Prices and Markets

Session 3

Consumer Demand

Prof. Amine Ouazad

This Session: Demand & Supply

and Consumer Demand

1.  The Cola Wars: The Elasticity of demand

2.  Connecting the dots: linear demand and log-linear demand

3.  The Elasticity Quiz

4.  Own-price elasticity, cross-price elasticity, income elasticity BMW and McDonald’s

5.  Really connecting the dots: How can I get the whole demand curve?

Next Session Costs !

“The Cola Wars” •  Coca Cola: b. 1886 in Atlanta GA.

•  Brad’s drink: b. 1893 in a New Bern NC.

•  quickly rechristened Pepsi-Cola.

Great Depression

•  1931: Coke dominant. Pepsi near bankruptcy.

•  Pepsi president Guth buys 12oz recycled beer bottles

•  Tries to sell at 10c, twice the price of 6oz Coke. Fails.

•  1933. Brilliant idea: Why not sell 12oz Pepsi @ 5c = price of 6oz Coke

•  Jingle: Twice as Much for a Nickel Too

•  Sales explode! Pepsi comes out of bankruptcy.

•  Sales: $2m. in 1936, $4m. in 1938.

•  “... brilliant marketing ploy ... saved the company.” Really??

•  Did a lower price lead to a higher revenue??

P

Q Qbefore

Pbefore x

Qafter

Pafter x

-

+

Loss of revenue

Extra revenue

The Cola Wars: Revenue Increased?? Comparing the Volume Effect and the Price Effect?

Use percentage changes!!

Pepsi case? %ΔQ>-%ΔP

Revenue and the elasticity of demand

Elasticity measures the Price-sensitivity of demand

E = �% change in Q

% change in P

If then a price drop causes revenue to

and we say demand is

E>1

E=1

E<1

They’re talking price elasticity

“We’ve done price elasticity studies”

Jeff Bezos - September 2012

“The price elasticity of heroin use is about 0.5”

Steve Levitt - 2003

"We feel quite confident with the response we've seen to our pricing actions," Rosenfeld said. “Price elasticity has been essentially where we expected it to be.” - Irene Rosenfeld, Kraft CEO (now Chairman), September 2011

About the KL-Singapore route: “Once we get the price elasticity right, I think it will be a huge route” - Tony Fernandes, Group CEO of Air Asia, January 2008.

� Experiment, Measure, Discover

Elasticity of demand for cars and computers

Model Elasticity Mazda 323 6.3 Honda Accord 4.8 Nissan Maxima 4.8 Nissan Sentra 6.5 Ford Taurus 4.2 Ford Escort 6.0 Lexus LS400 3.0 Chevrolet Cavalier 6.4 Cadillac Seville 3.9 BMW 735i 3.5 Cars 0.8

Price Elasticity

Apple iMac 14

Compaq Presario

27

Dell

Dimension 30

IBM Thinkpad 41

HP Omnibook 51

This Session: Demand & Supply

Consumer Demand

1.  The Cola Wars: The Elasticity of demand

2.  Connecting the dots: linear demand and log-linear demand

3.  The Elasticity Quiz

4.  Own-price elasticity, cross-price elasticity, income elasticity BMW and McDonald’s

5.  Really connecting the dots: How can I get the whole demand curve?

Next Session Costs !

Connecting the dots… with a linear demand P

Q Qbefore

Pbefore x

Qafter

Pafter x

Choke price P Q = A – B.P

Choke price Price at which consumers stop

buying your product.

Value?? A/B

Measuring Elasticity Loosely

E = �% change in Q

% change in P

E = �dQ

dP· P

Q

Small price changes? “More than 50% of price changes in retail are small, below 3% changes.” “80% of retail prices change from one week to another.” - Colin Ellis, Chief Economist Europe at Daiwa Capital Markets.

Arc Elasticity Given two points (P1, Q1) and (P2,Q2)

( ) ( )21

12

21

12

21

21 PP

PP

QQ

QQE+

−

+

−−=

For Small Price Changes… Point elasticity If demand is smooth then point elasticity at price P, where Q=d(P) is:

With a linear demand: Q = A – BxP What is your Point Elasticity at your Price P?

Choke price Price at which consumers stop

buying your product. P

P � P

P

Q

Price

Quantity

Point elasticity at price P Choke P

price

Disney CEO Bob Iger: Still 'Room to Increase Pricing’ August 2012. “Disney has been increasing pricing at the parks…” what about price elasticity?

Linear Demand - Extreme cases

Price

Quantity

Perfectly inelastic demand curve:

Demand does not change when the price changes.

Price

Quantity

Perfectly elastic demand curve:

Infinite quantity increases when lowering your price.

E=∞ E=0

The demand curve is horizontal: E=∞

The demand curve is vertical: E=0

The demand curve is very flat: large E !!

Very steep: very small E !!

Examples?? Examples??

Connecting the dots… with Log Demand

P

Q Qbefore

Pbefore x

Qafter

Pafter x

Q = AxP-B

Elasticity is B, right here!

Elasticity is constant along the demand curve

This Session: Demand & Supply

Consumer Demand

1.  The Cola Wars: The Elasticity of demand

2.  Connecting the dots: linear demand and log-linear demand

3.  The Elasticity Quiz

4.  Own-price elasticity, cross-price elasticity, income elasticity BMW and McDonald’s

5.  Really connecting the dots: How can I get the whole demand curve?

Next Session Costs !

The Elasticity Quiz 1.  The more close substitutes a good has, the elastic is demand.

2.  �Demand for a particular brand (Samsung) or type (17”) is elastic than demand for the entire category (computer displays).

3.  �The more differentiated the brand, the elastic is demand (for the

brand).

4.  Advertising usually both increases demand and makes it elastic.

5.  When a product’s close substitutes become more expensive, demand for the product becomes elastic.

6.  Demand is typically elastic for people with lower income.

This Session: Demand & Supply

Consumer Demand

1.  The Cola Wars: The Elasticity of demand

2.  Connecting the dots: linear demand and log-linear demand

3.  The Elasticity Quiz

4.  Own-price elasticity, cross-price elasticity, income elasticity BMW and McDonald’s

5.  Really connecting the dots: How can I get the whole demand curve?

Next Session Costs !

Daily Life Economics

“As far as recession-proof products go, tissue paper and toilet rolls seem as recession-proof as they come.” Trefis Stock Market Analyst. •  How does toilet paper demand respond to

consumer income??

During the recession, Procter & Gamble‘s, Georgia Pacific, and Kimberly-Clark experienced a major slowdown in sales of paper-based products placed at the higher end of the market. Trefis Stock Market Analyst. Joking: “It may not be advisable to make major investing decisions based solely on high-end toilet paper demand.” a Wall Street Analyst on Bloomberg. •  How does luxury toilet paper demand respond to

consumer income??

Other Elasticities: Income Elasticity

Inferior goods

Demand falls when income rises Income elasticity is negative Countercyclical Example??

Normal goods

Demand increases when income rises Income elasticity is positive Recession proof (Mid-Range) Toilet Paper

Normal goods that are Luxury goods

Demand increases faster than income Income elasticity is greater than 1 Procyclical

%�Q

%�I

Annual Report 2008

•  “BMW Profit Drops 74% as Recession Saps Luxury Sales.” Bloomberg, November 3, 2009.

“The company anticipates sales will decline 10% to 15% this year.”

•  “McDonald’s Loves Your Recession.” Forbes, February 17, 2009

At a time when recession-weary Americans are cutting back, McDonalds is showing growth. •  “Who Won the Recession? McDonald’s”

Slate, Tuesday, August 11, 2009.

McDonald’s same-store sales growth in 2008 was greater than in 2006 and in 2007.

Inferior good Normal good Luxury good

Inferior good Normal good Luxury good

06

BMW Group in figures

Revenuesin euro billion

55

50

45

40

35

30

04 05 06 07 08

44.3 46.7 49.0 56.0 53.2

Deliveries of automobilesin thousand units

1,500

1,400

1,300

1,200

1,100

1,000

04 05 06 07 08

1,208.7 1,328.0 1,374.0 1,500.7 1,435.9

Profit before taxin euro million

4,500

3,750

3,000

2,250

1,500

750

04 * 05 06 07 08

3,583 3,287 4,124 3,873 351

* adjusted for new accounting treatment of pension obligations

Profit before financial resultin euro million

4,500

3,750

3,000

2,250

1,500

750

04 05 06 07 08

3,774 3,793 4,050 4,212 921

Annual Report 2008

Other Elasticities: Cross-Price Elasticity

•  Two goods are complements if cross-price elasticity is negative.

e.g.: Razors and Blades. Real estate and house insurance.

Honeywell, avionics; GE, plane engines. Angostura bitters and whisky (for cocktail lovers).

•  Two goods are substitutes if cross-price elasticity is positive.

e.g.: an iPhone and a Lumia; Coke and Pepsi.

%�Q

%�Ps> 0

%�Q

%�Ps< 0

A Father of two, in the Boston Globe, about games: “I can’t afford to feed them [the kids]. You sit there, and you have a hot dog and a couple of beers [the kids?], and you walk out $100 lighter. I just don’t have that kind of money.” What’s going on here??

A 1% price increase at Amazon raises demand at

BN by 3.5%

A 1% price increase at BN raises demand at Amazon

by 0.2% !?

For the same book…

Movements along the demand curve

If you change your price

Shifts of the demand curve

If other firms change their price, or consumer income changes.

Pbefore

Pafter

Qafter Qbefore

P

Qafter Qbefore

P

Q

P

Q

Your firm lowers its price

Consumer income drops (normal good)

or a Competitor lowers his price

Wrap-Up: Other Elasticities

•  We can measure elasticities between any two related variables (e.g., demand and income, supply and price, etc.)

•  Elasticity = sensitivity in terms of % changes (rather than slope). •  Some elasticities of demand:

•  Own-price elasticity:

•  Cross-price elasticity:

•  Income elasticity:

•  Remember: •  This course: mostly on own-price elasticity; sometimes other elasticities. •  “Elasticity of demand” (no qualifier) means “own-price elasticity”. •  Own-price elasticity is only one we use the minus sign for.

�%�Q

%�P

%�Q

%�Ps

%�Q

%�I

This Session: Demand & Supply

Consumer Demand 1.  The Cola Wars: The Elasticity of demand

2.  Connecting the dots: linear demand and log-linear demand

3.  The Elasticity Quiz

4.  Own-price elasticity, cross-price elasticity, income elasticity BMW and McDonald’s

5.  Really connecting the dots: How can I get the whole demand curve?

Next Session Costs !

Really connecting the dots: Estimating the demand curve - Data Sources

1.  Scanner data Purchases made by every consumer at the cashier (Nielsen). Walmart has more than 500 Terabytes of scanner data at Bentonville, AR.

2.  Loyalty card data TESCO Clubcards. Flying blue, Star Alliance.

3.  Consumer focus groups How much would you be ready to pay for that product?

4.  Market experiments Amazon.com randomizes

5.  Survey data: all the consumption of selected households for a year/months Consumer Expenditure Survey (U.S., Bureau of Labor Statistics) Family Expenditure Survey (U.K., National Statistics) Budget des Menages (France, INSEE) Household Expenditure Survey (Statistics Singapore)

Price

Quantity

Really connecting the dots: Scatter Plot

•  How do we connect the dots here??

1.  Write down model (equation) for demand, with unspecified coefficients. It’s approximate, both art and science:

•  Include most relevant variables:

•  Consumer income

•  Prices of substitutes (competing products)

•  Prices of complements

•  Choose either linear or log demand curve

•  Depending on the shape of the scatter plot.

•  Using statistical techniques (UDJ).

2.  Fit line or curve to data points using statistical techniques (regression).

Really connecting the dots: Estimating the demand curve

Uncertainty, Data, and Judgment •  Sessions 11, 12, 13: Estimating the demand curve •  Session 14: Choosing linear or log demand

Debriefing the Gasoline Case Great work ! All groups did well !

•  Variables: GPC: Per-capita U.S. gasoline consumption PG: Price index for gasoline Y: Per capita disposable income PNC: Price index for new cars PUC: Price index for used cars

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

-0.2 -0.15 -0.1 -0.05 0 0.05 0.1

Scatter plot of log(price) on log(Gasoline per Capita)

log(GPC)

log(PG)

Scatter plot of demand line

156

158

160

162

164

166

168

170

172

174

176

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5

dem

and

of g

asol

ine

Price of gasoline

Session 3 Group work [E4-6]:

Comments?

This Session: Demand & Supply

Consumer Demand

1.  The Cola Wars: The Elasticity of demand

2.  Connecting the dots: linear demand and log-linear demand

3.  The Elasticity Quiz

4.  Own-price elasticity, cross-price elasticity, income elasticity BMW and McDonald’s

5.  Really connecting the dots: How can I get the whole demand curve?

Next Session Costs !

Wrap up •  Own-Price elasticity is a measure of the responsiveness of demand to own price.

•  Inelastic, Unit-elastic, Elastic demand.

•  Cross-Price elasticity is a measure of the responsiveness of demand to other products’ prices.

•  Complements, substitutes.

•  Income elasticity is a measure of the responsiveness of demand to income. •  Inferior, Normal, and Luxury goods.

•  Own-Price change vs other prices and income changes •  A change in the good’s price causes a movement along the demand curve.

•  A change in income or other products’ prices causes a shift of the demand curve.

•  Demand estimation •  Use statistical data to estimate your demand curve

Next Session: Production and Costs •  Course Guide Readings.

•  Chapter 4.

•  Readings. •  Kaiser makes a bundle by reselling power, Seattle Post, 2000. •  Long-run fixed costs in the cellular industry •  Vodafone, Telefonica ink deal to share network infrastructure, MarketWatch, 2009.

•  Recommended Exercises. •  Exercises 4.3 to 4.8 in the Course Guide.

•  Some ideas to watch for:

1.  Long-run fixed costs can be a source of economies of scale 2.  Economies of scale imply efficiency gains from mergers

Read Only if Interested – Not part of the Course • Choosing between

the log demand curve and the linear demand curve.