Consumer Behavior and Demand Analysis

2016/11/30

Managerial Economics

Part 3

Fall 2016

The Role of Demand Analysis  Demand

analysis serves three major managerial objectives. 1. It provides the insights necessary for marketing teams to effectively manage demand. 2. It helps forecast unit sales to inform operations decisions. 3. It projects the revenue portion of a firm’s cash flow stream for financial planning. planning.

 Before

making making demand analysis, the theory of consumer choice should be introduced.

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Outline • The Theory of Consumer Behavior • Demand Analysis: Elasticity and Demand » Elasticity in Economics: a numerical measure of the responsiveness of Q to one of its determinants. D

‒ Price Elasticity of Demand ‒ Income Elasticity of Demand ‒ Cross-Price Elasticity of Demand

The Theory of Consumer Behavior Peopl ople e f ace tr ade adeof offf s • Recall one of the Seven Principles: Pe . » Buying more of one good leaves less income income to to buy other goods. » Working ng more more hours means more income and more consumption, but less leisure time. time. » Redu Reduccing ing saving saving allows allows more consumption consumption today today but reduces future consumption.

• This section explores how consumers make choices like these. » What the Consumer Can Afford: The Budget Constraint » What the Consumer Wants: Preference Preferences, s, Utilities Utilities and and Indifference Curves » What the Consumer Chooses: Utility Optimization

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Outline • The Theory of Consumer Behavior • Demand Analysis: Elasticity and Demand » Elasticity in Economics: a numerical measure of the responsiveness of Q to one of its determinants. D

‒ Price Elasticity of Demand ‒ Income Elasticity of Demand ‒ Cross-Price Elasticity of Demand

The Theory of Consumer Behavior Peopl ople e f ace tr ade adeof offf s • Recall one of the Seven Principles: Pe . » Buying more of one good leaves less income income to to buy other goods. » Working ng more more hours means more income and more consumption, but less leisure time. time. » Redu Reduccing ing saving saving allows allows more consumption consumption today today but reduces future consumption.

• This section explores how consumers make choices like these. » What the Consumer Can Afford: The Budget Constraint » What the Consumer Wants: Preference Preferences, s, Utilities Utilities and and Indifference Curves » What the Consumer Chooses: Utility Optimization

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The Budget Constraint: What the Consumer Can Afford • Example: Hurley divides his income between two goods: fish and mangos. • A “consumption bundle” is a particular combination of the goods, e.g., 40 fish & 300 mangos. • Budget constraint: the limit on the consumption bundles that a consumer can afford.

© 2015 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.

Consumer’s Budget Line • Shows all possible commodity bundles that can be purchased at given prices prices with a fixed money income. income. M

PX X

PY Y

or Y

M

P X

PY

P Y

X

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The Budget Constraint

Exercise 1

Hurley’s income: $1200 per month Prices: P F = $4 per fish, P M = $1 per mango A. If Hurley spends all his income on fish, how many fish does he buy? B. If Hurley spends all his income on mangos, how many mangos does he buy? C. If Hurley buys 100 fish, how many mangos can he buy? D. Plot each of the bundles from parts A – C on a graph that measures fish on the horizontal axis and mangos on the vertical, connect the dots. © 2015 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.

The Slope of Budget Constraint From C to D,

“rise” = –200 mangos “run” = +50 fish

The slope of the b u d g e t c o n s t r a in t equals the relative price of the good on the X axis.

Quantity of Mangos

C

Slope = – 4

D

Hurley must give up 4 mangos to get one fish. Quantity of Fish © 2015 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.

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The Change of Budget Constraint Show what happens to Hurley’s budget constraint if: A. His income falls to $800. B. The price of mangos rises to P M = $2 per mango  A fall in income shifts the budget constraint down.  An increase in the price of one good pivots the

budget constraint inward.

Preferences: What the Consumer Wants  Utility An abstract measure of the satisfaction or happiness that a

consumer receives from a bundle of goods.  Marginal Utility The marginal utility of any good is the increase in utility

that the consumer gets from an additional unit of that good.

MU

U X

Di mini shin g marginal util ity : For most goods, the more of the good the consumer already has, the lower the marginal utility provided by an extra unit of that good.

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Preferences: What the Consumer Wants  Indifference curve  Also called as “equal-utility” curve  It shows consumption bundles that give the consumer the same level of satisfaction Quantity of Mangos

One of Hurley’s indifference curves

B A

I 1

A, B, and all other bundles on I 1 make Hurley equally happy: he is indifferent between them.

Quantity of Fish

Preferences: What the Consumer Wants Properties of Consumer Preferences • Completeness » For every pair of consumption bundles, A and B, the consumer can say one of the following: • A is preferred to B • B is preferred to A • The consumer is indifferent between A and B

• Transitivity » If A is preferred to B, and B is preferred to C , then A must be preferred to C

• Nonsatiation » More of a good is always preferred to less

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Indifference Map Higher indifference curves are preferred to lower ones.

Y f o y t i t n a u Q

IV III II I Quantity of X

Properties of Indifference Curves 1. Indifference curves are

downward-sloping.

Quantity of Mangos

A

- If the quantity of fish is reduced, the quantity of mangos must be increased to keep Hurley equally happy.

6 1

2. Indifference curves are

bowed inward (convex). - Hurley is willing to give up more mangos for a fish if he has few fish (A) than if he has many (B).

B

2 1

I 1

Quantity of Fish

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The Marginal Rate of Substitution Marginal rate of substitution (MRS): - the rate at which a consumer is willing to trade one good for another while keeping utility constant. - MRS falls as you move down along an indifference curve. Quantity of Mangos

MRS = Negativ e of the slope of indifference curve

A MRS = 6 1

B MRS = 2 1

I 1

Quantity of Fish

MRS and Marginal Utility M R S = N eg a t i v e o f t h e s l o p e o f i n d i f f e r en c e c u r v e

From point A to point B: Quantity of Mangos

U  MU X  X  MUY  Y 0 ＝

A MRS = 6 1

B MRS = 2 1

I 1

Quantity of Fish

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Optimization: What the Consumer Chooses The optimum is the bundle Hurley most prefers out of all the bundles he can afford.

A is the o p t i m u m : Quantity the point on the budget of Mangos constraint that touches the highest possible 1200 indifference curve.

- Hurley prefers B to A, but he cannot afford B.

B A

600

- Hurley can afford C and D, but A is on a higher indifference curve.

C D 150

300


Quantity of Fish

Optimization: What the Consumer Chooses At the optimum, slope of the indifference curve equals slope of the budget constraint:

Quantity of Mangos

Consumer opti mi zation i s another exampl e of

“thinking at the margin.”

1200

M RS = M U F/M U M = P F/P M marginal value of fish (in terms of mangos)

A

600

price of fish (in terms of mangos) 150


300

Quantity of Fish

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Optimization: What the Consumer Chooses At the optimum point A:

Quantity of Y

M RS = M U X/M U Y = P X/P Y

M U X/P X = M U Y/P Y

A

 At the optimum, the marginal

utility per dollar spent on good X equals the marginal utility per dollar spent on good Y Quantity of X

Exercise 2

Utility Maximization

A consumer’s budget constraint is $20 per day. The prices of bread and Coke is $2.5 and $2 respectively. Given the following utility table, What is the consumer’s best choice? Number of goods

of bread M U M U /P B B

of Coke M U

M U C /P C

1

20

8

60

30

2

15

6

40

20

3

12.5

5

20

10

4

10

4

16

8

5

7.5

3

8

4

6

5

2

4

2

Answer: 4 breads, 5 Cokes

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Individual Consumer Demand • An individual’s demand curve for a specific commodity relates utility-maximizing quantities purchased to market prices » Money income & prices held constant » Slope of demand curve illustrates law of demand — quantity demanded varies inversely with price

Deriving Hurley’s Demand Curve for Fish A: When P F = $4, Hurley demands 150 fish. B: When P F = $2, Hurley demands 350 fish. Quantity of Mangos

Price of Fish

A

$4

A

B B

$2

D Fish

150

350

Quantity of Fish

150

350

Quantity of Fish


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The Effects of a Price Change Initially, P F = $4

Quantity of Mangos

P M = $1

1200

initial optimum new optimum

P F falls to $2

budget constraint rotates outward, Hurley buys more fish and fewer mangos.

600 500

150

300

600 350

Quantity of Fish


The Income and Substitution Effects A fall in the price of fish has two effects on Hurley’s optimal consumption of both goods.

» Substitution effect A fall in P F makes mangos more expensive relative to fish, causes Hurley to buy fewer mangos and more fish.

» Income effect A fall in P F boosts the purchasing power of Hurley’s income, allows him to buy more mangos and more fish.

Notice: The net effect on mangos is ambiguous.

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The Income and Substitution Effects Initial optimum at A.

Quantity of Mangos

In this example, the net effect on mangos is negative.

P F falls. Substi tution effect:

from A to B, buy more fish and fewer mangos.

A

I ncome eff ect:

from B to C, buy more of both goods.

C B

Quantity of Fish


Income Effects and Substitution Effects A fall in the price of a good or service:  Income effect The change in consumption that arises because a lower price makes the consumer better off. It is represented by a movement from a lower indifference curve to a higher one.  Substitution effect The change that arises because a price change encourages greater consumption of the good that has become relatively cheaper. It is represented by a movement along an indifference curve.

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Application: Wages and Labor Supply Bu dget constr ain t

» Shows a person’s tradeoff between consumption and leisure. » Depends on how much time she has to divide between leisure and working. » The relative price of an hour of leisure is the amount of consumption she could buy with an hour’s wages. I ndi f f er ence cur ve

» Shows “bundles” of consumption and leisure that give her the same level of satisfaction.

Application: Wages and Labor Supply Carrie is awake for 100 hours per week and her wage per hour is $50. If she works a normal 40-hour week, she enjoys 60 hours of leisure and has weekly consumption of $2,000.

At the optimum, the MRS between leisure and consumption equals the wage.


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Application: Wages and Labor Supply An increase in the wage has two effects on the optimal quantity of labor supplied. » Substi tuti on eff ect (SE) : A higher wage makes leisure more expensive relative to consumption. The person chooses less leisure, i.e. , increases quantity of labor supplied. » I ncome ef f ect (I E) : With a higher wage, she can afford more of both “goods.” She chooses more leisure, i.e. , reduces quantity of labor supplied.

Application: Wages and Labor Supply For this person, SE > IE

So her labor supply increases with the wage


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Application: Wages and Labor Supply For this person, SE < IE

So his labor supply falls when the wage rises


Could This Happen in the Real World? Cases where the income effect on labor supply is very strong:

» Over last 100 years, technological progress has increased labor demand and real wages. The average workweek fell from 6 to 5 days. » When a person wins the lottery or receives an inheritance, his wage is unchanged — hence no substitution effect. But such persons are more likely to work fewer hours, indicating a strong income effect.

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3-2 Demand Analysis: Elasticity and Demand • Elasticity in Economics » A numerical measure of the responsiveness of Q to one of its determinants. D

• Different elasticities ‒ Price Elasticity of Demand ‒ Income Elasticity of Demand ‒ Cross-Price Elasticity of Demand

Price Elasticity of Demand ( E D ) • Measures responsiveness or sensitivity of consumers to changes in the price of a good

→ Slopes change with a change in units of measure.

• P & Q are inversely related by the law of demand so E D is always negative. » The larger the absolute value of E D , the more sensitive buyers are to a change in price.

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Calculating Percentage Changes Problem : The standard method gives different

answers depending on where you start.  From A to B,

P

$5

P falls 60%, Q rises 300%,

A

E = 300/(-60) = - 5 D

B

 From B to A,

$2 D

5

20

P rises 150%, Q falls 75%,

Q

E = (-75)/150 = -0.5 D

Calculating Percentage Changes: Arc Price Elasticity • So, we instead use the midpoint method to calculate E

D

between two points: (Q 1, P1) and (Q2, P2)

• Arc price elasticity is a measure of the average elasticity over a discrete demand range .

P

$5

A B

$2 D

5

20

Q

In this example, E between point A and B = -1.4 D

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Price Elasticity of Demand (E D ) • Percentage change in quantity demanded can be predicted for a given percentage change in price as:

= % P × E D » % Q D • Percentage change in price required for a given change in quantity demanded can be predicted as:

= % Q » % P D

E D

Exercise 3 • The price elasticity of demand for personal computers is estimated to be −2.2. If the price of personal computers declines by 20 percent, what will be the expected percentage increase in the quantity of computers sold? = %ΔQ/(−20%) = − 2.2 %ΔQ = +44% in personal computers sold

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Calculating Percentage Changes: Point Price Elasticity • The elasticity of demand at any price point:

P

$5

A

In this example,

B

$2

at point A = - 5, E D at point B = - 0.5 E D D

5

20

Q

The slope of a linear demand curve is constant, but its elasticity is not.

- Demand curve is vertical

- Demand curve is horizontal

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Price Elasticity (both point price and arc elasticity) 1. The slope of a linear demand curve is constant, but its elasticity is not. 2. Points with low price and high quantity: Inelastic demand

price

3. Points with high price and low quantity: Elastic demand

elastic region unit elastic

inelastic region quantity

Unit Elastic Demand  Nonlinear demand curve example:

E D = 1

Price Demand

$5

1. A 22% increase in price…

4

2. … leads to a 22% decrease in quantity demanded 0

80

100

Quantity

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Two Common Demand Curves The flatter the demand curve, the greater the price elasticity of demand.

Elastic Demand: E D > 1 Price

Inelastic Demand: 0 < E D < 1 Price

A 22% increase

2. … leads

1. A 22% increase

in price…

to an 11% decrease in quantity demanded

in price…

$5

$5 Demand

4

4

2. … leads to a

67% decrease in quantity demanded 0

50

100

Quantity

Demand

0

90 100

Quantity

What Determines Price Elasticity? Compare two common goods in each example. Suppose the prices of both goods rise by 20%. For which good does Q D drop the most? Why? •Breakfast Cereal vs. Sunscreen M ore avail abil ity and the closeness of substitutes, more elasti c.

•Apartment housing vs. Children’s toys L arger propor ti on of th e budget, more elasti c.

•Insulin vs. Caribbean Cruises Pri ce elastici ty is hi gher for lu xur ies (positi oni ng as i ncome ) than f or necessiti es. superior

•Gasoline in the Short Run vs. Gasoline in the Long Run Th e longer the tim e per iod of adj ustment, general ly, mor e elastic. *

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Empirical Price Elasticities • Apparel (whole market) -1.1

• Furniture -3.04

• Apparel (one firm) -4.1

• Glassware & China -1.2

• Beer -.84

• Household appliances -.64

• Wine -.55

• Flights to Europe -1.25

• Liquor -.50

• Shoes -.73

• Regular coffee -.16

• Soybean meal -1.65

• Instant coffee -.36

• Telephones -.10

• Adult visits to dentist

• Tires -.60

» Men -.65

• Tobacco products -.46

» Women -.78

• Tomatoes -2.22

» Children -1.4

• Wool -1.32

Price Elasticity of Demand & Revenue • Total revenue, TR » Amount paid by buyers and received by sellers of a good » Price of the good times the quantity sold (P » %TR = %P+ %Q

Q)

• For a price increase » If demand is inelastic, TR increases » If demand is elastic, TR decreases

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How TR Changes When Price Increase Elastic demand:

Inelastic demand: TR increases

TR decreases

P

Price Effect

P

Price Effect

$5

A

$5 4

4

B

A D

D

0

90 100

Quantity Effect

B

Quantity Effect Q

70

0

100

Q

Slide 47

Another Way to Remember

P

Elastic Unit Elastic

 Linear demand curve

A

Inelastic

 TR on other curve  Look at arrows to see

movement in TR A. Increasing price in the inelastic region raises revenue B. Increasing price in the elastic region lowers revenue

B

Q

TR

Q

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Marginal Revenue • Marginal revenue (M R ) is the change in total revenue per unit change in output • Since M R measures the rate of change in total revenue as quantity changes, M R is the ) curve slope of the total revenue ( T R M R

TR Q

Demand & Marginal Revenue Un it sales (Q)

Price

TR = P

Q M R =

0

$4.50

$

1

4.00

$4.00

$4.00

2

3.50

$7.00

$3.00

3

3.10

$9.30

$2.30

4

2.80

$11.20

$1.90

5

2.40

$12.00

$0.80

6

2.00

$12.00

$0

7

1.50

$10.50

$-1.50

0

TR/ Q --

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Panel A

Panel B

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MR , TR , & Price Elasticity Marginal revenue M R > 0

Total revenue

Price elasticity of demand

increases as TR increases Q (P decreases)

Elastic (│E D │> 1)

= 0 M R

TR is maximized

M R < 0

TR decreases as Q increases (P decreases)

Unit Elastic (│E D │= 1) Inelastic (│E D │< 1)

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Income Elasticity of Demand Income elasticity of demand (E y )

=

Percent change in Q D Percent change in income

 Income elasticity of demand measures the response of Q D to a change in consumer income.  Point income elasticity vs. Arc income elasticity Necessities: 0 < E y <1  For normal goods, E y > 0 Luxuries: E y >1  For inferior goods, E y < 0

• Suppose the demand function is: Q = 10 - 2•P + 3•Y

• find the income and price elasticities at a price of P = 2, and income Y = 10 • So: Q = 10 -2(2) + 3(10) = 36

• EY = ( Q/ Y)( Y/Q) = 3( 10/ 36) = .833 • ED = ( Q/ P)(P/Q) = -2(2/ 36) = -.111 • Characterize this demand curve, which means describe them using elasticity terms.

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Advertising Elasticity EA = % Q/ % ADV = ( Q/ ADV)( ADV/Q) • If the Advertising elasticity is .60, then a 1% increase in Advertising Expenditures increases the quantity of goods sold by .60%.

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Cross Price Elasticities Ecross = % QA / % PB = ( QA/ PB)(PB /QA) • Substitutes have positive cross price elasticities: » Pepsi and Coke • Complements have negative cross price elasticities: » gas cars and gas • When the cross price elasticity is zero or insignificant, the products are not related

An Empirical Illustration of Price, Income, and Cross Elasticities A study by Chapman etc. examined the elasticity of energy use by residential, commercial, and industrial users. They hypothesized that the demand for electricity was determined by the price of electricity, income levels, and the price of a substitute good — natural gas.

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Price Elasticity of Supply Price elasticity of supply (E S )

=

Percent change in Q S

=

ΔQ /Q S S

Percent change in P

=

ΔP /P

ΔQ S

P

ΔP

Q S

•

Price elasticity of supply measures how much Q S responds to a change in P .

• •

Loosely speaking, it measures sellers’ price-sensitivity. Arc price elasticity of supply vs. Point price elasticity of supply

The Variety of Supply Curves Elastic Supply

Inelastic Supply Perfectly Inelastic Supply

E S = 0

Perfectly Elastic Supply

Unit elastic Supply

0 < E S < 1 E S = 1

E S > 1

E = S

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Determinant of Price Elasticity of Supply  Time period of adjustment » Supply is more elastic in long run » The longer the time, the more easily sellers can change the quantity they produce, the greater the price elasticity of supply.

How the Price Elasticity of Supply Can Vary P



S

< 1 E S

$15



12 

> 1 E S

Supply often becomes less elastic as Q rises due to capacity limits. Points with low P and Q  Elastic supply  Capacity for production not being used Points with high P and Q  Inelastic supply

4

$3 Q

100 200 500 525

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Applications of Supply, Demand, and Elasticity 1. Can good news for farming be bad news for farmers? Consider the introduction of new hybrid of wheat that increases the production per acre. 2. Why did OPEC fail to keep the price of oil high?

Application 1 - New hybrid of wheat: increase production per acre 20% - Supply curve shifts to the right - Higher quantity and lower price - Demand is inelastic: total revenue falls

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Application 2 Why did OPEC fail to keep the price of oil high? - Analysis on the reduction in world market supply for oil

Homework 1. Five consumers have the following marginal utility of apples and pears. The price of an apple is $1, and the price of a pear is $2. Which, if any, of these consumers are optimizing over their choice of fruit? For those who are not, how should they change their spending? Marginal Utility of Apples

Marginal Utility of Pears

Claire

6

12

Phil

6

6

Haley

6

3

Alex

3

6

Luke

3

12

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Homework 2. Consider a couple’s decision about how many children to have. Assume that over a lifetime a couple has 200,000 hours of time to either work or raise children. The wage is $10 per hour. Raising a child takes 20,000 hours of time. a. Draw the budget constraint showing the trade-off between lifetime consumption and the number of children. (Ignore the fact that children come only in whole numbers!) Show indifference curves and an optimum choice. b. Suppose the wage increases to $12 per hour. Show how the budget constraint shifts. Using income and substitution effects, discuss the impact of the change on the number of children and lifetime consumption. c. We observe that, as societies get richer and wages rise, people typically have fewer children. Is this fact consistent with this model? Explain.

Homework 3. The demand function for bicycles in Holland has been estimated to be Q = 2,000 + 15Y − 5.5P where Y is income in thousands of euros, Q is the quantity demanded in units, and P is the price per unit. When P = 150 euros and Y = 15(000) euros, determine the following: a. Price elasticity of demand b. Income elasticity of demand

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Consumer Behavior and Demand Analysis

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