Sources of Demand

David Bryce © 1996-2002Adapted from Baye © 2002


Sources of DemandSources of Demand

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

David J. BryceDavid J. Bryce



ExerciseExercise

• I will name possible prices for a Reese’sI will name possible prices for a Reese’s

• As I name a price, please tell me how As I name a price, please tell me how many Reese’s you are willing to many Reese’s you are willing to purchase at that price, right now.purchase at that price, right now.

• This exercise is an offer to sell and it is This exercise is an offer to sell and it is real. I reserve the right to call in the real. I reserve the right to call in the cash from any individual at any time cash from any individual at any time who indicates their willingness to buy who indicates their willingness to buy (you can bring me the cash later if you (you can bring me the cash later if you don’t have it on hand!).don’t have it on hand!).

• I will name possible prices for a Reese’sI will name possible prices for a Reese’s

• As I name a price, please tell me how As I name a price, please tell me how many Reese’s you are willing to many Reese’s you are willing to purchase at that price, right now.purchase at that price, right now.

• This exercise is an offer to sell and it is This exercise is an offer to sell and it is real. I reserve the right to call in the real. I reserve the right to call in the cash from any individual at any time cash from any individual at any time who indicates their willingness to buy who indicates their willingness to buy (you can bring me the cash later if you (you can bring me the cash later if you don’t have it on hand!).don’t have it on hand!).



Class Demand For Reese’sClass Demand For Reese’s

$0.00

$0.25

$0.50

$0.75

$1.00

0 0 0 1 1 1

Quantity Demanded

Price



Market Demand CurveMarket Demand Curve

• Shows the amount of a good that will be purchased at alternative prices.

• Law of Demand – The demand curve is downward

sloping.

• Shows the amount of a good that will be purchased at alternative prices.

• Law of Demand – The demand curve is downward

sloping.

QuantityQuantity

DD

PricePrice



Determinants of DemandDeterminants of Demand

• Income• Prices of substitutes • Prices of complements• Advertising• Population changes• Consumer expectations

• Income• Prices of substitutes • Prices of complements• Advertising• Population changes• Consumer expectations



The Demand FunctionThe Demand Function

• An equation representing the demand curve

Qxd = f(Px , PY , M, H,)

– Qxd = quantity demand of good X.

– Px = price of good X.– PY = price of a substitute good Y.– M = income.– H = any other variable affecting demand

• An equation representing the demand curve

Qxd = f(Px , PY , M, H,)

– Qxd = quantity demand of good X.

– Px = price of good X.– PY = price of a substitute good Y.– M = income.– H = any other variable affecting demand



Change in Quantity DemandedChange in Quantity Demanded

PricePrice

QuantityQuantity

D0D0

A to B: Increase in quantity demanded

A to B: Increase in quantity demanded

44

1010AA

77

66BB



What could lead to a change in quantity demanded?What could lead to a change in quantity demanded?

• Only a change in price• Why?

– Because a given demand curve simply reflects preferences under a given set of conditions—it is a picture of stationary preferences

– When conditions change, preferences often do as well, so that the entire relationship of quantity to price also changes (shift in demand)

• Only a change in price• Why?

– Because a given demand curve simply reflects preferences under a given set of conditions—it is a picture of stationary preferences

– When conditions change, preferences often do as well, so that the entire relationship of quantity to price also changes (shift in demand)



PricePrice

QuantityQuantity

D0D0

Change in DemandChange in Demand

66

77 1313

D1D1

D0 to D1: Increase in DemandD0 to D1: Increase in Demand



What could lead to an increase in demand (shift in demand)?What could lead to an increase in demand (shift in demand)?

• A change in any of the determinants of demand:– Income– Prices of substitutes – Prices of complements– Advertising– Population changes– Consumer expectations

• A change in the quality or characteristics of a product, even if the changes are small

• A change in any of the determinants of demand:– Income– Prices of substitutes – Prices of complements– Advertising– Population changes– Consumer expectations

• A change in the quality or characteristics of a product, even if the changes are small



Where do demand curves come from?Where do demand curves come from?• Experiments

– Raise and lower price systematically over time and watch what happens to quantity

– Limitation: hard to control for changes in external factors (you may get a “wiggly” curve!)

• Market Research– Surveys in which consumers are asked to tradeoff

bundles of goods against price or other bundles in order to determine relative value and demand at given prices

– Limitation: Expensive; sampling bias; perception bias—spending real money is different than checking boxes on a survey

• Experiments – Raise and lower price systematically over time and

watch what happens to quantity– Limitation: hard to control for changes in external

factors (you may get a “wiggly” curve!)

• Market Research– Surveys in which consumers are asked to tradeoff

bundles of goods against price or other bundles in order to determine relative value and demand at given prices

– Limitation: Expensive; sampling bias; perception bias—spending real money is different than checking boxes on a survey



Where do demand curves come from?Where do demand curves come from?• Regression analysis

– Attempt to glean from multiple observations in multiple settings (geographic, store, product, etc.) the relationship between price and quantity

• Not always goods that are exactly like• Do not always have observations on the extremes of the

curve—extrapolation required

– Must control for the amount supplied (otherwise may get an upward sloping demand curve!)

– Limitation: Data is hard to get and you must assume that external factors are stable across observations or control for these in the statistics; CAUTION: If you don’t know what you’re doing, you could go wildly astray

• Regression analysis– Attempt to glean from multiple observations in

multiple settings (geographic, store, product, etc.) the relationship between price and quantity

• Not always goods that are exactly like• Do not always have observations on the extremes of the

curve—extrapolation required

– Must control for the amount supplied (otherwise may get an upward sloping demand curve!)

– Limitation: Data is hard to get and you must assume that external factors are stable across observations or control for these in the statistics; CAUTION: If you don’t know what you’re doing, you could go wildly astray



Where do demand curves come from?Where do demand curves come from?

• If all else fails – Use Intuition – “Sniff” the market by looking at how other

similar products seem to be doing– Ask your close friends and neighbors how

much they would pay– Pray about it (Limitation: faith)– Any other possible qualitative approach you

can think of– Believe it or not, you’re likely to get close …

and others are doing the same thing in practice

• Bottom line: No technique is fool-proof!

• If all else fails – Use Intuition – “Sniff” the market by looking at how other

similar products seem to be doing– Ask your close friends and neighbors how

much they would pay– Pray about it (Limitation: faith)– Any other possible qualitative approach you

can think of– Believe it or not, you’re likely to get close …

and others are doing the same thing in practice

• Bottom line: No technique is fool-proof!



Consumer Surplus – the value consumers get from a good but do not have to pay for

Consumer Surplus – the value consumers get from a good but do not have to pay for

• “I got a lousy deal!”• That car dealer drives

a hard bargain! • I almost decided not to

buy it!• They tried to squeeze

the very last cent from me!

• Total amount paid is close to total value.

• Consumer surplus is low.

• “I got a lousy deal!”• That car dealer drives

a hard bargain! • I almost decided not to

buy it!• They tried to squeeze

the very last cent from me!

• Total amount paid is close to total value.

• Consumer surplus is low.

• “I got a great deal!”

• That company offers a lot of bang for the buck!

• Dell provides good value.

• Total value greatly exceeds total amount paid.

• Consumer surplus is large.

• “I got a great deal!”

• That company offers a lot of bang for the buck!

• Dell provides good value.

• Total value greatly exceeds total amount paid.

• Consumer surplus is large.



PricePrice

QuantityQuantity

DD

1010

88

66

44

22

1 2 3 4 51 2 3 4 5

Consumer Surplus: the value received but notpaid for

Consumer Surplus: the value received but notpaid for

Consumer Surplus: The Discrete CaseConsumer Surplus: The Discrete Case



Consumer Surplus:The Continuous CaseConsumer Surplus:The Continuous Case

Price $Price $

QuantityQuantity

DD

1010

88

66

44

22

1 2 3 4 51 2 3 4 5

Valueof 4 unitsValueof 4 units

Consumer Surplus

Consumer Surplus

Total Cost of 4 UnitsTotal Cost of 4 Units

Sources of Demand

Documents

demand shift

class demand

demand curveqxd

law of demand

quantity demand of good

given demand curve

upward sloping demand

lower price