Mba1014 consumers markets elasticity 040513

Go Global !Go Global !
Managerial Economics :Managerial Economics :
Consumers, Markets &
Elasticity
By
Stephen OngStephen Ong
Visiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City University
Visiting Professor, College of Management,Visiting Professor, College of Management,
Shenzhen UniversityShenzhen University
May 2013May 2013

AgendaAgenda
1.1. Consumer BehaviourConsumer Behaviour
2.2. Elasticity of DemandElasticity of Demand
3.3. Demand Analysis &Demand Analysis &
PricingPricing

Learning ObjectivesLearning Objectives
To identify and explain the factorsTo identify and explain the factors
that influence consumer behaviourthat influence consumer behaviour
To explain the decision-makingTo explain the decision-making
process and how marketeers canprocess and how marketeers can
influence buyer behaviourinfluence buyer behaviour
To understandTo understand elasticity and applyelasticity and apply
concepts of price elasticity, cross-concepts of price elasticity, cross-
elasticity, and income elasticityelasticity, and income elasticity
To understand determinants ofTo understand determinants of
elasticity and how elasticity affectselasticity and how elasticity affects
business revenuebusiness revenue

11
Consumer BehaviourConsumer Behaviour

To WhichTo Which
Segment ofSegment of
Consumers WillConsumers Will
This Ad Appeal?This Ad Appeal?
A Segment of Consumers WhoA Segment of Consumers Who
are Environmentally Concernedare Environmentally Concerned

The behaviour thatThe behaviour that
consumers displayconsumers display
in searching for,in searching for,
purchasing, using,purchasing, using,
evaluating, andevaluating, and
disposing ofdisposing of
products andproducts and
services that theyservices that they
expect will satisfyexpect will satisfy
their needs.their needs.

Consumers
Consumers use
products to help them
define their identities

 Consumer behaviour is aConsumer behaviour is a
process.process.

Theory of consumer behaviourTheory of consumer behaviour
•Description of how consumers allocateDescription of how consumers allocate
incomes among different goods andincomes among different goods and
services to maximize their well-being.services to maximize their well-being.
Consumer behaviour is best understoodConsumer behaviour is best understood
in 3 distinct steps:in 3 distinct steps:
1.1. Consumer PreferencesConsumer Preferences
2.2. Budget ConstraintsBudget Constraints
3.3. Consumer ChoicesConsumer Choices

Consumer Tastes & PreferencesConsumer Tastes & Preferences
Effect on DemandEffect on Demand
Video : Domino’s Pizza TurnVideo : Domino’s Pizza Turn
AroundAround
http://www.youtube.com/watchhttp://www.youtube.com/watch?

Consumer PreferencesConsumer Preferences
Market basket (or bundle) List with specific quantitiesMarket basket (or bundle) List with specific quantities
of one or more goods.of one or more goods.
TABLE 1TABLE 1 ALTERNATIVE MARKET BASKETSALTERNATIVE MARKET BASKETS
AA 2020 3030
BB 1010 5050
DD 4040 2020
EE 3030 4040
GG 1010 2020
HH 1010 4040
MARKET BASKET UNITS OF FOOD UNITS OF CLOTHING
To explain the theory of consumer behaviour, we will ask whetherTo explain the theory of consumer behaviour, we will ask whether
consumersconsumers preferprefer one market basket to another.one market basket to another.

Some Basic Assumptions aboutSome Basic Assumptions about
PreferencesPreferences
Completeness:Completeness:
Preferences are assumed toPreferences are assumed to
bebe completecomplete. In other words,. In other words,
consumers can compare andconsumers can compare and
rank all possible baskets.rank all possible baskets.
Thus, for any two marketThus, for any two market
basketsbaskets AA andand BB, a consumer, a consumer
will preferwill prefer AA toto BB, will prefer, will prefer BB
toto AA, or will be indifferent, or will be indifferent
between the two. Bybetween the two. By
indifferentindifferent we mean that awe mean that a
person will be equallyperson will be equally
satisfied with either basket.satisfied with either basket.
Note that these preferencesNote that these preferences
ignore costs. A consumer mightignore costs. A consumer might
prefer steak to hamburger butprefer steak to hamburger but
buy hamburger because it isbuy hamburger because it is
cheaper.cheaper.

Some Basic AssumptionsSome Basic Assumptions
about Preferencesabout Preferences
Transitivity:Transitivity:
Preferences arePreferences are transitivetransitive..
Transitivity means that if aTransitivity means that if a
consumer prefers basketconsumer prefers basket AA toto
basketbasket BB and basketand basket BB toto
basketbasket CC, then the consumer, then the consumer
also prefersalso prefers AA toto CC..
Transitivity is normallyTransitivity is normally
regarded as necessary forregarded as necessary for
consumer consistency.consumer consistency.
More is better thanMore is better than
less:less:
Goods are assumed to beGoods are assumed to be
desirable—i.e., to bedesirable—i.e., to be goodgood..
Consequently,Consequently, consumersconsumers
always prefer more of anyalways prefer more of any
good to lessgood to less..
In addition, consumers areIn addition, consumers are
never satisfied or satiated;never satisfied or satiated;
more is always better, even ifmore is always better, even if
just a little betterjust a little better..

Consumer Tastes and PreferencesConsumer Tastes and Preferences
Preference orderings arePreference orderings are completecomplete..
MoreMore of the goods are preferred to lessof the goods are preferred to less
of the goods.of the goods.
Consumers areConsumers are selfishselfish..
The goods are continuouslyThe goods are continuously divisibledivisible soso
that consumers can always purchasethat consumers can always purchase
one more or one less unit of the goods.one more or one less unit of the goods.

Indifference CurvesIndifference Curves
 A consumer’sA consumer’s
indifference curveindifference curve
thatthat shows alternativeshows alternative
combinations of thecombinations of the
two goods thattwo goods that
provide the same levelprovide the same level
of satisfaction orof satisfaction or
utility.utility.
ΔY
ΔX
Y1
Y2
X1 X2
U2
U1

DESCRIBINGDESCRIBING
INDIVIDUALINDIVIDUAL
PREFERENCESPREFERENCES
Because more of eachBecause more of each
good is preferred to less,good is preferred to less,
we can compare marketwe can compare market
baskets in the shadedbaskets in the shaded
areas.areas.
BasketBasket AA is clearlyis clearly
preferred to basketpreferred to basket GG, while, while
EE is clearly preferred tois clearly preferred to AA..
However,However, AA cannot becannot be
compared withcompared with BB,, DD, or, or HH
without additionalwithout additional
information.information.
Indifference Curves
IIndifference curvendifference curve
Curve representing all combinations of market baskets thatCurve representing all combinations of market baskets that
provide a consumer with the same level of satisfaction.provide a consumer with the same level of satisfaction.

The indifference curveThe indifference curve UU11
that passes throughthat passes through
market basketmarket basket AA showsshows
all baskets that give theall baskets that give the
consumer the same levelconsumer the same level
of satisfaction as doesof satisfaction as does
market basketmarket basket AA; these; these
include basketsinclude baskets BB andand DD..
AN INDIFFERENCEAN INDIFFERENCE
CURVECURVE
Our consumer prefersOur consumer prefers
basketbasket EE, which lies, which lies
aboveabove UU11, to, to AA, but, but
prefersprefers AA toto HH oror GG, which, which
lie belowlie below UU11..
An Indifference CurveAn Indifference Curve

An indifference map is a set
of indifference curves that
describes a person's
preferences.
AN INDIFFERENCEINDIFFERENCE MAP
Indifference MapsIndifference Maps
IIndifference Mapndifference Map Graph containing a set of indifference curvesGraph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.showing the market baskets among which a consumer is indifferent.
Any market basket on
indifference curve U3, such
as basket A, is preferred to
any basket on curve U2
(e.g., basket B), which in
turn is preferred to any
basket on U1, such as D.

If indifference curves U1 and
U2 intersect, one of the
assumptions of consumer
theory is violated.
INDIFFERENCE CURVES CANNOT INTERSECTINDIFFERENCE CURVES CANNOT INTERSECT
According to this diagram, the
consumer should be
indifferent among market
baskets A, B, and D. Yet B
should be preferred to D
because B has more of both
goods.

The magnitude of theThe magnitude of the
slope of an indifferenceslope of an indifference
curve measures thecurve measures the
consumer’s marginalconsumer’s marginal
rate of substitutionrate of substitution
(MRS) between two(MRS) between two
goods.goods.
THE MARGINALTHE MARGINAL
RATE OFRATE OF
SUBSTITUTIONSUBSTITUTION
In this figure, the MRSIn this figure, the MRS
between clothing (between clothing (CC))
and food (and food (FF) falls from 6) falls from 6
(between(between AA andand BB) to 4) to 4
(between(between BB andand DD) to 2) to 2
(between(between DD andand EE) to 1) to 1
(between(between EE andand GG).).
The Shape of Indifference CurvesThe Shape of Indifference Curves

Marginal Rate of SubstitutionMarginal Rate of Substitution
The ratioThe ratio ΔΔY/Y/ΔΔX,X, which showswhich shows
the rate at which the consumerthe rate at which the consumer
is willing tois willing to trade offtrade off oneone
good for another and stillgood for another and still
maintain a constant utility level,maintain a constant utility level,
is called theis called the marginal rate ofmarginal rate of
substitution (MRSsubstitution (MRSxyxy).).

The Marginal Rate of SubstitutionThe Marginal Rate of Substitution
MMarginal rate of substitution (MRS)arginal rate of substitution (MRS)
Maximum amount of a good that a consumer isMaximum amount of a good that a consumer is
willing to give up in order to obtain onewilling to give up in order to obtain one
additional unit of another good.additional unit of another good.
CONVEXITYCONVEXITY
Observe that the MRS falls as we move down theObserve that the MRS falls as we move down the
indifference curve. The decline in the MRS reflects ourindifference curve. The decline in the MRS reflects our
fourth assumption regarding consumer preferences: afourth assumption regarding consumer preferences: a
diminishing marginal rate of substitutiondiminishing marginal rate of substitution..
When the MRS diminishes along an indifference curve,When the MRS diminishes along an indifference curve,
the curve is convex.the curve is convex.

Perfect Substitutes and PerfectPerfect Substitutes and Perfect
ComplementsComplements
PPerfect substituteserfect substitutes
Two goods for which the marginal rate ofTwo goods for which the marginal rate of
substitution of one for the other is asubstitution of one for the other is a
constant.constant.
PPerfect complementserfect complements
Two goods for which the MRS is zero orTwo goods for which the MRS is zero or
infinite; the indifference curves areinfinite; the indifference curves are
shaped as right angles.shaped as right angles.
BBadsads
Good for which less is preferred rather than more.Good for which less is preferred rather than more.

In (In (aa), Bob views orange juice), Bob views orange juice
and apple juice as perfectand apple juice as perfect
substitutes: He is alwayssubstitutes: He is always
indifferent between a glass ofindifferent between a glass of
one and a glass of the other.one and a glass of the other.
In (In (bb), Jane views left shoes and right), Jane views left shoes and right
shoes as perfect complements: Anshoes as perfect complements: An
additional left shoe gives her no extraadditional left shoe gives her no extra
satisfaction unless she also obtains thesatisfaction unless she also obtains the
matching right shoe.matching right shoe.
Perfect SubstitutesPerfect Substitutes && Perfect ComplementsPerfect Complements

Preferences for automobile attributes canPreferences for automobile attributes can
be described by indifference curves. Eachbe described by indifference curves. Each
curve shows the combination ofcurve shows the combination of
acceleration and interior space that give theacceleration and interior space that give the
same satisfaction.same satisfaction.
PREFERENCES FOR AUTOMOBILE ATTRIBUTESPREFERENCES FOR AUTOMOBILE ATTRIBUTES
Owners of Ford Mustang coupes (Owners of Ford Mustang coupes (aa) are) are
willing to give up considerable interiorwilling to give up considerable interior
space forspace for additional accelerationadditional acceleration..
The opposite is true for owners ofThe opposite is true for owners of
Ford Explorers. They preferFord Explorers. They prefer
interior spaceinterior space to accelerationto acceleration
((bb).).
DESIGNING NEW AUTOMOBILES (I)DESIGNING NEW AUTOMOBILES (I)

A utility function can be
represented by a set of
indifference curves, each with
a numerical indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50, and
100, respectively) associated
with the utility function:
UTILITY AND UTILITY FUNCTIONSUTILITY AND UTILITY FUNCTIONS
UtilityUtility Numerical score representing the satisfaction that aNumerical score representing the satisfaction that a
consumer gets from a given market basket.consumer gets from a given market basket.
Utility functionUtility function Formula that assigns a level of utility toFormula that assigns a level of utility to
individual market baskets.individual market baskets.
UTILITY FUNCTIONS ANDUTILITY FUNCTIONS AND
INDIFFERENCE CURVESINDIFFERENCE CURVES
u (F,C ) =
FC

A cross-countryA cross-country
comparisoncomparison
shows thatshows that
individuals livingindividuals living
in countries within countries with
higher GDP perhigher GDP per
capita are oncapita are on
average happieraverage happier
than those livingthan those living
in countries within countries with
lower per-capitalower per-capita
GDP.GDP.
INCOME AND HAPPINESSINCOME AND HAPPINESS
CAN MONEY BUY HAPPINESS?CAN MONEY BUY HAPPINESS?

Income andIncome and
Happiness:Happiness:
ComparingComparing
CountriesCountries

The Budget ConstraintThe Budget Constraint
 The consumer’sThe consumer’s
budget constraintbudget constraint
shows all theshows all the
combinations of twocombinations of two
goods that can begoods that can be
purchased with apurchased with a
given income andgiven income and
given the prevailinggiven the prevailing
prices of the twoprices of the two
goods.goods.

Market baskets associated with the budget lineMarket baskets associated with the budget line FF + 2+ 2CC = $80= $80
Budget constraintsBudget constraints
Constraints that consumers face as a result of limitedConstraints that consumers face as a result of limited
incomes.incomes.
BBudget lineudget line
All combinations of goods for which the total amountAll combinations of goods for which the total amount
of money spent is equal to incomeof money spent is equal to income..
Budget ConstraintsBudget Constraints
TABLE 2 MARKET BASKETS AND THE BUDGET LINE
MARKETMARKET
BASKETBASKET
FOODFOOD
((FF))
CLOTHINGCLOTHING
((CC))
TOTALTOTAL
SPENDINGSPENDING
AA 00 4040 $80$80
BB 2020 3030 $80$80
DD 4040 2020 $80$80
EE 6060 1010 $80$80
GG 8080 00 $80$80

A budget line describes the
combinations of goods that
can be purchased given the
consumer’s income and the
prices of the goods.
Line AG (which passes
through points B, D, and E)
shows the budget associated
with an income of $80, a price
of food of PF = $1 per unit,
and a price of clothing of PC =
$2 per unit.
The slope of the budget line
(measured between points B
and D) is −PF/PC = −10/20 =
−1/2.
FPPPIC CFC )/()/( −=
A BUDGET LINEA BUDGET LINE

Shifts in the Budget ConstraintShifts in the Budget Constraint
Increase in incomeIncrease in income Increase in price of good XIncrease in price of good X
Y1
B1
B2

INCOME CHANGESINCOME CHANGES
A change in income (withA change in income (with
prices unchanged)prices unchanged)
causes the budget line tocauses the budget line to
shift parallel to theshift parallel to the
original line (original line (LL11).).
When the income of $80When the income of $80
(on(on LL11) is increased to) is increased to
$160, the budget line$160, the budget line
shifts outward toshifts outward to LL22..
If the income falls to $40,If the income falls to $40,
the line shifts inward tothe line shifts inward to
LL33..
EFFECTS OF AEFFECTS OF A
CHANGE IN INCOMECHANGE IN INCOME
ON THE BUDGET LINEON THE BUDGET LINE
The Effects of Changes in IncomeThe Effects of Changes in Income
and Pricesand Prices

PRICE CHANGESPRICE CHANGES
A change in the price ofA change in the price of
one good (with incomeone good (with income
unchanged) causes theunchanged) causes the
budget line to rotatebudget line to rotate
about one intercept.about one intercept.
When the price of foodWhen the price of food
falls from $1.00 to $0.50,falls from $1.00 to $0.50,
the budget line rotatesthe budget line rotates
outward fromoutward from LL11 toto LL22..
However, when the priceHowever, when the price
increases from $1.00 toincreases from $1.00 to
$2.00, the line rotates$2.00, the line rotates
inward from Linward from L11 toto LL33..
EFFECTS OF AEFFECTS OF A
CHANGE IN PRICE ONCHANGE IN PRICE ON
THE BUDGET LINETHE BUDGET LINE
EFFECTS OF A CHANGE IN PRICE ON THEEFFECTS OF A CHANGE IN PRICE ON THE
BUDGET LINEBUDGET LINE

Consumer ChoiceConsumer Choice
 The consumerThe consumer
maximizes utilitymaximizes utility
by choosing aby choosing a
combination ofcombination of
good X and Y, lyinggood X and Y, lying
on the budgeton the budget
constraint andconstraint and
simultaneouslysimultaneously
lying on thelying on the
indifference curveindifference curve
furthest from thefurthest from the
origin.origin.

Consumer ChoiceConsumer Choice
The maximizing market basket must satisfyThe maximizing market basket must satisfy
two conditions:two conditions:
1.1. It must be located on the budget lineIt must be located on the budget line..
2.2. ItIt must give the consumer the mostmust give the consumer the most
preferred combination of goods and servicespreferred combination of goods and services..

A consumer maximizesA consumer maximizes
satisfaction by choosingsatisfaction by choosing
market basketmarket basket AA. At this. At this
point, the budget line andpoint, the budget line and
indifference curveindifference curve UU22 areare
tangent.tangent.
No higher level ofNo higher level of
satisfaction (e.g., marketsatisfaction (e.g., market
basketbasket DD) can be attained.) can be attained.
AtAt AA, the point of, the point of
maximization, the MRSmaximization, the MRS
between the two goodsbetween the two goods
equals the price ratio. Atequals the price ratio. At
BB, however, because the, however, because the
MRS [− (−10/10) = 1] isMRS [− (−10/10) = 1] is
greater than the pricegreater than the price
ratio (1/2), satisfaction isratio (1/2), satisfaction is
not maximized.not maximized.
MAXIMIZING CONSUMERMAXIMIZING CONSUMER
SATISFACTIONSATISFACTION
MAXIMIZING CONSUMER SATISFACTIONMAXIMIZING CONSUMER SATISFACTION

MMarginal Benefitarginal Benefit
Benefit from the consumption of one additional unit ofBenefit from the consumption of one additional unit of
a good.a good.
Marginal CostMarginal Cost
Cost of one additional unit of a good.Cost of one additional unit of a good.
So, we can then say that satisfaction is maximized whenSo, we can then say that satisfaction is maximized when
the marginal benefit—the benefit associated with thethe marginal benefit—the benefit associated with the
consumption of one additional unit of food—is equal toconsumption of one additional unit of food—is equal to
the marginal cost—the cost of the additional unit of food.the marginal cost—the cost of the additional unit of food.
The marginal benefit is measured by the MRS.The marginal benefit is measured by the MRS.
Satisfaction is maximized (given the budgetSatisfaction is maximized (given the budget
constraint) at the point whereconstraint) at the point where
MRS =MRS = PPFF//PPCC

The consumers in (The consumers in (aa) are willing to) are willing to
trade off a considerable amount oftrade off a considerable amount of
interior space for some additionalinterior space for some additional
acceleration.acceleration.
CONSUMER CHOICE OF AUTOMOBILE ATTRIBUTESCONSUMER CHOICE OF AUTOMOBILE ATTRIBUTES
Given a budget constraint, theyGiven a budget constraint, they
will choose a car that emphasizeswill choose a car that emphasizes
acceleration. The opposite is trueacceleration. The opposite is true
for consumers in (for consumers in (bb).).
Different preferences of consumer groups for automobiles can affect theirDifferent preferences of consumer groups for automobiles can affect their
purchasing decisions. Following up on Example 1, we consider twopurchasing decisions. Following up on Example 1, we consider two
groups of consumers planning to buy new cars.groups of consumers planning to buy new cars.
DESIGNING NEW AUTOMOBILES (II)DESIGNING NEW AUTOMOBILES (II)

Corner solutionCorner solution
Situation in which the marginal rate of substitution for one good in aSituation in which the marginal rate of substitution for one good in a
chosen market basket is not equal to the slope of the budget linechosen market basket is not equal to the slope of the budget line..
A CORNER SOLUTIONA CORNER SOLUTION
Corner SolutionsCorner Solutions
When a corner solutionWhen a corner solution
arises, the consumerarises, the consumer
maximizes satisfaction bymaximizes satisfaction by
consuming only one of theconsuming only one of the
two goods.two goods.
Given budget lineGiven budget line ABAB, the, the
highest level ofhighest level of
satisfaction is achieved atsatisfaction is achieved at
BB on indifference curveon indifference curve UU11,,
where the MRS (of icewhere the MRS (of ice
cream for frozen yogurt) iscream for frozen yogurt) is
greater than the ratio ofgreater than the ratio of
the price of ice cream tothe price of ice cream to
the price of frozen yogurt.the price of frozen yogurt.

CONSUMER PREFERENCES FOR HEALTH CARE VERSUSCONSUMER PREFERENCES FOR HEALTH CARE VERSUS
OTHER GOODSOTHER GOODS
These indifference curves show theThese indifference curves show the
trade-off between consumption of healthtrade-off between consumption of health
care (H) versus other goods (O). Curvecare (H) versus other goods (O). Curve UU11
applies to a consumer with low income;applies to a consumer with low income;
given the consumer’s budget constraint,given the consumer’s budget constraint,
satisfaction is maximized at point A.satisfaction is maximized at point A.
As income increases the budget lineAs income increases the budget line
shifts to the right, and curveshifts to the right, and curve UU22 becomesbecomes
feasible. The consumer moves to point B,feasible. The consumer moves to point B,
with greater consumption of both healthwith greater consumption of both health
care and other goods.care and other goods.
CurveCurve UU33 applies to a high-incomeapplies to a high-income
consumer, and implies less willingnessconsumer, and implies less willingness
to give up health care for other goods.to give up health care for other goods.
Moving from point B to point C, theMoving from point B to point C, the
consumer’s consumption of health careconsumer’s consumption of health care
increases considerably (fromincreases considerably (from HH22 toto HH33),),
while her consumption of other goodswhile her consumption of other goods
CONSUMER CHOICE OF HEALTH CARECONSUMER CHOICE OF HEALTH CARE

When given a collegeWhen given a college
trust fund that musttrust fund that must
be spent onbe spent on
education, the studenteducation, the student
moves frommoves from AA toto BB, a, a
corner solution.corner solution.
If, however, the trustIf, however, the trust
fund could be spentfund could be spent
on other consumptionon other consumption
as well as education,as well as education,
the student would bethe student would be
better off atbetter off at CC..
A COLLEGE TRUST FUND
A COLLEGE TRUST FUNDA COLLEGE TRUST FUND

If an individual facing budget
line l1 chose market basket A
rather than market basket B,
A is revealed to be preferred
to B.
Likewise, the individual facing
budget line l2 chooses market
basket B, which is then
revealed to be preferred to
market basket D.
Whereas A is preferred to all
market baskets in the green-
shaded area, all baskets in
the pink-shaded area are
preferred to A.
REVEALED PREFERENCE:
TWO BUDGET LINES
If a consumer chooses one market basket over another, and if theIf a consumer chooses one market basket over another, and if the
chosen market basket is more expensive than the alternative, thenchosen market basket is more expensive than the alternative, then
the consumer must prefer the chosen market basket.the consumer must prefer the chosen market basket.
Revealed PreferenceRevealed Preference

Facing budget line l3, the
individual chooses E, which is
revealed to be preferred to A
(because A could have been
chosen).
Likewise, facing line l4, the
individual chooses G, which is
also revealed to be preferred
to A.
Whereas A is preferred to all
market baskets in the green-
shaded area, all market
baskets in the pink-shaded
area are preferred to A.
REVEALED PREFERENCE:
FOUR BUDGET LINES
Revealed PreferencesRevealed Preferences

REVEALED PREFERENCE FOR RECREATION
When facing budget lineWhen facing budget line ll11, an individual chooses to use a health club for 10, an individual chooses to use a health club for 10
hours per week at pointhours per week at point AA..
When the fees are altered, she faces budget lineWhen the fees are altered, she faces budget line ll22..
She is then made better off because market basketShe is then made better off because market basket AA can still be purchased, ascan still be purchased, as
can market basketcan market basket BB, which lies on a higher indifference curve., which lies on a higher indifference curve.
REVEALED PREFERENCE FOR RECREATIONREVEALED PREFERENCE FOR RECREATION

MMarginal utility (MU)arginal utility (MU)
Additional satisfaction obtained fromAdditional satisfaction obtained from
consuming one additional unit of a good.consuming one additional unit of a good.
DDiminishing marginal utilityiminishing marginal utility
Principle that as more of a good is consumed,Principle that as more of a good is consumed,
the consumption of additional amounts willthe consumption of additional amounts will
yield smaller additions to utility.yield smaller additions to utility.
Equal marginal principleEqual marginal principle
Principle that utility is maximized when the consumerPrinciple that utility is maximized when the consumer
has equalized the marginal utility per dollar ofhas equalized the marginal utility per dollar of
expenditure across all goods.expenditure across all goods.
Marginal Utility and Consumer ChoiceMarginal Utility and Consumer Choice

Changes in Consumer ChoiceChanges in Consumer Choice
Increase in incomeIncrease in income Increase in priceIncrease in price
B

MARGINAL UTILITY AND HAPPINESSMARGINAL UTILITY AND HAPPINESS
A comparison of mean levels of satisfaction with life acrossA comparison of mean levels of satisfaction with life across
income classes in the United States shows that happinessincome classes in the United States shows that happiness
increases with income, but at a diminishing rate.increases with income, but at a diminishing rate.
MARGINAL UTILITY AND HAPPINESSMARGINAL UTILITY AND HAPPINESS
What, if anything, does research on consumer satisfaction tellWhat, if anything, does research on consumer satisfaction tell
us about the relationship between happiness and theus about the relationship between happiness and the
concepts of utility and marginal utility?concepts of utility and marginal utility?

INEFFICIENCY OF GASOLINE RATIONINGINEFFICIENCY OF GASOLINE RATIONING
When a good is rationed, less isWhen a good is rationed, less is
available than consumersavailable than consumers
would like to buy. Consumerswould like to buy. Consumers
may be worse off.may be worse off.
Without gasoline rationing, upWithout gasoline rationing, up
to 20,000 gallons of gasolineto 20,000 gallons of gasoline
are available for consumptionare available for consumption
(at point(at point BB).).
The consumer chooses pointThe consumer chooses point CC
on indifference curveon indifference curve UU22,,
consuming 5000 gallons ofconsuming 5000 gallons of
gasoline.gasoline.
However, with a limit of 2000However, with a limit of 2000
gallons of gasoline undergallons of gasoline under
rationing, the consumer movesrationing, the consumer moves
toto DD on the lower indifferenceon the lower indifference
curvecurve UU11..
RationingRationing

Some consumers will be worseSome consumers will be worse
off, but others may be better offoff, but others may be better off
with rationing. With rationingwith rationing. With rationing
and a gasoline price of $1.00,and a gasoline price of $1.00,
she buys the maximumshe buys the maximum
allowable 2000 gallons per year,allowable 2000 gallons per year,
putting her on indifferenceputting her on indifference
curvecurve UU11..
Had the competitive marketHad the competitive market
price been $2.00 per gallon withprice been $2.00 per gallon with
no rationing, she would haveno rationing, she would have
chosen pointchosen point FF, which lies, which lies
below indifference curvebelow indifference curve UU11..
However, had the price ofHowever, had the price of
gasoline been only $1.33 pergasoline been only $1.33 per
gallon, she would have chosengallon, she would have chosen
pointpoint GG, which lies above, which lies above
indifference curveindifference curve UU11..
COMPARING GASOLINE RATIONING TOCOMPARING GASOLINE RATIONING TO
THE FREE MARKETTHE FREE MARKET

CCost-of-living indexost-of-living index
Ratio of the present cost of a typicalRatio of the present cost of a typical
bundle of consumer goods and servicesbundle of consumer goods and services
compared with the cost during a basecompared with the cost during a base
period.period.
IIdeal cost-of-living indexdeal cost-of-living index
Cost of attaining a given level of utility at currentCost of attaining a given level of utility at current
prices relative to the cost of attaining the sameprices relative to the cost of attaining the same
utility at base-year prices.utility at base-year prices.
Cost-of-Living IndexesCost-of-Living Indexes

The initial budgetThe initial budget
constraint facing Sarahconstraint facing Sarah
in 2000 is given by linein 2000 is given by line ll11;;
her utility-maximizingher utility-maximizing
combination of food andcombination of food and
books is at pointbooks is at point AA onon
indifference curveindifference curve UU11..
Rachel requires a budgetRachel requires a budget
sufficient to purchase thesufficient to purchase the
food-book consumptionfood-book consumption
bundle given by pointbundle given by point BB
on lineon line ll22 (and tangent to(and tangent to
indifference curveindifference curve UU ).).
TABLE 3 IDEAL COST-OF-LIVING INDEX
Price of booksPrice of books $20/book$20/book $100/bk$100/bk
Number of booksNumber of books 1515 66
Price of foodPrice of food $2.00/lb.$2.00/lb. $2.20/lb.$2.20/lb.
Pounds of foodPounds of food 100100 300300
ExpenditureExpenditure $500$500 $1260$1260
2010 (RACHEL)2000 (SARAH)
COST-OF-LIVING INDEXES 1COST-OF-LIVING INDEXES 1

A price index, whichA price index, which
represents the cost ofrepresents the cost of
buying bundlebuying bundle AA atat
current prices relativecurrent prices relative
to the cost of bundleto the cost of bundle AA
at base-year prices,at base-year prices,
overstates the idealoverstates the ideal
cost-of-living index.cost-of-living index.
TABLE 3TABLE 3 IDEAL COST-OF-LIVING INDEX
Price of booksPrice of books $20/book$20/book $100/bk$100/bk
Number of booksNumber of books 1515 66
Price of foodPrice of food $2.00/lb.$2.00/lb. $2.20/lb.$2.20/lb.
Pounds of foodPounds of food 100100 300300
ExpenditureExpenditure $500$500 $1260$1260
2010 (RACHEL)2000 (SARAH)
COST-OF-LIVING INDEXES 2COST-OF-LIVING INDEXES 2

Fixed-weight indexFixed-weight index
Cost-of-living index in which the quantities of goods and servicesCost-of-living index in which the quantities of goods and services
remain unchanged.remain unchanged.
CChain-weighted price indexhain-weighted price index
Cost-of-living index that accounts for changes in quantities of goodsCost-of-living index that accounts for changes in quantities of goods
and services.and services.
A commission chaired by Stanford University professorA commission chaired by Stanford University professor
Michael Boskin concluded that the CPI overstated inflationMichael Boskin concluded that the CPI overstated inflation
by approximately 1.1 percentage points—a significantby approximately 1.1 percentage points—a significant
amount given the relatively low rate of inflation in the Unitedamount given the relatively low rate of inflation in the United
States in recent years. Approximately 0.4 percentage pointsStates in recent years. Approximately 0.4 percentage points
of the 1.1-percentage-point bias was due to the failure of theof the 1.1-percentage-point bias was due to the failure of the
Laspeyres price index to account for changes in the currentLaspeyres price index to account for changes in the current
yearyear mix of consumption of the productsmix of consumption of the products in the base-yearin the base-year
bundle.bundle.
THE BIAS IN THE CPITHE BIAS IN THE CPI

A Simple Model of Consumer Decision Making -
Figure 1.4

Segmenting Consumers:
Demographics
Demographics:
 Age
 Gender
 Family structure
 Social class/income
 Race/ethnicity
 Geography

1-58
Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall
Redneck Bank Targets by Social Class

Popular Culture
Music
Movies
Sports
Books
Celebrities
Entertainment
Marketers influence
preferences for
movie and music
heroes, fashions,
food, and decorating
choices.

Consumer-Brand RelationshipsConsumer-Brand Relationships
Self-concept
attachment
Nostalgic attachment
Interdependence
Love
1-60

1.1. Live on the Coke side of Life.Live on the Coke side of Life.
2.2. Smarter together.Smarter together.
3.3. Your potential. Our passion.Your potential. Our passion.
4.4. Don’t do evil.Don’t do evil.
5.5. Imagination at work.Imagination at work.
6.6. I’m lovin’ it.I’m lovin’ it.
7.7. Leap ahead.Leap ahead.
8.8. Think different.Think different.
9.9. Where dreams come true.Where dreams come true.
10.10.Invent.Invent.
11.11.It’s not the destination, it’sIt’s not the destination, it’s
the journey.the journey.
Who are you?Who are you?

The Best Global BrandsThe Best Global Brands
1.1. Coca-ColaCoca-Cola
2.2. IBMIBM
3.3. MicrosoftMicrosoft
4.4. GEGE
5.5. NokiaNokia
6.6. ToyotaToyota
7.7. IntelIntel
8.8. McDonald’sMcDonald’s
9.9. DisneyDisney
10.10.GoogleGoogle

Top 10Top 10 Ranked U.S. Companies in Terms ofRanked U.S. Companies in Terms of
Consumers’ Trust and Respect of PrivacyConsumers’ Trust and Respect of Privacy
Top 10 Companies
• American Express
• eBay
• IBM
• Amazon
• Johnson & Johnson
• Hewlett-Packard
• U.S. Postal Service
• Procter and Gamble
• Apple
• Nationwide

The Mobile ConsumerThe Mobile Consumer
• Wireless MediaWireless Media
Messages willMessages will
expand as:expand as:
– Flat-rate dataFlat-rate data
traffictraffic
increasesincreases
– Screen imageScreen image
quality isquality is
enhancedenhanced
– Consumer-userConsumer-user
experiencesexperiences
with webwith web
applicationsapplications
improveimprove
Penetration of Internet Usage AmongPenetration of Internet Usage Among
Mobile Subscribers in 16 Countries -Mobile Subscribers in 16 Countries -
FIGURE 1.3FIGURE 1.3

Consumer and the InternetConsumer and the Internet
The WebThe Web
isis
changingchanging
consumerconsumer
behaviour.behaviour.

Social MediaSocial Media
Social media are the online means of communication, conveyance,Social media are the online means of communication, conveyance,
collaboration, and cultivation among interconnected andcollaboration, and cultivation among interconnected and
interdependent networks of people, communities, andinterdependent networks of people, communities, and
organizations enhanced by technological capabilities and mobility.organizations enhanced by technological capabilities and mobility.
1-66

For ReflectionFor Reflection
Did you know
 If you were paid $1 for every time an article wasIf you were paid $1 for every time an article was
posted onposted on WikipediaWikipedia, you’d earn $156.23/hour?, you’d earn $156.23/hour?
 80% of companies use80% of companies use LinkedInLinkedIn as their primaryas their primary
recruiting tool?recruiting tool?
 More than 1.5 billion pieces of content are shared onMore than 1.5 billion pieces of content are shared on
FacebookFacebook daily?daily?

Do Marketers Promise Miracles?Do Marketers Promise Miracles?
Advertisers simply do not know enough
about people to manipulate them

22
Elasticity of DemandElasticity of Demand

OverviewOverview
The economic concept ofThe economic concept of
elasticityelasticity
The price elasticity of demandThe price elasticity of demand
The cross-elasticity of demandThe cross-elasticity of demand
Income elasticityIncome elasticity
Other elasticity measuresOther elasticity measures
Elasticity of supplyElasticity of supply

How sticky is
How long ago sinceHow long ago since
the price changed ?the price changed ?
MonthsMonths MonthsMonths
Dry cleaningDry cleaning McDonald’sMcDonald’s
MealMeal
NewspaperNewspaper Small CarSmall Car
HaircutHaircut MilkMilk
Taxi fareTaxi fare ElectricityElectricity
Medical servicesMedical services AirfareAirfare
MagazineMagazine PetrolPetrol
Personal ComputerPersonal Computer Teh tarikTeh tarik

Sticky PricesSticky Prices
• Average months between priceAverage months between price
changes (USA)changes (USA)
MonthsMonths MonthsMonths
Coin-operated LaundryCoin-operated Laundry
MachineMachine
46.446.4 BeerBeer 4.34.3
NewspaperNewspaper 29.929.9 MicrowaveMicrowave
OvensOvens
3.03.0
HaircutHaircut 25.525.5 MilkMilk 2.42.4
Taxi fareTaxi fare 19.719.7 ElectricityElectricity 1.81.8
Vet servicesVet services 14.914.9 AirfareAirfare 1.01.0
MagazineMagazine 11.211.2 GasolineGasoline 0.60.6
PC SoftwarePC Software 5.55.5

Why Should Managers StudyWhy Should Managers Study
Elasticity?Elasticity?
Own-price elasticityOwn-price elasticity helps managershelps managers
understand the impact that priceunderstand the impact that price
changes will have on their revenue.changes will have on their revenue.
Income elasticityIncome elasticity can help managerscan help managers
understand what income groups tounderstand what income groups to
target their product to.target their product to.
Cross-price elasticityCross-price elasticity can helpcan help
managers understand who their closestmanagers understand who their closest
competitors are.competitors are.

Demand ElasticityDemand Elasticity
Demand elasticity is theDemand elasticity is the
responsiveness of quantityresponsiveness of quantity
demanded to changes in thedemanded to changes in the
factors that influencefactors that influence
demand, product price,demand, product price,
income, or prices of relatedincome, or prices of related
products.products.

The economic concept ofThe economic concept of
Elasticity: theElasticity: the percentagepercentage
changechange in one variablein one variable
relative to a percentagerelative to a percentage
change in another.change in another.
Binchangepercent
Ainchangepercent
ElasticityoftCoefficien =

Price elasticity of demandPrice elasticity of demand
Price elasticity of demand:Price elasticity of demand:
the percentage change inthe percentage change in
quantity demanded causedquantity demanded caused
by aby a 1 percent change in1 percent change in
priceprice
Price%
Quantity%
E
∆
∆
=p

Own Price ElasticityOwn Price Elasticity
of Demandof Demand
 Measured as the percentage change inMeasured as the percentage change in
quantity demanded of a given good,quantity demanded of a given good,
relative to a percentage change in itsrelative to a percentage change in its
price, all else constant.price, all else constant.
eepp = %ΔQ= %ΔQxx ÷ %ΔP÷ %ΔPxx

Elasticity variesElasticity varies
along a linearalong a linear
demand curvedemand curve

Own Price Elasticity of Demand –Own Price Elasticity of Demand –
Graphical RepresentationGraphical Representation
P
Q
P1
P2
Q1 Q2
%∆P
%∆Q
A
B

Examples of Own-PriceExamples of Own-Price
ElasticityElasticity
Cereal: -0.55Cereal: -0.55
Fish: -0.29Fish: -0.29
Neuman’s Own Pasta Sauce:Neuman’s Own Pasta Sauce:
-2.32-2.32
Orange juice: -1.39Orange juice: -1.39

Categories of elasticityCategories of elasticity
Relative elasticity of demand:Relative elasticity of demand: EEpp > 1> 1
Relative inelasticity of demand:Relative inelasticity of demand: 0 < E0 < Epp < 1< 1
Unitary elasticity of demand:Unitary elasticity of demand: EEpp = 1= 1
Perfect elasticity:Perfect elasticity: EEpp == ∞∞
Perfect inelasticity:Perfect inelasticity: EEpp == 00

Own Price Elasticity and Total RevenueOwn Price Elasticity and Total Revenue
Value of priceValue of price
coefficientcoefficient
ElasticityElasticity
definitiondefinition
RelationshipRelationship
among variablesamong variables Impact on revenueImpact on revenue
|e|epp| > 1| > 1
ElasticElastic
demanddemand %%ΔΔQQdd > %> %ΔΔPPxx
Price increase results inPrice increase results in
lower total revenue.lower total revenue.
Price decrease results inPrice decrease results in
higher total revenue.higher total revenue.
|e|epp| < 1| < 1
InelasticInelastic
demanddemand %%ΔΔQQdd < %< %ΔΔPPxx
Price increase results inPrice increase results in
higher total revenue.higher total revenue.
Price decrease results inPrice decrease results in
lower total revenue.lower total revenue.
|e|epp| = 1| = 1
Unit orUnit or
unitaryunitary
elasticelastic
%%ΔΔQQdd = %= %ΔΔPPxx
Price increase or decreasePrice increase or decrease
has no impact on totalhas no impact on total
revenue.revenue.

If demand is elastic,a decrease in priceIf demand is elastic,a decrease in price
results in an increase in total revenue,results in an increase in total revenue,
and an increase in price results in aand an increase in price results in a
decrease in total revenue.decrease in total revenue.
If demand is inelastic,aIf demand is inelastic,a
decrease In price resultsdecrease In price results
in a decrease in totalin a decrease in total
revenue, and an increaserevenue, and an increase
in price results in ain price results in a
increase in total revenue.increase in total revenue.
Graphical Representation of RelationshipGraphical Representation of Relationship
Between Price Elasticity and Total RevenueBetween Price Elasticity and Total Revenue
P
Q
P1
P2
Q1 Q2
A
BY
X
P
Q
P1
P2
Q1 Q2
A
BY
X

Determinants of Own Price ElasticityDeterminants of Own Price Elasticity
 The number ofThe number of
substitute goods.substitute goods.
 The percent of aThe percent of a
consumer’s incomeconsumer’s income
that is spent on thethat is spent on the
product.product.
 The time periodThe time period
underunder
consideration.consideration.
Demand is generally moreDemand is generally more
inelastic:inelastic:
 The fewer the numberThe fewer the number
of substitutes orof substitutes or
perceived substitutesperceived substitutes
available.available.
 The smaller the percentThe smaller the percent
of the consumer’sof the consumer’s
income that is spent onincome that is spent on
the product.the product.
 The shorter the timeThe shorter the time
period underperiod under
consideration.consideration.

Perfectly ElasticPerfectly Elastic andand Inelastic DemandInelastic Demand

Factors affecting demandFactors affecting demand
ease ofease of substitutionsubstitution
proportion of totalproportion of total expendituresexpenditures
durabilitydurability of productof product
possibility of postponingpossibility of postponing
purchasepurchase
possibility of repairpossibility of repair
used product marketused product market
length oflength of timetime periodperiod

Derived demandDerived demand: the: the
demand for products or factorsdemand for products or factors
that are not directly consumed,that are not directly consumed,
but go into the production of abut go into the production of a
another (final) productanother (final) product
The demand for such a productThe demand for such a product
or factor exists because there isor factor exists because there is
demand for the finaldemand for the final
productproduct

The derived demand curve will be moreThe derived demand curve will be more
inelastic:inelastic:
the morethe more essentialessential is theis the
componentcomponent
the more inelastic is the demandthe more inelastic is the demand
curve for thecurve for the final productfinal product
the smaller is the fraction of totalthe smaller is the fraction of total
costcost going to this componentgoing to this component
the more inelastic is thethe more inelastic is the supplysupply
curve of cooperating factorscurve of cooperating factors

 A long-run demandA long-run demand
curve will generallycurve will generally
be more elastic than abe more elastic than a
short-run curveshort-run curve
As the time periodAs the time period
lengthens consumerslengthens consumers
find ways to adjust tofind ways to adjust to
the price change, viathe price change, via
substitution orsubstitution or
shiftingshifting
consumptionconsumption

 The relationship between price andThe relationship between price and
revenuerevenue depends on elasticitydepends on elasticity
Why? By itself, a price fall will reduce receiptsWhy? By itself, a price fall will reduce receipts
……
BUT because the demand curve is downwardBUT because the demand curve is downward
sloping, the drop in price will alsosloping, the drop in price will also
increase quantity demandedincrease quantity demanded
 Q: which effect will be stronger?Q: which effect will be stronger?

As price decreasesAs price decreases
revenue rises whenrevenue rises when
demand is elasticdemand is elastic
revenue falls when itrevenue falls when it
is inelasticis inelastic
revenue reaches itrevenue reaches it
peak ifpeak if elasticity =1elasticity =1
 the lower chartthe lower chart
shows theshows the effect ofeffect of
elasticity on totalelasticity on total
revenuerevenue

Marginal revenue: theMarginal revenue: the
change in total revenuechange in total revenue
resulting from changingresulting from changing
quantity by one unitquantity by one unit
Quantity
MR
∆
∆
=
RevenueTotal

MarginalMarginal
revenue curverevenue curve
is twice asis twice as
steep as thesteep as the
demanddemand
curvecurve

at the pointat the point
where marginalwhere marginal
revenue crossesrevenue crosses
the X-axis, thethe X-axis, the
demand curve isdemand curve is
unitary elasticunitary elastic
and totaland total
revenue reachesrevenue reaches
a maximuma maximum

ExamplesExamples: some real world elasticities: some real world elasticities
coffee: short run -0.2, long run -0.33coffee: short run -0.2, long run -0.33
kitchen and household appliances:kitchen and household appliances:
-0.63-0.63
meals at restaurants: -2.27meals at restaurants: -2.27
airline travel in U.S.: -1.98airline travel in U.S.: -1.98
beer: -0.84, Wine: -0.55beer: -0.84, Wine: -0.55

ExamplesExamples: some real world elasticities: some real world elasticities
white pan bread:-0.69white pan bread:-0.69
cigarettes: short run -0.4, long runcigarettes: short run -0.4, long run
-0.6-0.6
wine imports: -0.15wine imports: -0.15
crude oil: -0.06crude oil: -0.06
internet services: -0.6/-0.7internet services: -0.6/-0.7

Cross-Price Elasticity of DemandCross-Price Elasticity of Demand
 The percentage change in the quantityThe percentage change in the quantity
demanded of a given good,demanded of a given good, X, relative to aX, relative to a
percentagepercentage change in the price of good Ychange in the price of good Y,,
assuming all other factors constant.assuming all other factors constant.
eexyxy = %ΔQ= %ΔQxx ÷ %ΔP÷ %ΔPyy

Cross-elasticity of demandCross-elasticity of demand
Cross-elasticity of demand: theCross-elasticity of demand: the
percentage change in quantitypercentage change in quantity
consumed of one product as aconsumed of one product as a
result of a 1 percent change inresult of a 1 percent change in
the price of a related productthe price of a related product
B
A
x
P
Q
E
∆
∆
=
%
%

Cross-elasticity of demandCross-elasticity of demand
The sign of cross-elasticity forThe sign of cross-elasticity for
substitutes is positivesubstitutes is positive
The sign of cross-elasticity forThe sign of cross-elasticity for
complements is negativecomplements is negative
Two products are considered goodTwo products are considered good
substitutes or complements when thesubstitutes or complements when the
coefficient iscoefficient is larger than 0.5larger than 0.5
(in ab. value)(in ab. value)

SubstitutesSubstitutes
Two goods withTwo goods with
aa positivepositive
cross-pricecross-price
elasticityelasticity ofof
demanddemand
coefficient arecoefficient are
said tosaid to bebe
substitutesubstitute
goods.goods.
Boiler chickens andBoiler chickens and
beefbeef
eexyxy = 0.20= 0.20
Boiler chickens andBoiler chickens and
porkpork
eexyxy = 0.28= 0.28

ComplementsComplements
If two goods haveIf two goods have
aa negativenegative cross-cross-
price elasticityprice elasticity ofof
demanddemand
coefficient, theycoefficient, they
are calledare called
ccomplementaryomplementary
goods.goods.
BreadBread
and eggsand eggs
eexyxy ==
-0.03-0.03

Income Elasticity of DemandIncome Elasticity of Demand
 The percentage change in the quantityThe percentage change in the quantity
demanded of a given good,demanded of a given good, X, relativeX, relative
to a percentageto a percentage change in consumerchange in consumer
income(Y), assuming all other factorsincome(Y), assuming all other factors
constant.constant.
eeii = %ΔQ= %ΔQxx ÷ %ΔY÷ %ΔY

 Income elasticity of demand: theIncome elasticity of demand: the
percentage change in quantity demandedpercentage change in quantity demanded
caused by acaused by a 1 percent change in1 percent change in
incomeincome
Y is shorthand for incomeY is shorthand for income
Y
Q
EY
∆
∆
=
%
%

Categories of incomeCategories of income
superior goods:superior goods:
EEYY > 1> 1
normal goods: 0normal goods: 0 ≤≤ EEYY ≤≤ 11
inferior goods:inferior goods:
EEYY < 0< 0

Normal GoodNormal Good
Good X is aGood X is a
normal good ifnormal good if
the demand forthe demand for
good X movesgood X moves
in thein the samesame
directiondirection as aas a
change inchange in
income.income.
CreamCream
eeii = 1.72= 1.72
ApplesApples
eeii = 1.32= 1.32
PotatoesPotatoes
eeii = 0.15= 0.15

Inferior GoodInferior Good
Good X is anGood X is an
inferior good ifinferior good if
the demand forthe demand for
good X moves ingood X moves in
thethe oppositeopposite
directiondirection of aof a
change inchange in
income.income.
ChickenChicken
eeii = -0.106= -0.106

Other demand elasticitiesOther demand elasticities
ExamplesExamples: elasticity is encountered: elasticity is encountered
every time a change in some variableevery time a change in some variable
affects demandaffects demand
advertising expenditureadvertising expenditure
interest ratesinterest rates
population sizepopulation size

Price elasticity of supply: thePrice elasticity of supply: the
percentage change in quantitypercentage change in quantity
supplied as a result of asupplied as a result of a 1 percent1 percent
change in pricechange in price
The coefficient of supply elasticity isThe coefficient of supply elasticity is
a normally aa normally a positive numberpositive number
Price%
SuppliedQuantity%
E
∆
∆
=S

When the supply curve isWhen the supply curve is moremore elasticelastic,,
the effect of a change in demand willthe effect of a change in demand will
bebe greater on quantitygreater on quantity than on thethan on the
price of the productprice of the product
When the supply curve isWhen the supply curve is lessless elasticelastic, a, a
change in demand will have achange in demand will have a
greater effect on pricegreater effect on price
than on quantitythan on quantity

Global applicationGlobal application
 ExampleExample: price elasticities in Asia: price elasticities in Asia
importsimports almost alwaysalmost always
price inelasticprice inelastic
ifif exportsexports price inelastic,price inelastic,
export earnings will rise asexport earnings will rise as
prices riseprices rise
ifif exportsexports price elastic,price elastic,
export earnings will rise withexport earnings will rise with
world incomesworld incomes

33
Demand Analysis & PricingDemand Analysis & Pricing

Not Just for Lunch Anymore…Not Just for Lunch Anymore…
 Percent of revenues and profitsPercent of revenues and profits
McDonald’s gets from breakfast.McDonald’s gets from breakfast.
 Revenues: 25%Revenues: 25%
 Profits: 50%Profits: 50%
 Opportunity relates toOpportunity relates to usage situationusage situation
and is driven by time pressure andand is driven by time pressure and
other factors.other factors.
 Portability is keyPortability is key as many eat inas many eat in
their cars or at their desk.their cars or at their desk.
Consumer Behaviour In The News…Consumer Behaviour In The News…
Source: K. Macarthur, “Rise and Shine,” Advertising Age, July 31, 2006, p. 3 and 26.
13-112

DEMAND ANALYSISDEMAND ANALYSIS
A firm’s quantity of sales dependsA firm’s quantity of sales depends
on multiple economic factors.on multiple economic factors.
For instance, an airline’s seat demandFor instance, an airline’s seat demand
might be described by the equation:might be described by the equation:
Q = 25 + 3Y + PQ = 25 + 3Y + P°° – 2P.– 2P.
Here, demand depends on:Here, demand depends on:
customer income (Y),customer income (Y),
the rival’s price (Pthe rival’s price (P°°),),
and the airline’s price (P).and the airline’s price (P).

SHIFTS IN DEMANDSHIFTS IN DEMAND
Any change in the firm’s own priceAny change in the firm’s own price
shows up as a movement along theshows up as a movement along the
firm’s demand curve.firm’s demand curve.
A change in any other variableA change in any other variable
constitutes a shift in the positionconstitutes a shift in the position
of the demand curveof the demand curve
For instance, an increase in aFor instance, an increase in a
competitor’s price would causecompetitor’s price would cause
a favourable demand shift as shown.a favourable demand shift as shown.

ELASTICITY OF DEMANDELASTICITY OF DEMAND
How Responsive are Sales to Changes in Price?How Responsive are Sales to Changes in Price?
The Concept of Elasticity Supplies the Answer.The Concept of Elasticity Supplies the Answer.
EEPP = [% Change Q]/[% Change P] = [= [% Change Q]/[% Change P] = [∆∆Q/Q]/[Q/Q]/[∆∆P/P].P/P].
Example: PExample: P00 = 100 & Q= 100 & Q00 = 1200= 1200
PP11 = 110 & Q= 110 & Q11 = 1160= 1160
EEPP = [(1160 – 1200)/1200]/[(110 – 100)/100]= [(1160 – 1200)/1200]/[(110 – 100)/100]
= -3.33%/10%= -3.33%/10%
== -.-.333.333.

PROPERTIES OF ELASTICITYPROPERTIES OF ELASTICITY
Unitary Elastic: EUnitary Elastic: EPP = -1= -1
Inelastic: -1 < EInelastic: -1 < EPP < 0< 0
Elastic: -Elastic: -∞∞ < E< EPP < -1< -1
Elasticity Varies alongElasticity Varies along
a Linear Demand Curve.a Linear Demand Curve.
100
200
300
400
Demand is
Inelastic
Demand is
Elastic
EP = -1
EP = (∆Q/∆P)(P/Q)
Q = 1600 - 4P
B
A
400 800 1200 1600
MR
MR = 0
= (-4)(100/1200) = -.333 B
= (-4)(300/400) = -3 A

USING ELASTICITYUSING ELASTICITY
Predicting Sales:Predicting Sales:
∆∆Q/Q = (EQ/Q = (EPP)()(∆∆P/P) + (EP/P) + (EYY)()(∆∆Y/Y) + (EY/Y) + (EPP°° )()(∆∆PP°°/P/P°°) .) .
Other Elasticities:
Income Elasticity:Income Elasticity:
EEYY == (% change Q)/(% change Y)(% change Q)/(% change Y)
Necessities: 0 < ENecessities: 0 < EYY < 1< 1
Discretionary: EDiscretionary: EYY > 1> 1
Cross Price Elasticity:Cross Price Elasticity:
EEPP°° == (% change Q)/(% change P(% change Q)/(% change P°°))

USING ELASTICITY
Maximizing Profit and Revenue inMaximizing Profit and Revenue in
Pure Selling Problems (MC = 0).Pure Selling Problems (MC = 0).
Examples:
Selling SoftwareSelling Software
Selling a CDSelling a CD
Utilizing a Sports StadiumUtilizing a Sports Stadium
Pricing Olympics Cable
Coverage on Triple Cast
Optimal Solution: MR = 0Optimal Solution: MR = 0
or equivalently: Eor equivalently: EPP = -1.= -1.
Capacity
Revenue
With high demand, price to fillWith high demand, price to fill
stadium.stadium.
With low demand, do not cut priceWith low demand, do not cut price
to fill stadium.to fill stadium.
Hoped for Demand
Actual
Demand
Minimize loss, by drasticallyMinimize loss, by drastically
cutting price.cutting price.

OPTIMAL PRICINGOPTIMAL PRICING
1. The Markup Rule1. The Markup Rule
[P - MC]/P = -1/E[P - MC]/P = -1/EPP
or P = [Eor P = [EPP /(1+ E/(1+ EPP )] MC)] MC
MC = 100MC = 100
EEPP PP
-2
-3
-4
-6
2. Price Discrimination2. Price Discrimination
Apply Markup rule to separateApply Markup rule to separate
segments. More inelastic segmentssegments. More inelastic segments
get the higher markups (over common MC).get the higher markups (over common MC).
Equivalently, Set MREquivalently, Set MR11 = MR= MR22 = MC.= MC.
200
150
133
120

MAXIMIZING REVENUE W/ LIMITEDMAXIMIZING REVENUE W/ LIMITED
CAPACITYCAPACITY
Airline Yield Management:Airline Yield Management:
Maximizing Revenue utilizingMaximizing Revenue utilizing
Business Class and Economy Class seats.Business Class and Economy Class seats.
The key is to set: MRB = MRE.
Example: Airline has 180 seats and faces demand:Example: Airline has 180 seats and faces demand:
PPBB = 330 – Q= 330 – QBB and Pand PEE = 250 – Q= 250 – QEE. Therefore,. Therefore,
MRMRBB = 330 - 2Q= 330 - 2QBB = MR= MREE = 250 – 2Q= 250 – 2QEE..
We also know that: QWe also know that: QBB + Q+ QEE = 180.= 180.
The solution to these simultaneous equations is:The solution to these simultaneous equations is:
QQBB = 110 seats and Q= 110 seats and QEE = 70 seats.= 70 seats.
In turn, PIn turn, PBB = $220 and P= $220 and PEE = $180.= $180.

Casestudy : TESCOCasestudy : TESCO
1.1. Read and prepare theRead and prepare the
Casestudy on TESCOCasestudy on TESCO
(Johnson, Whittington &(Johnson, Whittington &
Scholes (2011)) forScholes (2011)) for
discussion and presentationdiscussion and presentation
next week.next week.
2.2. Identify and evaluate theIdentify and evaluate the
challenges facing TESCO’schallenges facing TESCO’s
global expansion byglobal expansion by
conducting Externalconducting External
Environment analysisEnvironment analysis
(PESTEL);and Industry(PESTEL);and Industry
(5+1 Forces) analysis.(5+1 Forces) analysis.

ConclusionConclusion
““In a free-market economy, theIn a free-market economy, the
government generally lets peoplegovernment generally lets people
decide what to buy with theirdecide what to buy with their
money... in the interests ofmoney... in the interests of
personal freedom the governmentpersonal freedom the government
should respect their preferences.”should respect their preferences.”
Paul SamuelsonPaul Samuelson

Core ReadingCore Reading
• Keat, Paul G. and Young, Philip KY (2009)
Managerial Economics, 6th
edition, Pearson
• Samuelson, William F. and Marks, Stephen G.
(2010) Managerial Economics, 6th
edition, John
Wiley
• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)
Microeconomics, 8th
edition, Pearson
• Samuelson, P.A. and Nordhaus, W. D.Samuelson, P.A. and Nordhaus, W. D.
(2010)(2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19thth
EditionEdition
• Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy –“Competitive Strategy –
Techniques for Analyzing Industries and Competitors”Techniques for Analyzing Industries and Competitors”
Free PressFree Press

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