1. David Bryce © 1996-2002 Adapted from Baye © 2002 Sources of Demand MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

2. David Bryce © 1996-2002 Adapted from Baye © 2002 Exercise I will name possible prices for a Reese’sI will name possible prices for a Reese’s As I name a price, please tell me how many Reese’s you are willing to purchase at that price, right now.As I name a price, please tell me how many Reese’s you are willing to purchase at that price, right now. This exercise is an offer to sell and it is real. I reserve the right to call in the cash from any individual at any time who indicates their willingness to buy (you can bring me the cash later if you don’t have it on hand!).This exercise is an offer to sell and it is real. I reserve the right to call in the cash from any individual at any time who indicates their willingness to buy (you can bring me the cash later if you don’t have it on hand!). I will name possible prices for a Reese’sI will name possible prices for a Reese’s As I name a price, please tell me how many Reese’s you are willing to purchase at that price, right now.As I name a price, please tell me how many Reese’s you are willing to purchase at that price, right now. This exercise is an offer to sell and it is real. I reserve the right to call in the cash from any individual at any time who indicates their willingness to buy (you can bring me the cash later if you don’t have it on hand!).This exercise is an offer to sell and it is real. I reserve the right to call in the cash from any individual at any time who indicates their willingness to buy (you can bring me the cash later if you don’t have it on hand!).

3. David Bryce © 1996-2002 Adapted from Baye © 2002 Class Demand For Reese’s Quantity Demanded Price

4. David Bryce © 1996-2002 Adapted from Baye © 2002 Market Demand Curve Shows the amount of a good that will be purchased at alternative prices. Law of Demand –The demand curve is downward sloping. Quantity D D Price

5. David Bryce © 1996-2002 Adapted from Baye © 2002 Determinants of Demand Income Prices of substitutes Prices of complements Advertising Population changes Consumer expectations Income Prices of substitutes Prices of complements Advertising Population changes Consumer expectations

6. David Bryce © 1996-2002 Adapted from Baye © 2002 The Demand Function An equation representing the demand curve 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 good Y. –M = income. –H = any other variable affecting demand An equation representing the demand curve 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 good Y. –M = income. –H = any other variable affecting demand

7. David Bryce © 1996-2002 Adapted from Baye © 2002 Change in Quantity Demanded Price Quantity D0D0 D0D0 A to B: Increase in quantity demanded 4 4 10 A A 7 7 6 6 B B

8. David Bryce © 1996-2002 Adapted from Baye © 2002 What could lead to a change in quantity demanded? Only a change in price Why? –Because a given demand curve simply reflects preferences under a given set of conditions—it is a picture of stationary preferences –When conditions change, preferences often do as well, so that the entire relationship of quantity to price also changes (shift in demand) Only a change in price Why? –Because a given demand curve simply reflects preferences under a given set of conditions—it is a picture of stationary preferences –When conditions change, preferences often do as well, so that the entire relationship of quantity to price also changes (shift in demand)

9. David Bryce © 1996-2002 Adapted from Baye © 2002 Price Quantity D0D0 D0D0 Change in Demand 6 6 7 7 13 D1D1 D1D1 D 0 to D 1 : Increase in Demand

10. David Bryce © 1996-2002 Adapted from Baye © 2002 What could lead to an increase in demand (shift in demand)? A change in any of the determinants of demand: –Income –Prices of substitutes –Prices of complements –Advertising –Population changes –Consumer expectations A change in the quality or characteristics of a product, even if the changes are small A change in any of the determinants of demand: –Income –Prices of substitutes –Prices of complements –Advertising –Population changes –Consumer expectations A change in the quality or characteristics of a product, even if the changes are small

11. David Bryce © 1996-2002 Adapted from Baye © 2002 Where do demand curves come from? Experiments –Raise and lower price systematically over time and watch what happens to quantity –Limitation: hard to control for changes in external factors (you may get a “wiggly” curve!) Market Research –Surveys in which consumers are asked to tradeoff bundles of goods against price or other bundles in order to determine relative value and demand at given prices –Limitation: Expensive; sampling bias; perception bias— spending real money is different than checking boxes on a survey Experiments –Raise and lower price systematically over time and watch what happens to quantity –Limitation: hard to control for changes in external factors (you may get a “wiggly” curve!) Market Research –Surveys in which consumers are asked to tradeoff bundles of goods against price or other bundles in order to determine relative value and demand at given prices –Limitation: Expensive; sampling bias; perception bias— spending real money is different than checking boxes on a survey

12. David Bryce © 1996-2002 Adapted from Baye © 2002 Where do demand curves come from? Regression analysis –Attempt to glean from multiple observations in multiple settings (geographic, store, product, etc.) the relationship between price and quantity Not always goods that are exactly like Do not always have observations on the extremes of the curve—extrapolation required –Must control for the amount supplied (otherwise may get an upward sloping demand curve!) –Limitation: Data is hard to get and you must assume that external factors are stable across observations or control for these in the statistics; CAUTION: If you don’t know what you’re doing, you could go wildly astray Regression analysis –Attempt to glean from multiple observations in multiple settings (geographic, store, product, etc.) the relationship between price and quantity Not always goods that are exactly like Do not always have observations on the extremes of the curve—extrapolation required –Must control for the amount supplied (otherwise may get an upward sloping demand curve!) –Limitation: Data is hard to get and you must assume that external factors are stable across observations or control for these in the statistics; CAUTION: If you don’t know what you’re doing, you could go wildly astray

13. David Bryce © 1996-2002 Adapted from Baye © 2002 Where do demand curves come from? If all else fails – Use Intuition –“Sniff” the market by looking at how other similar products seem to be doing –Ask your close friends and neighbors how much they would pay –Pray about it (Limitation: faith) –Any other possible qualitative approach you can think of –Believe it or not, you’re likely to get close … and others are doing the same thing in practice Bottom line: No technique is fool-proof! If all else fails – Use Intuition –“Sniff” the market by looking at how other similar products seem to be doing –Ask your close friends and neighbors how much they would pay –Pray about it (Limitation: faith) –Any other possible qualitative approach you can think of –Believe it or not, you’re likely to get close … and others are doing the same thing in practice Bottom line: No technique is fool-proof!

14. David Bryce © 1996-2002 Adapted from Baye © 2002 Estimating a curve example: A retailer wants to know the demand curve for tiesA retailer wants to know the demand curve for ties –Observes that over the past 2 weeks 100 ties have sold at $25 –Reduces price to $20 for next two weeks without announcement; sells 120 ties –Reduces price to $15 for following two weeks; sells 160 ties A retailer wants to know the demand curve for tiesA retailer wants to know the demand curve for ties –Observes that over the past 2 weeks 100 ties have sold at $25 –Reduces price to $20 for next two weeks without announcement; sells 120 ties –Reduces price to $15 for following two weeks; sells 160 ties

15. David Bryce © 1996-2002 Adapted from Baye © 2002 Estimating a curve example: Two Week Demand for Ties

16. David Bryce © 1996-2002 Adapted from Baye © 2002 Estimating a curve example: Two Week Demand for Ties

17. David Bryce © 1996-2002 Adapted from Baye © 2002 Consumer Surplus – t he value consumers get from a good but do not have to pay for “I got a lousy deal!” That car dealer drives a hard bargain! I almost decided not to buy it! They tried to squeeze the very last cent from me! Total amount paid is close to total value. Consumer surplus is low. “I got a lousy deal!” That car dealer drives a hard bargain! I almost decided not to buy it! They tried to squeeze the very last cent from me! Total amount paid is close to total value. Consumer surplus is low. “I got a great deal!” That company offers a lot of bang for the buck! Dell provides good value. Total value greatly exceeds total amount paid. Consumer surplus is large. “I got a great deal!” That company offers a lot of bang for the buck! Dell provides good value. Total value greatly exceeds total amount paid. Consumer surplus is large.

18. David Bryce © 1996-2002 Adapted from Baye © 2002 Price Quantity D D 10 8 8 6 6 4 4 2 2 1 2 3 4 5 Consumer Surplus: the value received but not paid for Consumer Surplus: the value received but not paid for Consumer Surplus: The Discrete Case

19. David Bryce © 1996-2002 Adapted from Baye © 2002 Consumer Surplus: The Continuous Case Price $ Quantity D D 10 8 8 6 6 4 4 2 2 1 2 3 4 5 Value of 4 units Value of 4 units Consumer Surplus Consumer Surplus Total Cost of 4 Units