Microeconomics
Demand
Curves sloping downward
From the firm to the industry
Estimating demand
Guideline to pricing strategy
From choosing to demand: review
F
Pc
The price of clothes falls and you
“re-optimize”, increasing your
consumption of clothes
E1
E2
The demand curve traces out
your choices as price changes,
holding other factors constant
Pc1
U2
Pc2
U1
C1* C2*
C
Demand
C1* C2*
C
Summing up – from individual to
market demand
Pc
The demand curve traces out
your choices as price changes,
holding other factors constant
Pc
The market demand curve is
the horizontal summation of
all individual demands at given
prices
Pc1
Market
Demand
Pc2
Individual
Demand
C1* C2*
C
C
The law
• Demand is the willingness and ability to purchase
at given prices
• Law of Demand: Other things equal, quantity
demanded decreases and prices increases.
• Demand curves slope downward
• Why do we say it is a “law”? Are there
exceptions?
Functions and curves
• In principle, demand depends on many factors
• We focus on 3 to start (“own” price, prices of
related goods and income)
Q  f ( P, Ps , Pc , I ,....)
where Ps and Pc are prices of substitute and
complementary goods.
• The demand curve plots the relationship between
Q and P, holding other factors fixed.
Players Theatre Company (PTC)
• 500-seat theatre
• At $30 per ticket, typical show draws 200
• Manager is considering whether to reduce the
ticket price to $25. How will this price change
affect revenue?
• Assume PTC demand function is
Q  117  6.6 P  1.66Ps  3.3Pr  0.0066 I
Price of symphony ticket
(substitute)
Price of restaurant meal
(complement)
PTC demand curve
• Holding the other factors
constant (at values Ps=50,
Pr=40 and I=50,000), PTC’s
demand curve is given by
P
60
A drop in ticket prices from $40 to
$30 increases the quantity of tickets
demanded from 133 to 200
Q  400  6.67 P
P  60  0.15Q
• Own price changes cause
movements along a demand
curve
• What causes a demand curve
to shift (demand to change)?
40
30
133 200
400
Q
Changes/shifts in PTC demand
• Changes in factors
other than the price of P
the good cause the
61
demand curve to shift 60
• Shifters in PTC’s
demand function
– Price of substitute
– Price of complement
– Income (normal vs
inferior goods)
• Others?
The rightward shift is the result of a
$1000 increase in income
D2 (I=51,000)
D1 (I=50,000)
400 406.6
Q
Income elasticities
• Income elasticity
I 
% Q
% I
>0 good is normal
>1 good is luxury
<0 good is inferior
• What are examples of these types of goods?
• What implications does this have for how your
revenues may vary over time?
Elasticity
• An elasticity is just a ratio of percentage
changes
• Unit-less measure of the responsiveness of
one thing to changes in another
• Price elasticity of demand
%Q
Q / Q
Q P
 



%P
P / P
P Q
Calculating the demand elasticity
for PTC
• How to calculate an elasticity?
– Use the basic formula for small
price changes
– Use the Arc formula (that
averages the two prices and
quantities) for large price
changes
• What does η = 1.4 mean?
• What is the connection
between η and the revenue
consequences of a price
change?
• What factors affect η?
P
60
Using the Arc formula,
η = 1.4 over this range
40
30
133 200
400
Q
Demand elasticity and revenue
• PTC total revenue
Re v  P  Q  60Q  .15Q 2
P
MR=0
6000
$
TR
• PTC marginal revenue (extra
revenue earned from selling
another ticket)
MR  60  .3Q
• When will reducing ticket
prices increase revenue?
• What ticket price will
maximize revenue? Maximize
profit?
60
200
Q
|η| > 1
|η| = 1
30
|η| < 1
D
200
400
MR
Q
Factors affecting demand
elasticity
• Demand is more elastic
– When close substitutes are available
– When the good is a big part of your budget
– When you have a longer time period to adjust to
price changes
• What are some goods with elastic demands?
Inelastic demands? In both cases, why?
Cross-price elasticities
• An elasticity is just a ratio of percentage
changes
 xy 
%Qx
%Py
> 0, if x and y are substitutes
< 0, if x and y are complements
• What are examples of substitutes and
complements?
Elasticity and public policy
[B]udget shortfalls are pushing more
than 20 states to look to tobacco for
revenue, even those that have avoided
cigarette taxes for years or decades.
City Room
NYT, 1 Apr 09
Policy makers use elasticity
• What is the price elasticity of demand for cigarettes?
• What will happen to tax revenue if the tobacco tax is
raised?
• What will happen if the tobacco tax is too high?
• What size must the tax be to deter smoking and raise
revenue?
• What are other examples of taxes on goods that have
inelastic demand?
• What examples of taxes on goods that have elastic
demand?
From the
firm to the industry
About the telephone…
“An amazing invention – but who
would ever want to use one?”
Rutherford B. Hayes
The company you keep
• Defining your “space”
• Firm vs industry demand
– PTC does not operate in isolation from other
entertainment industry organizations
– What elasticity might help PTC sort this out?
– What is more elastic – the demand for PTC’s
shows or the demand for entertainment events as
a whole?
Network effects
• Some products exhibit increasing returns on the
demand side
• Price decreases have the usual effect – plus each
new customer provides an externality that makes
the product more valuable
• Examples – telephone, Office, web browser
• Do network effects increase or decrease demand
elasticities?
• What might the pricing strategy be in an industry
with network effects?
Product development and
branding
• Recall the relationship between
substitutability and demand elasticity
• How is branding related to substitutability?
• Role of product attributes in establishing a
brand
• Examples – iPhone, Olive Garden, Toyota
• Role of branding in establishing market power
Estimating demand curves
The plural of anecdote is data.
George Stigler (attributed)
Qualitative approaches and
experiments
• Interviews
– Representative?
– Reliable?
– Actual choices or claims about hypothetical
choices?
• Pricing experiments
– Vary prices across separate, local markets
– Problems with controls
– Risk of losing customers
Econometrics
• Basic idea – specify the demand function
Q  f ( P, Ps , Pc , I )
as a regression model
Q   0  1P   2 Ps  3 Pc   4 I  
• Estimate model by least squares
• Can use the coefficient estimates to calculate
elasticities
Estimated cigarette demand
• Data
– Q = daily cigarette consumption
– Cigarette price = state price in
cents per pack
– Income = annual income
– Restaurant restriction = 1, if
state restricts smoking in
restaurants
– Education = years of schooling
– Age = years
• Why measure price and income in
logs?
• What is the effect of a 10 percent
increase in the price of cigarettes?
Is the effect statistically significant?
• What about income?
• What factors do affect smoking?
Conclusions
• Demand curves slope downward
• Changes in price move you along a demand curve
• Changes in other things (other prices, income, etc) shift
the demand curve
• Elasticities measure responsiveness to change
• The effect of a price change on revenue depends on
the demand elasticity
• Understanding elasticity makes you more profitable
• Demand-side network effects arise because new
customers create externalities
• Data analysis is extremely important