Customer Power: Economics of
Elasticity and Demand
MANEC 387
Economics of Strategy
David J. Bryce
David Bryce © 1996-2002
Adapted from Baye © 2002
The Structure of Industries
Threat of new
Entrants
Bargaining
Power of
Suppliers
Competitive
Rivalry
Threat of
Substitutes
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David Bryce © 1996-2002
Adapted from Baye © 2002
Bargaining
Power of
Customers
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
David Bryce © 1996-2002
Adapted from Baye © 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 D denote changes in value.
– Then the elasticity is
% DQ

% DP
David Bryce © 1996-2002
Adapted from Baye © 2002
Q1  Q0
Q0
P1  P0
P0

DQ
Q0
DP
P0
DQ P0


DP Q0
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
– Mercedes-Benz
David Bryce © 1996-2002
Adapted from Baye © 2002
– Water
– Milk
– Diamonds
– Air
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
David Bryce © 1996-2002
Adapted from Baye © 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 are a large fraction
of consumer’s budget is more inelastic
David Bryce © 1996-2002
Adapted from Baye © 2002
Uses of Elasticities
•
•
•
•
•
•
Pricing
Managing cash flows
Impact of changes in competitors’ prices
Impact of economic booms and recessions
Impact of advertising campaigns
And lots more!
David Bryce © 1996-2002
Adapted from Baye © 2002
Elasticity Calculations
1 
1 2
2
5 4
4
Price
 2.0
1
5
4
3
2 
4 5
5
2 1
1
David Bryce © 1996-2002
Adapted from Baye © 2002
2
2
 0.2
1
1
2
3
4
5
Quantity
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?
David Bryce © 1996-2002
Adapted from Baye © 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.
David Bryce © 1996-2002
Adapted from Baye © 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?
David Bryce © 1996-2002
Adapted from Baye © 2002
Answer
Calls would increase by 25.92 percent!
Q
X
, PX
%DQXd
 8.64 
%DPX
%DQXd
 8.64 
 3%
 3%    8.64  %DQXd
%DQXd  25.92%
David Bryce © 1996-2002
Adapted from Baye © 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Summary and Takeaways
• Customers and substitutes threaten to
reduce the firm’s price; suppliers threaten
to raise the firm’s costs.
• Their success will be determined, in part,
by the elasticity of demand.
• General knowledge of elasticities is a
good substitute for specific knowledge of
the demand curve.
David Bryce © 1996-2002
Adapted from Baye © 2002