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
1U2U
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
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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?
IQ
I
%%
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
QP
PQ
PPQQ
PQ
//
%%
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
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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