), the rival’s price (Pthe rival’s price (P),), and the airline’s price (P).and the airline’s price (P).

SHIFTS IN DEMANDSHIFTS IN DEMANDAny change in the firm’s own priceAny change in the firm’s own priceshows up as a movement along the shows up as a movement along the firm’s demand curve.firm’s demand curve.

A change in any other variable A change in any other variable constitutes a shift in the position constitutes a shift in the position of the demand curveof the demand curve

For instance, an increase in aFor instance, an increase in acompetitor’s price would causecompetitor’s price would causea favourable demand shift as shown.a favourable demand shift as shown.

ELASTICITY OF DEMANDELASTICITY OF DEMAND

How Responsive are Sales to Changes in Price?How Responsive are Sales to Changes in Price?

The Concept of Elasticity Supplies the Answer.The Concept of Elasticity Supplies the Answer.

EEPP = [% Change Q]/[% Change P] = [ = [% Change Q]/[% Change P] = [Q/Q]/[Q/Q]/[P/P].P/P].

Example: PExample: P00 = 100 & Q = 100 & Q00 = 1200 = 1200

PP11 = 110 & Q = 110 & Q11 = 1160 = 1160

EEPP = [(1160 – 1200)/1200]/[(110 – 100)/100] = [(1160 – 1200)/1200]/[(110 – 100)/100]

= -3.33%/10%= -3.33%/10%

= = -.-.333.333.

PROPERTIES OF ELASTICITYPROPERTIES OF ELASTICITY

Unitary Elastic: EUnitary Elastic: EPP = -1 = -1

Inelastic: -1 < EInelastic: -1 < EPP < 0 < 0

Elastic: -Elastic: - < E < EPP < -1 < -1

Elasticity Varies alongElasticity Varies alonga Linear Demand Curve.a Linear Demand Curve.

100

200

300

400

Demand isInelastic

Demand isElastic

EP = -1

EP = (Q/P)(P/Q)

Q = 1600 - 4P

B

A

400 800 1200 1600

MR

MR = 0

= (-4)(100/1200) = -.333 B

= (-4)(300/400) = -3 A

USING ELASTICITYUSING ELASTICITY

Predicting Sales: Predicting Sales:

Q/Q = (EQ/Q = (EPP)()(P/P) + (EP/P) + (EYY)()(Y/Y) + (EY/Y) + (EPP)()(PP/P/P) .) .

Other Elasticities:

Income Elasticity:Income Elasticity:EEYY = = (% change Q)/(% change Y)(% change Q)/(% change Y) Necessities: 0 < ENecessities: 0 < EYY < 1 < 1

Discretionary: EDiscretionary: EYY > 1 > 1

Cross Price Elasticity:Cross Price Elasticity:EEPP = = (% change Q)/(% change P(% change Q)/(% change P))

USING ELASTICITY

Maximizing Profit and Revenue inMaximizing Profit and Revenue inPure Selling Problems (MC = 0).Pure Selling Problems (MC = 0).

Examples: Selling SoftwareSelling SoftwareSelling a CDSelling a CD

Utilizing a Sports StadiumUtilizing a Sports Stadium

Pricing Olympics Cable Coverage on Triple Cast

Optimal Solution: MR = 0Optimal Solution: MR = 0or equivalently: Eor equivalently: EPP = -1. = -1.

Capacity

Revenue

With high demand, price to fill With high demand, price to fill stadium.stadium.With low demand, do not cut price With low demand, do not cut price to fill stadium.to fill stadium.

Hoped for Demand

ActualDemand

Minimize loss, by drasticallyMinimize loss, by drasticallycutting price.cutting price.

OPTIMAL PRICINGOPTIMAL PRICING

1. The Markup Rule1. The Markup Rule[P - MC]/P = -1/E[P - MC]/P = -1/EPP

or P = [Eor P = [EP P /(1+ E/(1+ EP P )] MC)] MC

MC = 100MC = 100

EEPP P P

-2-3-4-62. Price Discrimination2. Price Discrimination

Apply Markup rule to separateApply Markup rule to separatesegments. More inelastic segmentssegments. More inelastic segmentsget the higher markups (over common MC).get the higher markups (over common MC).

Equivalently, Set MREquivalently, Set MR11 = MR = MR22 = MC. = MC.

200150133120

MAXIMIZING REVENUE W/ LIMITED MAXIMIZING REVENUE W/ LIMITED CAPACITYCAPACITY

Airline Yield Management:Airline Yield Management:Maximizing Revenue utilizingMaximizing Revenue utilizingBusiness Class and Economy Class seats.Business Class and Economy Class seats.

The key is to set: MRB = MRE.

Example: Airline has 180 seats and faces demand:Example: Airline has 180 seats and faces demand:PPBB = 330 – Q = 330 – QBB and P and PEE = 250 – Q = 250 – QEE. Therefore,. Therefore,

MRMRBB = 330 - 2Q = 330 - 2QBB = MR = MREE = 250 – 2Q = 250 – 2QEE. . We also know that: QWe also know that: QBB + Q + QEE = 180. = 180.

The solution to these simultaneous equations is:The solution to these simultaneous equations is:QQBB = 110 seats and Q = 110 seats and QEE = 70 seats. = 70 seats.

In turn, PIn turn, PBB = $220 and P = $220 and PEE = $180. = $180.

Casestudy : TESCOCasestudy : TESCO

1.1. Read and prepare the Read and prepare the Casestudy on TESCO Casestudy on TESCO (Johnson, Whittington & (Johnson, Whittington & Scholes (2011)) for Scholes (2011)) for discussion and discussion and presentation next week. presentation next week.

2.2. Identify and evaluate the Identify and evaluate the challenges facing TESCO’s challenges facing TESCO’s global expansion by global expansion by conducting External conducting External Environment analysis Environment analysis (PESTEL);and Industry (PESTEL);and Industry (5+1 Forces) analysis.(5+1 Forces) analysis.

ConclusionConclusion

““In a free-market economy, the In a free-market economy, the government generally lets people government generally lets people decide what to buy with their decide what to buy with their money... in the interests of money... in the interests of personal freedom the government personal freedom the government should respect their preferences.” should respect their preferences.” Paul SamuelsonPaul Samuelson

Core ReadingCore Reading

• Keat, Paul G. and Young, Philip KY (2009) Managerial Economics, 6th edition, Pearson

• Samuelson, William F. and Marks, Stephen G.(2010) Managerial Economics, 6th edition, John Wiley

• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013) Microeconomics, 8th edition, Pearson

• Samuelson, P.A. and Nordhaus, W. D. Samuelson, P.A. and Nordhaus, W. D. (2010)(2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19thth EditionEdition

• Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy – “Competitive Strategy – Techniques for Analyzing Industries and Competitors”Techniques for Analyzing Industries and Competitors” Free PressFree Press

Questions?Questions?

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