Market Demand and the Pricing Decision

1. Market Demand and the Pricing Decision Session 3 Professor Dermot McAleese

2. OUTLINE  Rational consumer  Market demand curve  Elasticities of demand  Estimating the demand curve  Pricing decision

3. 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

4. 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 O O S R H’ H Individual J Individual H Market demand

5. PRICE ELASTICITY OF DEMAND • Determinants •  range of available goods •  definition of the product •  share of spending in consumer’s budget •  time period

6. INCOME ELASTICITY OF DEMAND  luxury goods (E > 1)  necessities (0 < E <1)  inferior goods (E < 0)

7. CROSS-PRICE ELASTICITY OF DEMAND  substitutes  complements …within the relevant price range

8. Table. 1 Price and income elasticities for the service sector Source: R.E. Falvey and N. Genmell, ‘Are services income-elastic?: some new evidence’, Review of Income and Wealth, September 1996.

9. Table. 2 Consumption of alcoholic beverages: short- run and long-run elasticities for beer, spirits and wine in Canada Source: J. Johnson et al., ‘Short-run and long-run elasticities for Canadian consumption of alcoholic beverages’, Review of Economics and Statistics (February 1992).

10. 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

11. 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

12. 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

13. 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)

14. MARKET SEGMENTATION P 10 E(P)>1 E(P)=1 6 E(P)<1 D 5 O 10 Q MR