MANAGERIAL ECONOMICS An Analysis of Business Issues

1. MANAGERIAL ECONOMICSAn Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall

2. Chapter 16: Non-price Competition and the Marketing Mix

3. At the end of this lecture you should be able to: • 1. Use a simple economic model to explain the need for a properly balanced MARKETING MIX • 2. Extend the formal economic model of the firm to include marketing variables • 3. Evaluate the ‘rules-of-thumb’ which are used by firms to set their marketing budgets • 4. Apply basic economic concepts to: product characteristics; the promotional mix; the product mix

4. The Marketing Mix • What are the 4 ‘P’s of the MARKETING MIX?

5. The Marketing Mix • What are the 4 ‘P’s of the MARKETING MIX? • Product, Price, Promotion, Place

6. What Does Simple Economic Thinking Tell Us About the Optimal Marketing Mix? • The optimal marketing mix is where the contribution from an additional $ spent on each aspect of the marketing mix is ; • equal to each other • equal to zero • d$/d(price) = d$/d(product) = d$/d(promotion) = d$/d(place) = 0 • WHY?

7. What Does Simple Economic Thinking Tell Us About the Optimal Marketing Mix? • The optimal marketing mix is where the contribution from an additional $ spent on each aspect of the marketing mix is ; • equal to each other • equal to zero • d$/d(price) = d$/d(product) = d$/d(promotion) = d$/d(place) = 0 • WHY? • Because in any other situation it would be possible to increase profit by either shifting spending from one aspect of the mix to another, or by increasing total spending

8. Extending the Profit-Maximising Model • We can include Advertising and Promotion expenditure (or any other spending designed to increase demand) by re-writing the model as follows: • $ = TR -TC - A • TC = TOTAL COST OF PRODUCTION • TR = TOTAL REVENUE • A = COST OF ADVERTISING • TR = P.Q = P[Q(P,A)]; Q = QUANTITY PRODUCED AND SOLD • TC = C[Q] Demand depends on P and A

9. The Profit Equation is Then • $ = P[Q(P,A)] - C[Q(P,A)] - A • Maximising this with respect to P and A gives two conditions: • (P - MC)/P = 1/Ed - the familiar condition • A/PQ = Ea/Ed - the Dorfman-Steiner condition • The ratio of advertising spending to total revenue should equal the ratio of advertising elasticity to price elasticity

10. The Model Shows that Advertising Elasticity of Demand is Important • What determines advertising elasticity (the effectiveness of advertising)? • The absolute level of advertising Impact on Sales Level of A spending Threshold level

11. What Else Determines Advertising Elasticity? • The structure of the industry and the behaviour of rivals • do they ‘follow the leader’ do they retaliate when I raise A? • IF MY RIVALS RETALIATE WHEN I INCREASE MY ADVERTISING, WILL Ea BE LOW OR HIGH? • My market share • if my market share is very high, what will be the effect on my advertising elasticity? • The nature of the product • new/old, luxury/necessity, frequent purchase/infrequent purchase • The general state of the economy • when there is concern about recession, what is the impact on advertising elasticity?

12. Rules of Thumb for Setting Advertising Budgets • Percentage of sales • decide on a fixed % of sales to spend on A • matches D-S in form but the same ‘circularity’ problem as in pricing • if my rival increases A and I lose sales, I would reduce A • if demand falls for any other reason, I would reduce A • has serious weaknesses if used mechanically • ‘All you can afford’ approach • spend on A until you meet the profit constraint • may be preferred by Marketing departments • unlikely to max profits • Competitive parity approach • match the competition • will be optimal only if everyone faces same elasticities and the others get it right!

13. The ‘Objective and Task’ Approach make a list of specific objectives increase sales in Kowloon by 50% achieve 40% market share in Guangzhou identify the revenue implications of meeting each objective identify the advertising tasks which need to be carried out to meet the objectives, and the extra cost of those tasks advertise twice per week in HK newspapers - $3m spend $5m on TV advertising in Guangdong carry out every task where the extra revenue exceeds the extra cost May solve the problem in principle but costs and revenues must be calculable Is There a Rule of Thumb which Offers a Way to Optimise?

14. The profit-maximising model is essentially short-run and ‘tactical’ Firms may also need to consider longer-run and ‘strategic’ implications of advertising advertising as investment in goodwill this can be modelled, but it is complex advertising to build entry barriers customer loyalty can deter entry threat of advertising campaigns may deter entry use of other promotional tools ‘air miles’ to increase customers’ switching costs What About Long-run and Strategic Implications of Advertising and Promotion?

15. Equate the MARGINAL SALES REVENUE per dollar of each component of the promotional mix: the extra revenue for an extra $ spent on TV advertising should equal the extra $ spent on salespeople and newspaper advertising But how practical is it to try to estimate these effects? Econometric analysis is not reliable enough Might be able to estimate the number of potential customers exposed and then use market research to measure their awareness. Use awareness as a proxy for the revenue effect. What About the Promotional Mix?

16. Lancaster developed the idea that goods are bundles of ‘characteristics’ a car is a combination of acceleration, speed, safety, luxury a computer is speed, memory, functions a university is courses offered, academic grading, location, facilities consumers want characteristics rather than products marketing managers should assess preferences for characteristics not products What About Product Characteristics?

17. Market research has a technique called ‘conjoint analysis’ ask customers to rank a set of products which have different characteristics software uses the rankings to estimate customers ‘utilities’ or ‘part-worths’ for the different level of each attribute e.g. HK school students value “having the course I want” most highly, compared with “facilities”, “academic reputation” Some economists have used ‘hedonic price indices’ to value the characteristic s of products e.g. computers, fish catches in the Phillipines use the price of different products as the dependent variable in a regression, with characteristics as the independent Can We Use the Characteristics Approach in Practice?

18. What About the Product Mix? Maximise Revenue given the Production Possibilities Product B Production Possibilities Product A Iso-Revenue Line: TR = APa+BPb Slope is the ratio of the product prices

19. What About the Product Mix? Maximise Revenue given the Production Possibilities Product B Optimal Product Mix Production Possibilities Iso-Revenue Line: TR = APa+BPb Product A