Demand Analysis and Strategy Paul C. Godfrey Mark H. Hansen Marriott School of Management

What strategists need to know: What determines demand? How sensitive is demand? How can managers work with/influence demand to create competitive advantage?

What determines (drives) demand?

The law of demand In general, the cheaper a product/service is, the more people will buy. Based on declining marginal utility Demand curves are downward sloping Exceptions to the law of demand: Will lower priced products always sell more? No, Veblen (conspicuous consumption) goodsprice is a signal of quality and a direct determinant of utility Giffen goods consumption goes up in difficult times and price follows

Market demand curve A schedule of different consumers willingness to pay Shows response to change in priceand nothing else Shows the amount of a good that will be purchased at alternative prices. Quantity D Price

Determinants of Demand Own Price Advertising Commodity status Consumer expectations Income Need Population changes Prices of substitutes Prices of complements Tastes and preferences Technological changes these are all demand shifters

The demand function The demand equation Q x d = f(P x, P Y, M, H,) Q x d = quantity demand of good X P x = price of good X P Y = price of a substitute/complement good Y M = income H = all other variables affecting demand

Substitutes and Complements Substitute goods:an increase (decrease) in the price of good Y leads to an increase (decrease) in the demand for good X Complementary goods: an increase (decrease) in the price of good Y leads to a decrease (increase) in the demand for good X Coke & Pepsi Tortilla Chips & Salsa

Managing Demand: Price Changes $ Quantity D0D A 7 6 B Graphic compliments of David Bryce

$ Quantity D0D0 Managing Demand: Shifting Demand Graphic compliments of David Bryce D1D1 B B1B1

Managing Determinants of Demand Own Price Advertising Commodity status Consumer expectations Income Need Population changes Prices of substitutes Prices of complements Tastes and preferences Technological changes

Example: Estimating a demand curve A retailer wants to know the demand curve for ties Observes that over the past 2 weeks, with prices at $20, 110 ties have sold Raises price to $25 for next two weeks without announcement; sells 100 ties Reduces price to $15 for following two weeks; sells 140 ties Adapted from David Bryce © 2005

Two Week Demand for Ties Example: Estimating a demand curve Adapted from David Bryce © 2005

Two-Week Demand for Ties Quantity of ties sold Price of ties sold Example: Estimating a demand curve Adapted from David Bryce © 2005

Total Revenue for Ties Based on q = 197 – 4p Note: To get total revenue from the demand curve, multiply p q e.g., p q = p ( p) p q = 197p – 4p 2

Total Revenue (R ) = p q Thus, R = p (197 – 4p) = 197p – 4p 2 Now find where slope of revenue function is at a maximum by taking derivative and setting equal to 0 dR/dp = 197 – 8p = 0 Solve for p -8p = -197 p = -197/-8 = $24.63 Maximizing Total Revenue for Ties

How can managers use/ influence demand to create competitive advantage?

Price discrimination The demand schedule represents willingness to pay of different customer groups, or segments If groups can be segmented according to discrete and identifiable benefits, and If products can be configured to contain (omit) features, then... Managers can increase total revenues and profits

Price issues price discrimination Pricing High: Selling 1 Million units to high value zealots = $60 Million Pricing Low: Selling 1 Million zealots and 1 Million units to the lay users = $40 Million Can you price for $80 Million in revenue? Value to customer

Price discrimination strategies The internet/ flexible manufacturing allows ultimate product customization and personalized pricing (e.g., Dell) Differentiate versions based on product attributes (e.g., WSJ on- line edition, current vs. archival search) Differentiate based on customer behaviorsupermarkets fresh values and airline skymiles Use promotions to measure price elasticity among and between groups

Isolate the demand curve Products that are commodities can be perfectly summed to a market demand curve Products that are customized cannot –Monopolistic competition (the demand for iPods is not the demand for Zune) –Idiosyncratic markets (professional athletes, entertainers, high end homes) Firms can take several steps to isolate demand from the general market –Brand building and advertising –Switching costs –Lock-in and legacy features –Quality of performance/ design issues –Supply chain integration (e.g., JIT)

Understand and look for consumer surplus The demand curve represents consumers willingness to pay The consumer paying P* at point A, is paying exactly what they are willing to pay All consumers above point A are paying less than they are willing to pay, and get a surplus Consumers below point A on the demand curve do not buy Remember, strategy is about creating more surplus for everyone $ Quantity D0D0 P* A Consumer Surplus

Understand the investment horizon Understand the only short-term tool is price –Price reductions –Price-based advertising The longer terms tools are all longer term –Technology development (you and your competitors) –Commodity status of your offering (brand or other differentiation) –Advertising/ marketing that changes (captures) tastes and preferences Build strategy around long term levers, tactics around short term

How sensitive is demand? (come back next time)