Transcript Session3(mba)

Market Demand and the
Pricing Decision
Session 3
Professor Dermot McAleese
OUTLINE
 Rational consumer
 Market demand curve
 Elasticities of demand
 Estimating the demand curve
 Pricing decision
WHAT IS A RATIONAL CONSUMER?
The rational individual behaves in a way which most people
would consider an acceptable approximation of reality – they
maximise utility
 Assumptions
 comparability
 non-satiation
 consistency
 convexity
 independent utilities
 Challenges to assumptions
 insufficient information to rank preferences
 uncertain utility from the consumption of a particular good or service
 satisfaction obtained from the consumption of a good because others are
unable to afford it
THE MARKET DEMAND CURVE
The market demand curve is derived by the
addition of individual demand curves in a process
of lateral summation.
K’
P1
K
P
O
J’
J
Individual J
O H’ H
Individual H
O
S
R
Market demand
PRICE ELASTICITY OF DEMAND
E(   
% changein quantitydemanded
% changein price
Determinants
 range of available goods
 definition of the product
 share of spending in consumer’s budget
 time period
INCOME ELASTICITY OF DEMAND
E( y  
% changein quantitydemanded
% changein disposableincome
 luxury goods (E > 1)
 necessities (0 < E <1)
 inferior goods (E < 0)
CROSS-PRICE ELASTICITY OF
DEMAND
E ( x, y  
% changein quantitydemandedof x
% changein price of y
 substitutes
 complements
…within the relevant price range
Table. 1 Price and income elasticities for the service sector
Price
Income
Services
Housing
Health
Purchased transport
Communications
Recreation
Education
Government
-0.73
-0.82
-1.11
-1.63
-0.97
-0.55
-1.36
1.186
1.582
0.955
1.315
1.410
0.959
1.071
Total services
-0.32
0.979
Mixed (industry and services)
Fuel and power
Other household
Transport
-0.86
-1.28
-1.24
0.967
0.986
1.418
Total Services and Mixed
-0.28
1.013
Source: R.E. Falvey and N. Genmell, ‘Are services income-elastic?: some
new evidence’, Review of Income and Wealth, September 1996.
Table. 2 Consumption of alcoholic beverages: shortrun and long-run elasticities for beer, spirits
and wine in Canada
Short run
Long run
Beer
Price
Income
Warm days
-0.27
0.48
0.03
Price
Income
Warm days
-0.28
0.46
0.10
Spirits
Price
Income
-0.45
0.85
Price
Income
0.84
1.33
Wine
Price
Income
-0.86
1.13
Price
Income
-1.26
2.59
Source: J. Johnson et al., ‘Short-run and long-run elasticities for Canadian
consumption of alcoholic beverages’, Review of Economics and Statistics
(February 1992).
ESTIMATING A DEMAND FUNCTION
Think of a demand function of general form:
Qi = 0 + 1Y - 2Pi + 3Ps - 4Pc + 5Z+ e
where:
Qi = quantity demanded of good i
Pi = price of good i
Ps = price of substitute(s)
Pc = price of complement(s)
Z = other relevant determinants of demand
e = error term representing random factors
Then follow these steps:
 Identify independent variables:
income, own price, price of substitutes and complements, other influences
 Decide on form of function:
linear, log linear, translog; lag structure; prior constraints
 Determine statistical estimation techniques:
ordinary least squares is one of a large number of possible estimation techniques
 Derive parameters:
often reported as short-term and long-term elasticities
 Evaluate results and cross-check with other procedures:
surveys, marketing tests, managers' opinions
 Set up different scenarios of future Y, P, and Z and use
simulations to derive forecasts for Q
WHY DEMAND ANALYSIS IS USEFUL TO BUSINESS
 Forecasting and projecting trends in demand
 Price forecasting
 Estimating the incidence of tax
 Market segmentation and pricing
 Defining the market through cross elasticities
 Understanding market structure
PRICE ELASTICITIES AND THE PRICING
DECISION
 Marginal revenue curve
(finding the price that will maximise revenue)
 Market segmentation
(separating high and low price elasticity segments; different prices to
different groups of consumers)
 Finding a market niche
(to escape constraints of prefect competition and to make the demand curve
inelastic to some degree)
 Competitors’ reactions
(price wars and non-price competition)
MARKET SEGMENTATION
P
1
2
3
4
5
6
7
8
9
10
P
10
Q
10
9
8
7
6
5
4
3
2
1
TR
10
18
24
28
30
30
28
24
18
10
MR
8
6
4
2
0
-2
-4
-6
-8
E(P)>1
E(P)=1
6
E(P)<1
D
O
5
MR
10 Q