Market Demand and the Pricing Decision Session 3 Professor Dermot McAleese

OUTLINE  Rational consumer  Market demand curve  Elasticities of demand  Estimating the demand curve  Pricing decision

WHAT IS A RATIONAL CONSUMER? The rational individual behaves in a way which most people would consider an acceptable approximation of reality – they maximise utility  Assumptions  comparability  non-satiation  consistency  convexity  independent utilities  Challenges to assumptions  insufficient information to rank preferences  uncertain utility from the consumption of a particular good or service  satisfaction obtained from the consumption of a good because others are unable to afford it

The market demand curve is derived by the addition of individual demand curves in a process of lateral summation. THE MARKET DEMAND CURVE Individual JMarket demandIndividual H RS HH’ JOJ’O O P P1P1 K K’

 Determinants  range of available goods  definition of the product  share of spending in consumer’s budget  time period PRICE ELASTICITY OF DEMAND

 luxury goods (E > 1)  necessities (0 < E <1)  inferior goods (E < 0) INCOME ELASTICITY OF DEMAND

 substitutes  complements …within the relevant price range CROSS-PRICE ELASTICITY OF DEMAND

Table. 1 Price and income elasticities for the service sector Source: R.E. Falvey and N. Genmell, ‘Are services income-elastic?: some new evidence’, Review of Income and Wealth, September 1996.

Table. 2 Consumption of alcoholic beverages: short- run and long-run elasticities for beer, spirits and wine in Canada Source: J. Johnson et al., ‘Short-run and long-run elasticities for Canadian consumption of alcoholic beverages’, Review of Economics and Statistics (February 1992).

ESTIMATING A DEMAND FUNCTION Think of a demand function of general form: Q i =  0 +  1 Y -  2 P i +  3 P s -  4 P c +  5 Z+ e where: Q i = quantity demanded of good i P i = price of good i P s = price of substitute(s) P c = price of complement(s) Z = other relevant determinants of demand e = error term representing random factors

 Identify independent variables: income, own price, price of substitutes and complements, other influences  Decide on form of function: linear, log linear, translog; lag structure; prior constraints  Determine statistical estimation techniques: ordinary least squares is one of a large number of possible estimation techniques  Derive parameters: often reported as short-term and long-term elasticities  Evaluate results and cross-check with other procedures: surveys, marketing tests, managers' opinions  Set up different scenarios of future Y, P, and Z and use simulations to derive forecasts for Q Then follow these steps:

WHY DEMAND ANALYSIS IS USEFUL TO BUSINESS  Forecasting and projecting trends in demand  Price forecasting  Estimating the incidence of tax  Market segmentation and pricing  Defining the market through cross elasticities  Understanding market structure

 Marginal revenue curve (finding the price that will maximise revenue)  Market segmentation (separating high and low price elasticity segments; different prices to different groups of consumers)  Finding a market niche (to escape constraints of prefect competition and to make the demand curve inelastic to some degree)  Competitors’ reactions (price wars and non-price competition) PRICE ELASTICITIES AND THE PRICING DECISION

MARKET SEGMENTATION O MR D Q P 5 6 E(P)=1 10 E(P)<1 E(P)>1