1. Customer Power Economics of Elasticity of Demand David J. Bryce copyright 2000, 2002 David J. Bryce copyright 2000, 2002 Managerial Economics 387 The Economics of Strategy Managerial Economics 387 The Economics of Strategy

2. Nile Hatch © 1996, 2000, 2002 Exploring Industry Structure RivalrybetweenCompetitorsRivalrybetweenCompetitors Threat of PotentialEntrants PotentialEntrants Customer Power & PreferencesCustomer Preferences ThreatofSubstitutesThreatofSubstitutes Bargaining Power of SuppliersBargaining Suppliers

3. Nile Hatch © 1996, 2000, 2002 Customer Power & Preferences Customers influence industry performance through –Their ability to exercise bargaining power (industrial markets with a few firms) –Differences in and strengths of preferences (elasticity of demand) We will first focus our analysis on the strength of customer preferences in the form of customer demand and price elasticities. Customers influence industry performance through –Their ability to exercise bargaining power (industrial markets with a few firms) –Differences in and strengths of preferences (elasticity of demand) We will first focus our analysis on the strength of customer preferences in the form of customer demand and price elasticities.

4. Nile Hatch © 1996, 2000, 2002 Sources of Customer Power Buyers are sensitive to prices, product quality, and/or product characteristics –Products sold to buyers are undifferentiated –Many substitute products are available –Products are a large fraction of customer’s final costs –Buyers are not earning significant economic profits Customer is relatively important to our firm –Low switching costs –Information asymmetry with customers –Large purchasing volumes by customers Buyers are sensitive to prices, product quality, and/or product characteristics –Products sold to buyers are undifferentiated –Many substitute products are available –Products are a large fraction of customer’s final costs –Buyers are not earning significant economic profits Customer is relatively important to our firm –Low switching costs –Information asymmetry with customers –Large purchasing volumes by customers

5. Nile Hatch © 1996, 2000, 2002 Sensitivity to Prices Price Elasticity of Demand The rate at which quantity demanded falls as price rises is defined by the price elasticity of demand. Demand elasticity defines sensitivity to price in terms of percentage changes. –Let the subscript 0 denote starting points, 1 denote new values, and  denote changes in value. –Then the elasticity is The rate at which quantity demanded falls as price rises is defined by the price elasticity of demand. Demand elasticity defines sensitivity to price in terms of percentage changes. –Let the subscript 0 denote starting points, 1 denote new values, and  denote changes in value. –Then the elasticity is

6. Nile Hatch © 1996, 2000, 2002 Own Price Elasticity of Demand |  < 1 implies inelastic demand |  = 1 implies unitary elasticity |  > 1 implies elastic demand Interpreting elasticity – a one percent increase in price results in an  % decrease in quantity demanded Consider some examples –Textbooks– Water – Diamonds –Mercedes-Benz– Milk – Air |  < 1 implies inelastic demand |  = 1 implies unitary elasticity |  > 1 implies elastic demand Interpreting elasticity – a one percent increase in price results in an  % decrease in quantity demanded Consider some examples –Textbooks– Water – Diamonds –Mercedes-Benz– Milk – Air

7. Nile Hatch © 1996, 2000, 2002 Own-Price Elasticity of Demand and Total Revenue Elastic – an increase (a decrease) in price leads to a decrease (an increase) in total revenue Inelastic – increase (a decrease) in price leads to an increase (a decrease) in total revenue Unitary – total revenue is maximized at the point where demand is unitary elastic Elastic – an increase (a decrease) in price leads to a decrease (an increase) in total revenue Inelastic – increase (a decrease) in price leads to an increase (a decrease) in total revenue Unitary – total revenue is maximized at the point where demand is unitary elastic

8. Nile Hatch © 1996, 2000, 2002 Factors Affecting Own Price Elasticity Available substitutes – the more substitutes available for the good, the more elastic the demand. Time – demand tends to be more inelastic in the short term than in the long term because time allows consumers to seek out available substitutes. Expenditure share – goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes. Available substitutes – the more substitutes available for the good, the more elastic the demand. Time – demand tends to be more inelastic in the short term than in the long term because time allows consumers to seek out available substitutes. Expenditure share – goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

9. Nile Hatch © 1996, 2000, 2002 Uses of Elasticities Pricing Managing cash flows Impact of changes in competitors’ prices Impact of economic booms and recessions Impact of advertising campaigns Pricing Managing cash flows Impact of changes in competitors’ prices Impact of economic booms and recessions Impact of advertising campaigns

10. Nile Hatch © 1996, 2000, 2002 Elasticity Calculations 1 1 2 2 3 3 4 4 5 5 1 1 2 2 3 3 4 4 5 5 Price Quantity 11 11 22 22

11. Nile Hatch © 1996, 2000, 2002 Example 1: Pricing and Cash Flows According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64 AT&T needs to boost revenues in order to meet it’s marketing goals To accomplish this goal, should AT&T raise or lower it’s price? According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64 AT&T needs to boost revenues in order to meet it’s marketing goals To accomplish this goal, should AT&T raise or lower it’s price?

12. Nile Hatch © 1996, 2000, 2002 Answer: Lower price! Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.

13. Nile Hatch © 1996, 2000, 2002 Example 2: Quantifying the Change If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

14. Nile Hatch © 1996, 2000, 2002 Answer Calls would increase by 25.92 percent!

15. Nile Hatch © 1996, 2000, 2002 Buyers Have Power When They Have Elastic Demand – sensitive to prices Increasing elasticity is caused by –Products with few unique features ( undifferentiable) –Buyers whose expenditures on our product are a large share of their total expenditures –Buyers of an input into an elastic product Decreasing elasticity is caused by –Limited ability to compare substitutes –Buyers pay only a fraction of the cost –High switching costs Increasing elasticity is caused by –Products with few unique features ( undifferentiable) –Buyers whose expenditures on our product are a large share of their total expenditures –Buyers of an input into an elastic product Decreasing elasticity is caused by –Limited ability to compare substitutes –Buyers pay only a fraction of the cost –High switching costs

16. Nile Hatch © 1996, 2000, 2002 Responding to Increasing Buyer Power Reduce buyer power by increasing buyer own price elasticity of demand –Advertising/branding –New product introductions –Increase quality Reduce buyer bargaining power –Vertically integrate downstream –Alliances and long-term contracts –Increase home industry concentration Reduce buyer power by increasing buyer own price elasticity of demand –Advertising/branding –New product introductions –Increase quality Reduce buyer bargaining power –Vertically integrate downstream –Alliances and long-term contracts –Increase home industry concentration

17. Nile Hatch © 1996, 2000, 2002 Summary and Takeaways Customers and substitutes threaten to reduce our prices; suppliers threaten to raise our costs. Their probable success can be measured using elasticity. General knowledge of elasticities is a good substitute for specific knowledge of the demand curve. What role will the Internet play in providing information about elasticities? Customers and substitutes threaten to reduce our prices; suppliers threaten to raise our costs. Their probable success can be measured using elasticity. General knowledge of elasticities is a good substitute for specific knowledge of the demand curve. What role will the Internet play in providing information about elasticities?