IMBA NCCU Managerial Economics Lecturer: Jack Wu Lecture Two: Demand IMBA NCCU Managerial Economics Lecturer: Jack Wu

Demand Two fundamental building blocks of managerial economics: demand costs

RISING GASOLINE PRICES Between September 2004 and September 2005, the monthly average retail price of gasoline jumped from $1.85 per gallon to $3.08 per gallon. Sales of full-size SUVs dropped 16.8% over the same time period (with a particularly sharp 42.5% drop for full-size GM SUVs).

GM Vice Chairman: Bob Lutz May 31, 2004: “It sounds cavalier, but in any household budget, gasoline isn't a factor”, Business Week. July 1, 2005: “The demise of the full-size truck is a figment of the imagination of the popular press. Everybody assumes it is true but the market is still buying”, Reuters. “The effect will decrease over time as people adjust to the thought of $3 a gallon, just as they did when it was $2 a gallon and just as they did when it was $1 a gallon”, New York Times. Sources: Business Week, May 31, 2004 Reuters, July 1, 2005 Bob Lutz quoted at Milford, Michigan: “G.M. Hopes a Line of Pickups Will Lead Back to Prosperity”, New York Times, August 3, 2006.

MANAGERIAL ECONOMICS QUESTIONS How important are gasoline prices to the sales of SUVs and other types of automobiles? How should the auto manufacturers respond to the increasing price of gasoline? Are manufacturer incentives (i.e. price reductions) an effective response? What are the combined effects of incentives and increasing gas prices?

MANAGERIAL ECONOMICS TOOL: DEMAND We apply demand to show how the rising price of gasoline has caused decreases in large SUV sales, and how manufacturer incentives can offset these reductions.

OUTLINE Individual Demand Demand and income Other demand factors Market Demand Buyer Surplus Business Demand

Individual Demand Curve Definition: graph of quantity that buyer will purchase at every possible price Construction -- “Other things equal, how many would you buy at a price of ….?’’ vertical axis -- price horizontal axis -- quantity

Individual Demand Schedule Price Quantity ($ per movie) (movies per month) 10.00 0 7.50 1 5.00 2 2.50 4 0.00 7

INDIVIDUAL DEMAND CURVE 10 7.50 Price ($ per movie) 5 individual demand curve 2.50 1 2 4 7 Quantity (Movies a month)

Individual Demand Schedule II Price Quantity ($ per movie) (movies per month) 20.00 0 19.00 1 18.00 2 …. … 0.00 20

Another Type of Individual demand Curve

Two Views for every possible price, it shows the quantity demanded for each unit of item, it shows the maximum price that the buyer is willing to pay

Demand Curve: Slope diminishing marginal benefit -- each additional unit of consumption/usage provides less benefit than the preceeding unit  demand curve slopes downward

Consumer Differences individual preferences  different demand curves changes in consumer's preferences, eg, age different consumers

A negative price case: Hoover, 1992 Hoover’s special promotion -- two free air tickets (worth more than £400) for purchase of appliance over £100. promotion attracted over 100,000 customers Hoover incurred £48 million loss

OUTLINE Individual Demand Demand and income Other demand factors Market Demand Buyer Surplus Business Demand

normal product – demand increases with income Demand and Income Changes in income normal product – demand increases with income inferior product – demand falls with income

Demand and income

OUTLINE Individual Demand Demand and income Other demand factors Market Demand Buyer Surplus Business Demand

Demand and Other Factors prices of related products substitutes complements advertising

Other demand factors: Substitutes Direct MBA education: Dartmouth / NYU / USC Transportation: American Airlines / British Airways Functional MBA education – residential / distance learning Security: Lock and key / biometric / password Communication: airline / train / video-conferencing / mail Substitutes: increase in price  demand for substitute shifts up

Other demand factors: Complements Complements: increase in price  demand for complement shifts down

Recorded Music Argentina Canada CD purchases 0.5 2.6 cassette purchases 0.2 0.4 GDP/capita $9,413 $19,831 CD price $13.80 $11.55 cassette price $ 7.80 $ 6.06

Recorded Music Why the average Canadian bought more of both CDs and cassettes? Why the ratio of CD to cassette purchases was relatively higher in Canada?

Recorded Music Canadians enjoyed higher incomes Cassettes were a relatively inferior product compared to CDs Another possible explanation: difference in the relative prices of CDs and cassettes _ Canada: 11.55/6.06=1.9 _ Argentina: 13.80/7.80=1.77 * don’t not explain why Canadians bought relatively more CDs than Argentines.

Football: To broadcast? Live broadcasting of away games and attendance at home games are complements Live broadcasting of home games and attendance at home games are both substitutes and complements

Other demand factors: Durable goods Expectations about future prices and income Financing costs Prices of used models substitute for new good future value of new good Consumer examples: housing automobiles boats computer equipment Industrial examples: oil tankers tractors and agricultural machinery airplanes

Used Cars 1990 1997/98 avg car age 7.5 yr 8.7 yr median household income up 29.9% avg new car price up 48.4%

Used Cars Reasons for the increasing demand for used cars: _ fast rising price of new cars _ increasing quality of used cars _ auto manufacturer reduced frequency of changing designs _ financial institutions began to offer more favorable rates.

OUTLINE Individual Demand Demand and income Other demand factors Market Demand Buyer Surplus Business Demand

Market demand Market demand = horizontal summation of individual demands Horizontal summation: at every price, add the quantities demanded by each person in the market; can show through table also show graphically (section 5 of text)

Market demand: Construction

MARKET DEMAND: MACRO FACTORS Income Average Distribution Demographic Population Age structure Urban-rural Cultural-social Macro factors are difficult for business to influence

MARKET DEMAND: MICRO FACTORS Price Advertising R&D

OUTLINE Individual Demand Demand and income Other demand factors Market Demand Buyer Surplus Business Demand

Buyer Surplus individual buyer surplus: difference between consumer’s benefit and price she must pay for the item market buyer surplus: sum of individual buyer surpluses.

INDIVIDUAL BUYER SURPLUS 10 individual buyer surplus at $2.50 price d a 7.50 Price ($ per movie) individual demand (marginal benefit) curve 5 b e c c f 2.50 h g j 1 2 4 7 Quantity (Movies a month)

Buyer surplus: Individual Total benefit (the benefit yielded by all the units that the buyer purchases) = area under the buyer's demand curve up to an including the last unit purchased Maximum price that a seller can charge is the buyer's total benefit Buyer surplus (the difference between buyer's total benefit from some quantity of purchases and her or his actual expenditure) = area under demand curve and above price line

Gains from price cut lower price on the quantity that he/she would have purchased at the original price (inframarginal units) he/she can buy more (marginal units) Case: Student discount price for movie

Package Deal charge buyer just a little less than her/his total benefit leave buyer with almost zero surplus

Buyer surplus: Two-part pricing fixed payment usage charge fixed payment usage charge Fixed payment area under the demand curve and above the usage charge leaves zero buyer surplus

Buyer surplus: Two-part pricing Business Provider Fixed Fee Usage Fee Broadband access, Hong Kong PCCW Netvigator 3M Single User Plan HK$298 per month (incl. 100 free hrs) HK$2 per additional hr Mobile telephone service, UAE Etisalat Corporation, GSM Standard Service 125 dirham connection fee; 60 dirham per qtr 0.24/0.18 dirham per min (peak/ offpeak) Other examples: credit card: annual subscription + percentage on each charge + interest on outstanding balance

Buyer surplus: Two-part pricing Business Provider Fixed Fee Usage Fee Check-writing bank account, California Bank of America, VERSATEL Checking nil US$2 per teller transaction Weekday car rental, Melbourne Airport RentaCar, Toyota Camry A$70 for one day (incl. 100 free km) A$0.25 per additional km

OUTLINE Individual Demand Demand and income Other demand factors Market Demand Buyer Surplus Business Demand

Business Demand, I Business demands items as inputs into further production, not for consumption finished/semi-finished components -- raw materials and energy labor and other services capital

Business Demand, II Demand for inputs depends on quantity of final output prices of complements and substitutes in production

Business Demand Curve marginal benefit = increase in revenue arising from an additional unit of the input diminishing marginal benefit  downward- sloping demand

Automated Teller Machines increase in wages  teller service became increasingly costly banks used ATMs to substitute for tellers compare use of ATMs in US vs India

GM: What metal to use? aluminium vis-à-vis steel auto weight  price fuel consumption emissions price

Discussion Question 1 In 1998, the value of worldwide sales of recorded music in the form of singles, music cassettes, and CDs was $38.7 billion. Americans bought 3.1 CDs and 0.6 music cassette per capita, while Mexicans bought 0.5 CD and 0.3 music cassette per capita. Explain why per capita CD sales were relatively higher while per capita sales of music cassettes were relatively lower in the United States than in Mexico.

Discussion Question 1 continued On a suitable diagram, draw the U.S. demand for music CDs. Explain how the following changes would affect the demand curve: (i) increase in the price of CDs; (ii) rise in the ownership of CD players; and (iii) fall in the price of music cassettes.

Discussion Question 1 continued On another diagram, draw the demand for music CDs in Mexico. Explain how the following changes would affect the demand curve: (i) fall in advertising by music publishers such as Sony and Time Warner; (ii) reduction in the penalty for copyright infringement; and (iii) increase in the price of hamburgers.