Techniques for Understanding Consumer Demand & Behavior

1. Techniques for Understanding Consumer Demand & Behavior New Products have no historical data – so surveys can assess interest in new ideas. Common Survey Problems • Sample bias--telephone, magazine • Biased questions-- • advocacy surveys • Ambiguous questions • Respondents may lie on questionnaires Survey Research Center of U. of Mich. does repeat surveys of households on Big Ticket items (Autos) Surveys of Spending Plans

2. Sources of information on demand • Consumer Surveys • ask a sample of consumers their attitudes • panel data of a sample of customers • Consumer Clinics • experimental groups try to emulate a market (Hawthorne effect), Laboratory experiments • Market Experiments • get demand info by trying different prices, store audit, in store pricing experiments • scanning data, uncontrolled studies of actual purchases • Historical Data • what happened in the past is guide to the future

3. Just Plot Historical Data quantity Q • Look at the relationship of price and quantity over time • Plot it Q = a + b P +  • Plotting is subject to difference of opinion on “best fitting line” Slope isb a 03 05 02 08 07 04 06 Price P

4. Simple Linear Regression OLS -- ordinary least squares Q • Qt = a + b Pt + t Time subscripts & error term Find “best fitting” line t = Qt - a - b Pt t 2= [Qt - a - b Pt] 2 • mint 2= [Qt - a - b Pt] 2 • Solution: • b = Cov(Q,P) / Var(P) • a = mean(Q) - b•mean(P) a b is slope _ Q _ P

5. Functional Forms: 1. Linear Demand Functions • Linear Form Q = a + b •P + c •I • The effect of each variable is constant • The effect of each variable is independent of other variables • Elasticities • Price elasticity is: E P = b•P /Q =DQ/DP)(P/Q) • Income elasticity is: E I = c•I /Q=DQ/DI) (I/Q)

6. 2. MultiplicativeorLog Linear • MultiplicativeQ = A • P b • Ic • The effect of each variable depends on all the other variables and is not constant • It is log linear or also called double logged Ln Q = a + b•Ln P + c•Ln I • The price elasticity is b • The income elasticity is c • Proof: E P = DQ/DP) ( P/Q ) = (b A•P b-1•I c)(P/ A• P b • I c) =b

7. R2 The Coefficient of Determination Q • R-square -- % of variation in dependent variable that is explained • Ratio of RSS [Qt -Qt] 2 TSS [Qt - Qt] 2 . • As more variables are included, R-square rises • Adjusted R-square, however, can decline, see page 101 ^ Qt Qt ^ [Qt -Qt] 2 _ Q ^ = _ P

8. Table 3.9 Multiple Regressionpage 106 Linear Q = a + bP + cA + dD PRICE, Advertising, & Distance to Campus N = 10 observations from ten apartments complexes of 100 units each run by FCI R-square = .79, and Adj R-square = .69 Coeff Std Err T-value Intercept 135.15 20.65 6.54 Price -.14 .06 -2.41 Advertising .54 .85 0.85 Distance -5.78 1.26 -4.61 • What is the estimated demand curve? • Does this make economic sense? Which are significant? • Find the price elasticity and suggest if rents should be raised. Average Price = $420. Average Quantity Rented = 53.1. Average advertising = $8 Average Distance = 2 miles Price Elasticity = -.14 (420) / 53.1 = - 1.11 Advertising Elasticity = .54(8) / 53.1 = .081 Distance Elasticity = -5.78(2)/53.1 = .218 • Characterize these elasticities.

9. A Log Linear Example Dependent Variable: Ln Q Variable Coefficient Std Error T-value Constant 14 7 2 Log P -1.15 .5 -2.3 Log A .05 .06 0.83 Log D .19 .04 4.75 R-sqr = .567 Adj R-sqr = .545 N=10 • Do the signs of the coefficients make economic sense? • Which form, linear or log linear fit the data better? • What are the three elasticities?

10. Smoking and SmugglingChapter 9 of MBN • Canada raised the tax on cigarettes. What do you expect would happen? • A 10% increase in price, lowers quantity 4%. • What is the price elasticity of cigarettes? • Are they elastic or inelastic? • What is impact on the income distribution of cigarette ever higher excise taxes? • What does history teach about a tax on tea? • Discussion questions on page 58-59.

11. Consumer Choice & Individual Behavior • Baye: Chapter 4 • De gustibus non est disputandum - of tastes, there is no disputing (or, there’s no accounting for tastes) • Nevertheless, we do display tastes as we rank movies, books, universities and travel spots • We can and do compare baskets of goods • Prefer apples to prunes • Dislike avocados • Pears and apples are similar

12. Individual Choice • Economist think people do what they intend to do • Rational Decision -- maximizes what the person thinks is his or her self-interest • Irrational Decisions -- usually part of psychology • Adam Smith - 1776 - self interest maximizes the social interest -- led as if by an invisible hand • farmer’s decision on what to plant • consumer’s decision on what to buy • alternative, is to assume an all knowing social planner to make decisions

13. Pain Measuring Pleasure or • Can we determine what Georgiana or Prakash would do over a set of choices, if we knew how they valued each choice? • We measure light in candles and power in horsepower, so need a unit of pleasure or pain, the util. • We need a utilometer. • Jeremy Bentham, teacher of John Stuart Mill, argued for the basis of ethics using utilitarianism: • Thou shalt not kill, based on highest social welfare using this rule.

14. Cardinal vs.Ordinal Utility • Cardinal utility is measured, using some index. • Hard to compare two people’s utility • Can, nevertheless, develop measures • Expect to find Diminishing Marginal Utility in consumption • Ordinal utility simply assumes we can compare the happiness or satisfaction across objects or choices. • Using ordinal utility, we can construct Indifference Curves that show choices that tend to have the same level of happiness or satisfaction Bentham life size wax

15. Total Utility Marginal Utility Cardinal Utility Diminishing Marginal Utility Pizza slices Pizza slices

16. Indifference Curves U • Consumers attempt to max happiness, or utility: U(X, Y) • Subject to an income constraint: I = Px•X + Py•Y • Graph in 3 dimensions Uo Y Uo X

17. U2 U1 X Consumer Choice - assume consumers can rank preferences (completeness), that more is better than less (nonsatiation), that preferences are transitive (transitivity), and that individuals have diminishing marginal rates of substitution. Then indifference curves slope down, never intersect, and are convex to the origin. Uo 9 7 6 convex 5 6 7 Y give up 2X for a Y

18. Indifference Curves Using Ordinal Utility candy bars • Can graph all points of same utility, as in Uo, called an indifference curve. • As price changes, tend to buy more of the cheaper good • Deriving the demand curve for sodas C U2 B U1 A U0 soda P D soda

19. Indifference Curves Uo U1 X We "derive" a demand curve graphically from maximization of utility subject to a budget constraint. As price falls, we tend to buy more due to (i) theIncome Effect (b to c) and (ii) the Substitution Effect (a to b). Similar to the example, on p. 144 c a b Y Py demand Y

20. Downward Slope in Demand • Two reasons that price and quantity are negatively related include: • income effect--as the price of a good declines, the consumer can purchase more of all goods since his or her real income increased. • substitution effect--as the price declines, the good becomes relatively cheaper.

21. Use the labor-leisure tradeoff and suppose that you get more money from heaven. Opportunity set shifts out. The amount of leisure increases by the income effect. From A to B. A $600 Subsidy and Work Income B U1 $600 Shift Up A U0 24 hours of Leisure

22. Labor – Leisure Choices • 24 hr/day • $10 to a $15 wage rate increase income and the price of leisure • Leisure & income tradeoff • When the wage rises, what is the • Income effect? • Substitution effect? Income $15 C $10 B U1 A U0 24 hours of Leisure

23. Gifts versus Cash as Presents Sweaters • Recipient of a sweater is improved from point A to B • Recipient of the cash equivalent of the sweater goes to point C, at a higher level of utility. • Why don’t we give cash rather than things? • Apply this to a grant of food stamps. B C U2 U1 A U0 All other things

24. Utility Maximizing Rule • RULE:Consume until MU per dollar in each use is equal. • Suppose MU of bars is 30, and price is $1 • Suppose MU of soda is 10 and price is $.50 • What should you do? • A rational consumer maximizes satisfaction by reorganizing consumption until the marginal utility in each good per dollar is equal where: MUA/PA = MUB/PB = MUC/PC = ... • If MU per dollar in A and B differ, the consumer can improve utility by purchasing more of the one with higher MU per dollar.