LECTURE TWO: DEMANDManagerial Economics

Lecturer: Jack Wu

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.

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.

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

0

2.50

5

7.50

10

1 4 72

individual demand curve

Quantity (Movies a month)

Pri

ce (

$ p

er

movie

)

INDIVIDUAL DEMAND CURVE

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

HOOVER, 1992

A negative price case:

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

DEMAND AND INCOME

Changes in incomenormal product – demand increases with income

inferior product – demand falls with income

DEMAND AND INCOME

DEMAND AND OTHER FACTORS

prices of related products substitutes complements

advertising

OTHER DEMAND FACTORS: COMPLEMENTS

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

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.

MARKET DEMAND

Price Joy Max Lucas Market

$10 0 0 0 0

$7.50 1 0 0 1

$5 2 1 0 3

$2.50 4 2 3 9

$0 7 6 4 17

Market demand = horizontal summation of individual demands

MARKET DEMAND: CONSTRUCTION

MARKET DEMAND: MACRO FACTORS

Income Average Distribution

Demographic Population Age structure Urban-rural

Cultural-social

MARKET DEMAND: MICRO FACTORS

Price Advertising R&D

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.

0

2.50

5

7.50

10

1 2 4 7

c b e

h

j

g

d a

individual buyer surplus at $2.50 price

individual demand(marginal benefit) curve

Quantity (Movies a month)

Pri

ce (

$ p

er

movie

)

c

f

INDIVIDUAL BUYER SURPLUS

BUYER SURPLUS: INDIVIDUAL

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

usage charge

fixed payment

BUYER SURPLUS: TWO-PART PRICINGBusiness 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)

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.