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Microeconomics Demand Curves sloping downward From the firm to the industry Estimating demand Guideline to pricing strategy

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From choosing to demand: review The price of clothes falls and you re-optimize, increasing your consumption of clothes E2E2 E1E1 The demand curve traces out your choices as price changes, holding other factors constant Demand

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Summing up – from individual to market demand The market demand curve is the horizontal summation of all individual demands at given prices Market Demand The demand curve traces out your choices as price changes, holding other factors constant Individual Demand

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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?

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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 P s and P c 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 Price of symphony ticket (substitute) Price of restaurant meal (complement)

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PTC demand curve Holding the other factors constant (at values P s =50, P r =40 and I=50,000), PTCs 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 tickets demanded from 133 to 200 60 400 40 30 133200

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Changes/shifts in PTC demand Changes in factors other than the price of the good cause the demand curve to shift Shifters in PTCs demand function – Price of substitute – Price of complement – Income (normal vs inferior goods) Others? The rightward shift is the result of a $1000 increase in income 60 400 61 406.6 D 2 (I=51,000) D 1 (I=50,000)

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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?

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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

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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 60 400 40 30 133200

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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 60 400 30 200 D MR |η| > 1 |η| < 1

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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?

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Cross-price elasticities An elasticity is just a ratio of percentage changes What are examples of substitutes and complements? > 0, if x and y are substitutes < 0, if x and y are complements

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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 Room NYT, 1 Apr 09

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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?

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Deterring smoking and raising revenue What is the price elasticity of demand for cigarettes according to the CDC? What is it according to Gary Becker (see comments) What size must it be to deter smoking and raise revenue? What will happen if the cigarette tax is set too high?

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From the firm to the industry About the telephone… An amazing invention – but who would ever want to use one? Rutherford B. Hayes

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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 PTCs shows or the demand for entertainment events as a whole?

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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?

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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, ToyotaOlive Garden Role of branding in establishing market power

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Estimating demand curves The plural of anecdote is data. George Stigler (attributed)

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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

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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?

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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

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Chapter 20: Demand and Supply Elasticity

Chapter 20: Demand and Supply Elasticity

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