Microeconomics

DemandCurves sloping downward

From the firm to the industryEstimating demand

Guideline to pricing strategy

From choosing to demand: review

F

C

The price of clothes falls and you“re-optimize”, increasing your consumption of clothes

1U

2U

E2

*2C

E1

*1C

cP

C

The demand curve traces outyour choices as price changes, holding other factors constant

1cP

Demand

2cP

*2C

*1C

Summing up – from individual to market demand

cP

C

The market demand curve is the horizontal summation of all individual demands at given prices

MarketDemand

cP

C

The demand curve traces outyour choices as price changes, holding other factors constant

1cP

IndividualDemand

2cP

*2C

*1C

The law

• Demand is the willingness and ability to purchase at given prices

• Law of Demand: Other things equal, quantity demanded decreases and prices increases.

• Demand curves slope downward

• Why do we say it is a “law”? Are there exceptions?

Functions and curves

• In principle, demand depends on many factors

• We focus on 3 to start (“own” price, prices of related goods and income)

where Ps and Pc are prices of substitute and complementary goods.

• The demand curve plots the relationship between Q and P, holding other factors fixed.

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Players Theatre Company (PTC)

• 500-seat theatre• At $30 per ticket, typical show draws 200• Manager is considering whether to reduce the

ticket price to $25. How will this price change affect revenue?

• Assume PTC demand function is

IPPPQ rs 0066.03.366.16.6117

Price of symphony ticket(substitute)

Price of restaurant meal(complement)

PTC demand curve• Holding the other factors

constant (at values Ps=50, Pr=40 and I=50,000), PTC’s demand curve is given by

• Own price changes cause movements along a demand curve

• What causes a demand curve to shift (demand to change)?

A drop in ticket prices from $40 to $30 increases the quantity of ticketsdemanded from 133 to 200

P

Q

60

400

40

30

133 200

QP 15.060

PQ 67.6400

Changes/shifts in PTC demand

• Changes in factors other than the price of the good cause the demand curve to shift

• Shifters in PTC’s demand function– Price of substitute– Price of complement– Income (normal vs

inferior goods)

• Others?

P

Q

The rightward shift is the result of a$1000 increase in income

60

400

61

406.6

D2 (I=51,000)

D1 (I=50,000)

Income elasticities

• Income elasticity

>0 good is normal>1 good is luxury<0 good is inferior

• What are examples of these types of goods? • What implications does this have for how your

revenues may vary over time?

I

QI

%

%

Elasticity

• An elasticity is just a ratio of percentage changes

• Unit-less measure of the responsiveness of one thing to changes in another

• Price elasticity of demand

Q

P

P

Q

PP

QQ

P

Q

/

/

%

%

Calculating the demand elasticity for PTC

• How to calculate an elasticity?– Use the basic formula for small

price changes– Use the Arc formula (that

averages the two prices and quantities) for large price changes

• What does η = 1.4 mean?• What is the connection

between η and the revenue consequences of a price change?

• What factors affect η?

Using the Arc formula, η = 1.4 over this range

P

Q

60

400

40

30

133 200

Demand elasticity and revenue

• PTC total revenue

• PTC marginal revenue (extra revenue earned from selling another ticket)

• When will reducing ticket prices increase revenue?

• What ticket price will maximize revenue? Maximize profit?

|η| = 1

$

Q

60

400

30

200

D

MR

|η| > 1

|η| < 1

215.60Re QQQPv

QMR 3.60

TR

200 Q

P

6000 MR=0

Factors affecting demand elasticity

• Demand is more elastic – When close substitutes are available– When the good is a big part of your budget– When you have a longer time period to adjust to

price changes• What are some goods with elastic demands?

Inelastic demands? In both cases, why?

Cross-price elasticities

• An elasticity is just a ratio of percentage changes

• What are examples of substitutes and complements?

y

xxy P

Q

%

% > 0, if x and y are substitutes< 0, if x and y are complements

Elasticity and public policy

[B]udget shortfalls are pushing more than 20 states to look to tobacco for

revenue, even those that have avoided cigarette taxes for years or decades.

City RoomNYT, 1 Apr 09

Policy makers use elasticity

• What is the price elasticity of demand for cigarettes? • What will happen to tax revenue if the tobacco tax is

raised? • What will happen if the tobacco tax is too high?• What size must the tax be to deter smoking and raise

revenue? • What are other examples of taxes on goods that have

inelastic demand? • What examples of taxes on goods that have elastic

demand?

From the firm to the industry

About the telephone…“An amazing invention – but who

would ever want to use one?”

Rutherford B. Hayes

The company you keep

• Defining your “space”• Firm vs industry demand– PTC does not operate in isolation from other

entertainment industry organizations– What elasticity might help PTC sort this out?– What is more elastic – the demand for PTC’s

shows or the demand for entertainment events as a whole?

Network effects

• Some products exhibit increasing returns on the demand side

• Price decreases have the usual effect – plus each new customer provides an externality that makes the product more valuable

• Examples – telephone, Office, web browser• Do network effects increase or decrease demand

elasticities?• What might the pricing strategy be in an industry

with network effects?

Product development and branding

• Recall the relationship between substitutability and demand elasticity

• How is branding related to substitutability?• Role of product attributes in establishing a

brand• Examples – iPhone, Olive Garden, Toyota• Role of branding in establishing market power

Estimating demand curves

The plural of anecdote is data.

George Stigler (attributed)

Qualitative approaches and experiments

• Interviews– Representative?– Reliable?– Actual choices or claims about hypothetical

choices?• Pricing experiments– Vary prices across separate, local markets– Problems with controls– Risk of losing customers

Econometrics

• Basic idea – specify the demand function

as a regression model

• Estimate model by least squares• Can use the coefficient estimates to calculate

elasticities

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Estimated cigarette demand• Data

– Q = daily cigarette consumption– Cigarette price = state price in

cents per pack– Income = annual income– Restaurant restriction = 1, if state

restricts smoking in restaurants– Education = years of schooling– Age = years

• Why measure price and income in logs?

• What is the effect of a 10 percent increase in the price of cigarettes? Is the effect statistically significant?

• What about income?• What factors do affect smoking?

Conclusions

• Demand curves slope downward• Changes in price move you along a demand curve• Changes in other things (other prices, income, etc) shift the

demand curve• Elasticities measure responsiveness to change• The effect of a price change on revenue depends on the

demand elasticity• Understanding elasticity makes you more profitable• Demand-side network effects arise because new customers

create externalities• Data analysis is extremely important