1b elasticity
TRANSCRIPT
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Customer PowerEconomics of Elasticity of Demand
David J. Brycecopyright 2000, 2002
Managerial Economics 387
The Economics of Strategy
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Exploring Industry Structure
Rivalrybetween
Competitors
Threat ofPotentialEntrants
CustomerPower &
Preferences
Threatof
Substitutes
BargainingPower ofSuppliers
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Customer Power & Preferences
Customers influence industry performancethrough
Their ability to exercise bargaining power(industrial markets with a few firms)
Differences in and strengths of preferences(elasticity of demand)
We will first focus our analysis on thestrength of customer preferences in the formof customer demand and price elasticities.
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Sources of Customer Power
Buyers are sensitive to prices,productquality, and/or product characteristics Products sold to buyers are undifferentiated
Many substitute products are available Products are a large fraction of customers finalcosts
Buyers are not earning significant economic profits
Customer is relatively important to our firm Low switching costs Information asymmetry with customers
Large purchasing volumes by customers
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Sensitivity to PricesPrice Elasticity of Demand
The rate at which quantity demanded falls asprice rises is defined by the price elasticity ofdemand.
Demand elasticity defines sensitivity to price interms of percentage changes. Let the subscript 0 denote starting points, 1 denote
new values, and Ddenote changes in value.
Then the elasticity is
0
0
0
0
0
01
0
01
%
%
Q
P
P
Q
P
Q
PP
QQ
P
PP
QQQ
D
D
D
D
D
D
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Own Price Elasticity of Demand
||< 1 implies inelasticdemand
||= 1 implies unitaryelasticity
||> 1 implies elasticdemand
Interpreting elasticitya one percent increasein price results in an % decrease in quantitydemanded
Consider some examples Textbooks Water Diamonds
Mercedes-Benz Milk Air
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Own-Price Elasticity of Demand
and Total Revenue Elastican increase (a decrease) in price leads to a
decrease (an increase) in total revenue
Inelasticincrease (a decrease) in price leads toan increase (a decrease) in total revenue
Unitarytotal revenue is maximized at the pointwhere demand is unitary elastic
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Factors Affecting Own PriceElasticity
Available substitutesthe more substitutesavailable for the good, the more elastic the demand.
Timedemand tends to be more inelastic in the shortterm than in the long term because time allowsconsumers to seek out available substitutes.
Expenditure sharegoods that comprise a smallshare of consumers budgets tend to be more inelasticthan goods for which consumers spend a large portionof their incomes.
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Uses of Elasticities
Pricing
Managing cash flows
Impact of changes in competitors prices Impact of economic booms and recessions
Impact of advertising campaigns
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0.2
4
45
2
21
1
Elasticity Calculations
2.01
12
5
54
2
1 2 3 4 5
1
2
3
4
5
Price
Quantity
1
2
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Example 1: Pricing and Cash Flows
According to an FTC Report by Michael Ward,AT&Ts own price elasticity of demand forlong distance services is -8.64
AT&T needs to boost revenues in order tomeet its marketing goals
To accomplish this goal, should AT&T raise orlower its price?
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Answer: Lower price!
Since demand is elastic, a reduction in pricewill increase quantity demanded by a greater
percentage than the price decline, resulting inmore revenues for AT&T.
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Example 2: Quantifying the
Change
If AT&T lowered price by 3 percent, what
would happen to the volume of long distancetelephone calls routed through AT&T?
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Answer
Calls would increase by 25.92 percent!
%92.25%%64.8%3
%3
%64.8
%
%64.8
,
D
D
D
D
D
d
X
d
X
d
X
X
d
XPQ
QQ
QP
QXX
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Buyers Have Power When They HaveElastic Demandsensitive to prices
Increasing elasticity is caused by Products with few unique features (undifferentiable)
Buyers whose expenditures on our product are alarge share of their total expenditures
Buyers of an input into an elastic product
Decreasing elasticity is caused by Limited ability to compare substitutes
Buyers pay only a fraction of the cost
High switching costs
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Responding to Increasing Buyer
Power Reduce buyer power by increasing buyer own
price elasticity of demand
Advertising/branding New product introductions
Increase quality
Reduce buyer bargaining power
Vertically integrate downstream
Alliances and long-term contracts
Increase home industry concentration
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Summary and Takeaways Customers and substitutes threaten to reduce
our prices; suppliers threaten to raise our costs.
Their probable success can be measured usingelasticity.
General knowledge of elasticities is a goodsubstitute for specific knowledge of the demand
curve. What role will the Internet play in providing
information about elasticities?