Customer Power
Economics of Elasticity of Demand
Managerial Economics 387
The Economics of Strategy
David J. Bryce
copyright 2000, 2002
Exploring Industry Structure
Customer
Power &
Preferences
Threat of
Potential
Entrants
Rivalry
between
Competitors
Threat
of
Substitutes
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Bargaining
Power of
Suppliers
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.
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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
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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
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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
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– 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
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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.
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Uses of Elasticities
•
•
•
•
•
Pricing
Managing
Impact of
Impact of
Impact of
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cash flows
changes in competitors’ prices
economic booms and recessions
advertising campaigns
Elasticity Calculations
1 
1 2
2
5 4
4
Price
 2.0
1
5
4
3
2 
4 5
5
2 1
1
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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?
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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.
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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?
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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%
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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
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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
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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?
Nile Hatch © 1996, 2000, 2002