Managerial Economics
IMBA 2020
Fudan University
Managerial economics:
Road map
Demand
(Part 1)
Cost
(Part 2a)
Managerial
decision
Information
(Part 5)
Competition
Competitive market:
Supply (Part 2b)
Monopoly:
Pricing (Part 3)
Oligopoly:
Strategic thinking
(Part 4)
Demand
Outline
Case: The Players Theater Company
l Elasticity and pricing
l Buyer (Consumer) surplus and pricing
l
Demand Analysis
4
The Players Theater Company
Introduction
l
l
l
l
l
The Players Theater Company (PTC) is a regional
theater.
Each year, it produces six plays, ranging from
Shakespeare to contemporary musicals.
PTC has priced its tickets at $30. On a typical night,
approximately 200 of the theater’s 500 seats are
filled.
The PTC board met recently to discuss a possible
price decrease to $25 for next season.
At the meeting, the PTC board engaged in a heated
debate over the proposal.
Information
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It soon became evident that the board had
insufficient information to make a sound
decision.
For instance, nearby restaurants, which
serve PTC customers, have indicated that
they are planning to implement substantial
price increase before the beginning of the
next season.
Would this increase affect the demand faced
by PTC and thus appropriate ticket price?
Key information
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Although customers might buy more tickets
at lower prices, would total revenue or profits
necessarily increase?
Would it be better to attract additional
customers by lowering price or by improving
quality of PTC plays?
What’s the key information the board needs?
Demand Estimation
l
Three general techniques
–
interviews
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–
price experimentation
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–
surveys, questionnaires
track changes in sales when prices change
statistical analysis
l
regression
4-9
Demand for PTC Tickets
Q = 117 - 6.6P + 1.66Ps - 3.3Pr + 0.00661I
where P is PTC ticket price, Ps is the ticket price at
a nearby symphony hall, Pr is price of nearby
restaurant meals, and I is average per capita
income
Variable Values
Suppose the variables have the following values:
P = $30
Ps = $50
Pr = $40
I = $50,000
How many tickets will PTC sell?
4-11
The Demand Curve
Substitute variable values (except for P) into
the equation and simplify:
P = 60 - 0.15Q
This is the equation for the demand curve.
Law of demand – as the price of a good rises,
the quantity demanded falls
4-12
Graphing the Demand Curve
$
$
Ticket price (in dollars)
Income = 51,000
61
60
60
Income = $50,000
D1
D
D0
Q
Q
400
Quantity of PTC tickets
Quantity of PTC tickets
406.0
4-13
Price Elasticity of Demand
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Measures the responsiveness of quantity
demanded to changes in price
Often referred to as elasticity of demand
Helps firms determine the effect of price
changes on total revenue
4-14
Own-price elasticity
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Definition: percentage change in quantity demanded
resulting from 1% increase in price of the item.
Alternatively,
% c h a n g e in q u a n t ity d e m a n d e d
% c h a n g e in p ric e
l
or
æ %DQ ö DQ / Q
h =ç
÷=
è %DP ø DP / P
15
Own Price Elasticity of PTC
$
Ticket price in dollars
η = [ΔQ/Q]
60
[ΔP/P]
=(-6.6)X [30/200]
= -1
P2
P1
(200, $30)
D
Q2
Q1
Quantity of PTC tickets
400
4-16
Price Changes and Total
Revenue
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Demand is elastic (< -1),
1% price increase leads to more than 1%
drop in quantity
Demanded price and total revenue move in
opposite directions
- If P↑ then TR↓
- If P↓ then TR↑
4-17
Price Changes and Total
Revenue
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Demand is inelastic (> -1),
1% price increase leads to less than 1% drop
in quantity demanded
price and total revenue move together
- If P↑ then TR↑
- If P↓ then TR↓
If demand is unit elastic (= -1),
4-18
Price Changes and Total
Revenue
Total revenue is P x Q
l For PTC, P=60-.15Q
l And TR = (60-.15Q)´Q=60Q-.15Q2
l Marginal revenue, MR, is
DTR/DQ=60-.30Q
l
4-19
Demand, Total Revenue,
& Marginal Revenue
Ticket price (in dollars)
$
60
Elastic demand (η < -1)
η = -1
30
Inelastic demand (η > -1)
Q
Total revenue (in dollars)
$
6,000
200
Quantity of PTC tickets
Q
4-20
Variable Values change
Previous the variables have the following values:
P = $30
Ps = $50
Pr = $40
I = $50,000
What would happen if Pr changes to $50 while
others unchanged?
4-21
Other Elasticities
l
The Income Elasticity is the % change in demand over the %
change in income and is usually positive.
æ DQ Q ö
ç
÷
è DY Y ø
Commodity
Income Elasticity
Wine
Electricity (Household)
Beef
Beer
Chicken
Pork
Flour
2.59
1.94
1.06
0.46
0.28
0.14
-0.36
(Date)
1992
1970
1990
1990
1990
1990
1970
The Cross-Price Elasticity
l
The Cross-Price Elasticity is the % change in demand over the %
change in another good’s price.
æ DQ Q ö
ç
0
0 ÷
è DP P ø
This measures how sensitive your demand is to your competitor’s prices.
This is important in internal decisions when you make many products,
Eg Volkswagen and Audi A4, VW Passat.
It is also measures how competitive the market is?
Example : Dupont
l
It was referred to the FTC because it had a
large share of the market for plastic wraps.
l
Showed that waxed paper and aluminum foil
had high cross-price elasticities with plastic
wraps and so only actually had 20% of the
total market.
Elasticity
l
Own price elasticity = -1
Cross price elasticity for symphony? For
meals?
Income elasticity = ?
l
Q = 117 - 6.6P + 1.66Ps - 3.3Pr + 0.00661I
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Substitutes/complements
l
Definition:
–
–
l
substitutes: pa ↑ è qb ↑
complements: pa ↑ è qb ↓
Notice:
–
–
relation between one product’s price and another
product’s quantity demanded
it’s not about usage/function, because usage
depends on circumstances
l Ocean Park and Disney, car park and MTR
l concepts meaningful only for their implications
Demand Analysis
26
Complements
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You are the monopolist supplier of
components A and B
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–
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value of A+B: $10
cost of A or B: $2
optimal pricing of A and B? profit?
Component B becomes competitive. Good
or bad for you?
–
–
B’s price: $3
B’s price: $1
Demand Analysis
27
Complements
l
Within a value chain, market power over one
component is enough. No need to control every
component
–
landlord versus retailer
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–
–
–
extension of MTR island line
Country Park kiosk: rent = $2,000/day
restaurant business
l good in terms of sales: long queues
l bad in terms of turnover
taxi driver versus license holder
Cecil Rhodes: monopolize steam-powered pump in
South Africa diamond mines
Demand Analysis
28
Complements
l
Video games or smartphones: hardware
versus software
–
–
–
the two prices should be jointly determined
l low price for hardware and high price for
software
no need to control both
l focus on the one that is not easy to copy:
hardware
encourage competition among apps developers
Demand Analysis
29
p
20
p=20-q
19
18
BS=(20-12)(8)/2=32
p=12
q
1
2
8
Demand Analysis
20
30
Buyer surplus
l
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Definition: buyer’s net benefit (gross benefit
minus expenditure paid)
Graph: area below the demand curve and
above the price line, up to the purchased
quantity
Demand Analysis
31
p
20
Buyer retains surplus:
room for seller to
make more money.
But how?
p=20-q
14
12
Raising the
price may not
work
mc=4
q
6
8
Demand Analysis
20
32
p
20
Pay $32 to enter
the park (or join a
club), then pay $12
per ride
32
12
64
mc=4
q
8
Demand Analysis
20
33
Two-part pricing
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Fixed fee plus usage charge
Examples:
–
–
–
–
internet service
mobile telephony
car rental
club membership
Demand Analysis
34
Optimal two-part pricing
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The seller needs to determine two values:
–
–
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For any given unit price
–
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unit price: p=12
fixed fee: F=32
optimal fixed fee = buyer surplus (at that
particular unit price)
Is the unit price of $12 optimal?
Demand Analysis
35
Optimal unit price
p
p
32
12
128
64
mc=4
8
mc=4
q
Demand Analysis
64
16
36
q
Do not oversell
p
p
16
mc=4
mc=4
q
q
Demand Analysis
20
37
Optimal unit price
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Equals marginal cost: p=4
–
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Logic
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–
–
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adjust membership fee accordingly: F=128
buyer gets zero surplus (when F is optimally chosen)
you should maximize joint surplus (buyer + seller)
joint surplus is maximized when social value (buyer’s marginal
benefit, declining with q) = social cost (seller’s marginal cost,
constant)
Summary
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–
use unit price to induce the right amount of consumption: to
maximize the two parties’ joint surplus
use fixed fee to extract buyer surplus
Demand Analysis
38
Two-part pricing
l
Alternative format of two-part pricing: block
sale of 16 rides
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–
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at price 128 + 64 = 192: area of the trapezoid
profit: area of triangle
What prevents a seller from extracting all
buyer surplus?
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–
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competition
information
buyer heterogeneity
Demand Analysis
39
Package deal
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Implication of the theory:
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if marginal cost is zero, unit price should be zero
Package deal: fixed fee without usage charge
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information transmission: internet connection,
telephone (fixed line, mobile)
subscription to database: used to be $1,000 for each
piece of information, now $10,000 for unlimited use
group consumption: theme parks (day pass and
annual pass), public transportation (monthly pass)
Demand Analysis
40
Buffet
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Yesterday you paid $80 for an all-you-caneat buffet, and you ate 8 dishes
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$10 per dish on average
Tonight when you visit the restaurant, you
are surprised to find that they’ve changed the
policy: $10 per dish
–
how many dishes do you eat (assuming you are
equally hungry)?
Demand Analysis
41
Buffet
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Eat less. Why?
–
–
–
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MB = p
last night’s MB is smaller
last night’s q is larger
Exactly how many dishes?
–
–
–
need more information about demand
one point known from the setting: q=8 when p=0
need another point to determine a straight line
l assumption: vertical intercept = 40
l try other values: qualitative results remain valid
Demand Analysis
42
p
40
Is the consumer better off?
Last night: q=8
BS = (40)(8)/2 – 80 = 80
Tonight: q=6
BS = (30)(6)/2 = 90
Consumer is better off.
Other values of vertical
intercept?
10
q
6
8
Demand Analysis
Consumers are always
better off!
43
Economic thinking
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Consumers must be better off
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tonight if you want, you can eat 8 dishes
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if you choose differently, then you must be better
off
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then you are equally better off as yesterday
otherwise why do you choose differently?
Consumers always prefer unit pricing in
general (not want buffet)?
–
important condition: original consumption is still
feasible: p ≤ 10 tonight
Demand Analysis
44
Summary: Demand
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Two questions
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–
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Demand is derived from marginal valuation
–
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where does demand come from?
what’s the implication for pricing?
compared with price
Implications for pricing
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direction of change (slopes downward)
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magnitude of change (elasticity)
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buyer surplus and two-part pricing
raise price when demand is inelastic
joint demand (complements)
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no need to have pricing power in every component
Demand Analysis
45
Summary: methodology
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Worldview: all choices can and must be
rationalized
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people make deliberate choice
implication: mechanically copying others’ strategy
won’t work
l you only see action/performance, but actions
are not arbitrary (advertising, MBA)
Demand Analysis
46
Summary: methodology
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Freedom
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–
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two-part pricing: give seller more freedom (control two
variables rather than one)
block sale: restrict buyer’s freedom
Separate value creation from value retention
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size of the pie (product quantity, induce the right q)
versus allocation of the pie
when you can get most of the pie, you want the size
to be as large as possible
l
helping your rival is helping yourself
Demand Analysis
47
Calculation
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Buyer surplus: area of the triangle
Two-part pricing
1. unit
price = marginal cost
2. fixed fee = buyer surplus at the unit price
Demand Analysis
48