Chapter Four: Demand or Knowing Your Customer

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Chapter Four Demandor Knowing Your Customer

• Demand Function The relation between demand and
  factors influencing its level.
• Quantity of product X demanded Qx
• f(Price of X, Prices of Related Goods, Consumer
  Income, Advertising Expenditure, etc.)

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The Market Demand Function, cont.

• The model
• Qx a0 a1Px a2Pz a3Y a4POP a5i a6AD
  e
• The terms a0 , a1 , etc. are the parameters of
  the model.
• This is what we need to estimate.
• Estimation of the model
• Q 100 -.002Px .001Pz .00008Y .22POP
  -800i .002A
• Interpretation of the model
• If the average price increases by 1, the demand
  for the product falls by .002 units

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The Demand Curve

• Demand Curve The relation between price and the
  quantity demanded, holding all else constant.
• General Form P a bQ
• Why is this the general form?
• Moving from the Demand Function to the Demand
  Curve.

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Connecting the Curve to the Function

• Changes in quantity demanded movement along a
  given demand curve reflecting a change in price
  and quantity.
• Shift in demand Switch from one demand curve to
  another following a change in a non-price
  determinant of demand
• IF AN INDEPENDENT VARIABLE CHANGES, OTHER THAN
  PRICE OF THE GOOD, YOU MUST DRAW A NEW DEMAND
  CURVE!!!

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Demand Analysis and Estimation

• Demand Sensitivity Analysis Elasticity
• Price Elasticity of Demand
• Cross Price Elasticity of Demand
• Income Elasticity of Demand
• Additional Demand Elasticity Concepts

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Demand Sensitivity Analysis Elasticity

• Elasticity The percentage change in a dependent
  variable resulting from a 1 change in an
  independent variable.
• Elasticity change in Y / change in X
• ELASTICITY IS A RATIO!!!

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Price Elasticity of Demand

• Price Elasticity of Demand (Own-Price)
• Measure of the magnitude by which consumers alter
  the quantity of some product they purchase in
  response to a change in the price of that
  product.
• Responsiveness of the quantity demanded to
  changes in the price of the product, holding
  constant the values of all other variables in the
  demand function.
• Estimating from the Demand Function.
• Estimating from the Demand Curve.

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Own Price Elasticity and the Demand Curve

• Own-price elasticity
• ?Q / ?P
• How does elasticity vary along a linear demand
  curve?
• The upper half of a linear demand curve is
  elastic.
• The lower half of a linear demand curve is
  inelastic.
• BE ABLE TO EXPLAIN WHY!!!
• The search for substitutes as price increases
• Big number, small number explanation
• Calculating elasticity at the midpoint.

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Elasticity and Total Revenue

• Connecting Elasticity to Total Revenue
• If change in Q gt change in P
• decreasing the price will increase TR
• and marginal revenue must be positive.
• If change in Q lt change in P
• increasing the price will increase TR
• and marginal revenue must be negative.
• BE ABLE TO ILLUSTRATE THE RELATIONSHIP

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Optimal Pricing Policy

• MR P 1 1/EP
• Be able to show why this relationship exists.
• To maximize profits MR MC
• MC P 11/EP
• P MC / 1 1/EP
• LI P-MC /P
• Allows us to see the market power of the firm, or
  the ability of the firm to influence the price of
  the product.
• LI 1/EP
• Be able to show why this relationship exists.
• PUNCHLINE If elasticity increases, mark-up will
  decline. If the product becomes less elastic,
  mark-up will increase.

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Determinants of Price Elasticity

• The extent the good is considered a necessity.
• Proportion of income spent on the product
• Time
• Availability of substitutes
• HINT The fourth determinant encompasses the
  first three.

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Cross Price Elasticity of DemandSubstitutes vs.
Complements

• Substitutes products for which a price increase
  for one leads to an increase in demand for the
  other.
• NOTE Two goods are substitutes only if the
  consumer behavior indicates this relationship.
• Complements products for which a price increase
  for one leads to a decrease in demand for the
  other.

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Cross- Price Elasticity

• Responsiveness of demand for one product to
  changes in the price of another.
• Calculating from the Demand Function
• Note We already know if two goods are
  substitutes or complements from the demand
  function. We do not know the magnitude of the
  relationship without calculating elasticity.

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Income ElasticityNormal vs. Inferior Goods

• Normal Goods products for which demand is
  positively related to income.
• Inferior Goods products for which demand is
  negatively related to income.
• Note What is normal or inferior can vary across
  time and geographic distance.

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Income Elasticity

• Responsiveness of demand to changes in income.
• Calculating from the Demand Function
• Note We already know if two goods are normal or
  inferior from the demand function. We do not
  know the magnitude of the relationship without
  calculating elasticity.

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Income Elasticity and the Business Cycle

• Counter-cyclical goods inferior goods
• During recessions demand will increase.
• During expansion demand will decrease.
• Non-cyclical normal goods income elasticity is
  less than 1.
• Cyclical normal goods superior goods luxury
  goods income elasticity is greater than 1.

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Additional Demand Elasticity Concepts

• Advertising Elasticity
• Interest Rate Elasticity
• Weather Elasticity
• Any factor that can be included in a demand
  function can be analyzed in terms of elasticity.

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Rationality and Consumer Behavior

• Rationality economic actors choose efficiently
  the means that advance the actors objectives.
• Milton Friedman hypothesized that a researcher
  could explain the shots of an expert billiard
  player by assuming the player understood the
  complex physical relationships underlying his/her
  actions. However, one would not expect that
  billiard players to be experts at physics, rather
  a researcher would be successful in his/her
  predictions simply because it would not be
  possible for billiard players to excel in this
  sport if the shots taken were not consistent with
  said physical relationships Friedman 21 A
  similar analogy, according to Friedman, can be
  offered with respect to economic agents.
  Although one may not expect the average economic
  actor to understand complex economic
  relationships, a successful player in the
  economic world cannot obtain his/her status
  without behaving in a fashion consistent with the
  dictates of economic data. In other words,
  economic agents must process information
  efficiently if the agent is to survive Friedman
  21-22.

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How rational are we?

• A Simple Example
• Choose a value between 0 and 100 that is one-half
  the average values chosen by everyone else in a
  class.

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Framing

• Framing evaluating information in terms of a
  point of reference.
• Example The Ultimate Game
• Example In five pages of text, how many words
  finish ...ing.? How many words have an n as
  the second to last letter?
• Which is more common, murder or suicide?

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Anchoring and Adjustment

• People tend to be overly tied to initial
  estimates and are slow to adjust.
• Example Calculate each very quickly
• 1 X 2 X 3 X 4 X 5 X 6 X 7 X 8
• 8 X 7 X 6 X 5 X 4 X 3 X 2 X 1
• Example Drafting NBA players
• Colin Camerer and Roberto Weber examined the
  relationship between draft position and minutes
  played (holding productivity constant). Several
  years into a players career draft position still
  impacted how many minutes a player played. In
  other words, years of less productive play did
  not convince coaches that the initial assessment
  was flawed.

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Market Research

• Primary Data Data generated from surveys.
• Focus Groups, Surveys, Experiments
• Secondary Data Data gathered for one purpose
  yet used for another.
• Sales, Price, Income, etc..
• The problem with primary data is that it only
  captures what people say, not what they do.