Managerial Economics Lecturer: Jack Wu Lecture Two: Demand Managerial Economics Lecturer: Jack Wu Two fundamental building blocks of managerial economics: demand costs

Individual Demand Curve, I 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 Curve Price Quantity ($ per movie) (movies per month) 10.00 0 7.50 1 5.00 2 2.50 4 0.00 7

Individual Demand Curve 10 7.50 Price ($ per movie) 5 individual demand curve 2.50 1 2 4 7 Quantity (Movies a month)

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 price  quantity view: the way to construct individual demand curve; quantity  price view: very useful in pricing policy; indicates the maximum 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 Hoover is British home appliance manufacturer; in 1992, was owned by Maytag Autumn 1992 promotion: for a £100 appliance, Hoover’s effective price was - £300; what is quantity demanded at negative price? Maytag sacked senior managers; sold business to Italian company.

Demand and Income Changes in income normal product – demand increases with income inferior product – demand falls with income Graphically, changes in price – movement along demand curve income – shift of entire demand curve Examples: fast food chains & upscale restaurants afternoon matinees & evening shows public vis-à-vis private transportation music cassettes vis-à-vis CDs Broad product categories tend to be normal, particular products within the categories may be inferior distinction between normal and inferior products is important for business strategy when the economy is growing/contracting demand for normal products is relatively higher in richer countries, while the demand for inferior products is relatively higher in poorer countries

Demand and Other Factors prices of related products substitutes complements advertising Substitutes: chicken/beef video/movie sound cards/sound chips Complements: meat/wine movie/popcorn microprocessor/memory/disk drive automobile/gasoline Durability: cross-ply  radial tyres music cassettes  audio CDs  MP3 (too durable?)

Complement 10 demand curve with $1 popcorn 7.50 Price ($ per movie) 5 2.50 1 2 7 Quantity (Movies a month)

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 Canadians bought more of both formats relatively more CDs Economic explanations: Canadians enjoyed higher income price of CDs relatively higher in Canada -- not consistent with the observed difference, unless music cassettes were relatively inferior product

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 factors: higher live attendance boosts sales of concession items improves TV picture and audience other factors in demand fans’ income weather complements – parking facilities, public transportation

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% Median household income grew more slowly than average new car price  demand for new cars grew more slowly.

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 Market demand = horizontal summation of individual demands Horizontal summation: at every price, add the quantities demanded by each person in the market; can show through table also show graphically (section 5 of text)

Market Demand Market demand = horizontal summation of individual demands Market Demand Factors --own price (move along the demand curve) --other factors (shift the demand curve) _ income level and distribution _ prices of related goods _ population _ demographics _ consumer tastes Market demand factors same as individual demand factors plus: distribution of income population and demographic factors, eg, Japan has aging population compared with China --> differences in demand for health care and pharmaceuticals

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. Business applications of buyer surplus – pricing: package deals two-part tariff Essential objective: to extract all buyer surplus

Individual Buyer Surplus 10 individual buyer surplus at $2.50 price d a 7.50 Price ($ per movie) individual demand (marginal benefit) curve 5 b e c c f 2.50 h The more you buy, the more you save? Total benefit (the benefit yielded by all the units that the buyer purchases) = area under the buyer's demand curve up to an including the last unit purchased Maximum price that a seller can charge is the buyer's total benefit Buyer surplus (the difference between a buyer's total benefit from some quantity of purchases and her or his actual expenditure) = area under demand curve and above price line g j 1 2 4 7 Quantity (Movies a month)

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 Buyer surplus concept gives exact way of measuring buyer’s gain from price cut; simple view that gain is no. of units x saving on each unit is wrong (only works with completely inelastic demand)

Package Deal charge buyer just a little less than her/his total benefit leave buyer with almost zero surplus Examples of package deals: AOL unmetered service for $21.95/month mobile telephone service -- $X for Y minutes per month car rental – “200 free kilometers”

Two-Part Tariff fixed payment usage charge eg, advertisng area under the demand curve and above the usage charge leaves zero buyer surplus Examples: mobile phone service: $Y for X free minutes plus p per minute for additional calls golf club: monthly membership fee plus additional green fee credit card: annual fee plus interest charges

Business Demand, I Business demands items as inputs into further production, not for consumption finished/semi-finished components -- raw materials and energy labor and other services capital Simple textbooks suppose that businesses are completely vertically integrated, and buy only raw materials, labor, and capital; actually, large portion of purchases are finished/semi-finished products, eg, machine tools, trucks, electrical components, parts other services: information technology, advertising, logistics, transportation

Business Demand, II Demand for inputs depends on quantity of final output prices of complements and substitutes in production Quantity of final output: When demand for GM automobiles drops, GM will cut back on purchases of all inputs; GM’s demand for inputs is derived from demand for GM products. Inputs may be substitutes, eg, using machines or workers to sort packages, advertising on TV/internet complements, eg, trucks and drivers, advertising and production

Business Demand Curve marginal benefit = increase in revenue arising from an additional unit of the input diminishing marginal benefit  downward-sloping demand Similarities between consumer and business demand curve change in price  movement along the curve change in other factors  shift of the curve

Automated Teller Machines increase in wages  teller service became increasingly costly banks used ATMs to substitute for tellers compare use of ATMs in US vs India Retail bank: major service is dispensing cash to customers; traditionally, cash dispensed by tellers operating within the bank office. Eventually, used ATMs to provide better service outside bank premises 24-hour service US vs India: demand side: cost of labor should be high infrastructure: need reliable telecommunications network

GM: What metal to use? aluminium vis-à-vis steel auto weight  price fuel consumption emissions price Market conveys information from end-user to manufacturer: End-user concerned about fuel consumption  auto manufacturer responds by supplying lighter car. However, aluminium is more expensive than steel

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.

Discussion Question 2 Suppose that a typical household's demand for long-distance calls is represented by the equation, D = 200 - 4p + 0.4Y, where D is the quantity demanded in minutes a month, p is the price of calls in cents per minute, and Y is the household's income in thousands of dollars a year. Assume that Y = 100.

Discussion Question 2 continued Draw the household's demand curve. How many minutes will the household buy at a price of 25 cents a minute? What is the maximum lump sum that a long-distance carrier can charge the household for a package of 140 minutes of calls?