PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Demand and Revenue Management 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CHAPTER 12

Price, Sales, and Consumer Choice Profit –Revenue minus cost Revenue –Depends on the customer Consumer behavior - making choices –Choices reveal preferences –If people spend money on something and not on something else Revealing their preferences 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Price, Sales, and Consumer Choice Law of demand –The quantity of a good or service that is purchased –Will decline as the price of that good or service rises –Everything else unchanged 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Price elasticity of demand –Magnitude by which consumers alter the quantity of some product they purchase –In response to a change in the price of that product The more price-elastic demand is –The more responsive consumers are to a price change 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Price elasticity of demand –Percentage change in the quantity demanded of a product –Divided by the percentage change in the price of that product e d = %ΔQ / %ΔP –%ΔQ = percentage change in quantity demanded –%ΔP = percentage change in price 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Price elasticity of demand –If between -1 and - ∞: elastic demand –If = -1: unit elastic demand –If between -1 and 0: inelastic demand Demand curve –Illustrates the quantity of an item that will be purchased at each price –Relationship between the price and quantity demanded of a good or service 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Shape of a demand curve –Depends on the price elasticity of demand Perfectly elastic demand curve –Horizontal line Consumers can purchase any quantity they want at the single prevailing price –Even the smallest price change Consumers switch to the producer with the lowest price 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Perfectly inelastic demand curve –Vertical line Consumers cannot or will not change the quantity of a good they purchase when the price of that good is changed Downward sloping demand curve –The steeper – the less elastic 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 12.1 The demand curve is a graphic relationship between quantity demanded and price. The graph is drawn with price on the vertical axis and quantity on the horizontal axis. (a) Perfectly elastic demand: Demand is so sensitive to price that even an infinitesimal change leads to a total change in quantity demanded. (b) Perfectly inelastic demand: The quantity demanded is the same no matter the price. Demand is completely insensitive to price. (c) Alternative demand curves: and D 2 represents straight downward-sloping demand curves. D 2 is said to be more elastic than D 1 because at every single price the elasticity of demand is higher at D 2 than D 1. Demand Curves 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Price Elasticity and Revenue –Total revenue, TR = P × Q –Dollar value of sales –Price of a product multiplied by the quantity sold As price is increased, total revenue: –Increases if demand is inelastic –Decreases if demand is elastic –Does not change if demand is unit-elastic 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Elasticity of demand depends on –How many substitutes and how good of substitutes they are More substitutes – more elastic demand Commoditization – price elasticity of demand is very large –Period over which we measure the price elasticity Longer – more elastic demand 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 12.2 Demand is perfectly elastic for Demand 1. The firm cannot charge more without losing all of its customers because the product is a commodity—there are many perfect substitutes. The firm undertakes an advertising campaign to change the image of the product. If successful, consumers begin to think the product is not a commodity, that there are not lots of perfect substitutes. The demand curve then becomes steeper, as with Demand 2. Changing Price Elasticity 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Price Elasticity of Demand for Gasoline Price elasticity of demand for gasoline, US –Over a period of one year or less = − % hike in the price of gasoline lowers quantity demanded by 2.6% –Long-run = − % hike in gasoline causes quantity demanded to decline by 5.8% 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Price Elasticity of Demand for Gasoline 10% increase in real price of fuel –Volume of traffic decline By 1% within a year By 3% in longer run (5 years) –Volume of fuel consumed decreases By 2.5% within a year By 6% in the longer run –Efficiency of use of fuel increases By 1.5% within a year By 4% in the longer run 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Demand Elasticities Other elasticity measures –Income elasticity of demand –Cross price elasticity of demand –Advertising elasticity –Promotion elasticity 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 12.3 The demand curve is a relation between price and quantity demanded, everything else held constant. The things held constant are income, advertising, expectations, tastes, preference, and anything else that could affect demand. When one of these changes, the demand curve shifts. For instance, Demand 2 represents demand following an increased income. The distance the demand curve shifts is reflective of the income elasticity of demand. Changes Other than Price 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Demand Elasticities U.S. economy –Has grown over the years –The growth has not been at a steady pace Business cycles –Upswing in business activity Incomes are growing Sales of many products are rising –Downswing Incomes are not rising Sales may be declining 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 12.4 The real output or GDP of the U.S. economy each year is pictured. The picture points out two things: The total output has grown over the years, and the growth has not been a steady rise. Economic Growth and the Business Cycle 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 12.5 Taking out the growth part of Figure 12.4 leaves just the cycles. Business Cycle 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Demand Elasticities Income Elasticity of Demand –Responsiveness of consumer purchases to income changes –Percentage change in demand Divided by the percentage change in income Everything else held constant 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Demand Elasticities Luxury good –Very high income elasticity (>1.0) 1% increase in income will lead to a greater than 1% rise in demand As long as the economy is growing –And incomes are rising –Sales are rising 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Demand Elasticities Normal good –Positive but <1 income elasticity –As income rises, demand rises –Cyclical goods Inferior good –Negative income elasticity –As income rises, demand falls –Countercyclical goods 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Demand Elasticities Complements –Items used together Substitutes –Items used in place of each other Cross elasticity of demand –Measures whether goods and services are complements or substitutes 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Demand Elasticities Cross elasticity of demand –Percentage change in demand of one good Divided by the percentage change in the price of a related good –Close substitutes: high positive cross elasticities –Complements: negative cross-price elasticities –Unrelated goods: zero cross-price elasticity 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Estimates Computer technology –Much better information about customers and the elasticities of demand –Enabling many “low-margin” industries to improve their margins By knowing their customers better –Firms are increasing profits because they better understand the customer 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Estimates Elasticity models –Daily evaluation of pricing factors Site by site That are stored on a running database –Historical price, volume, and competitive data –Continual fine-tuning accomplished through daily data updates 26 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity Estimates Gasoline - typical elasticity estimates –For a single retailer –According to the pricing company MPSI Systems Inc. –6 for regular –4.5 for mid-grade –3 for premium 27 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.