customer power economics of elasticity of demand david j. bryce copyright 2000, 2002 david j. bryce...

Customer PowerEconomics of Elasticity of DemandCustomer PowerEconomics of Elasticity of Demand

David J. Bryce copyright 2000, 2002

David J. Bryce copyright 2000, 2002

Managerial Economics 387

The Economics of StrategyManagerial Economics 387

The Economics of Strategy

Nile Hatch © 1996, 2000, 2002Nile Hatch © 1996, 2000, 2002

Exploring Industry StructureExploring Industry Structure

Rivalry Rivalry between between

CompetitorsCompetitors

Rivalry Rivalry between between

CompetitorsCompetitors

Threat of Threat of Potential Potential EntrantsEntrants

Threat of Threat of Potential Potential EntrantsEntrants

CustomerCustomerPower &Power &

PreferencesPreferences

CustomerCustomerPower &Power &

PreferencesPreferences

ThreatThreatofof

SubstitutesSubstitutes

ThreatThreatofof

SubstitutesSubstitutes

Bargaining Bargaining Power ofPower ofSuppliersSuppliers

Bargaining Bargaining Power ofPower ofSuppliersSuppliers


Customer Power & PreferencesCustomer Power & Preferences

• Customers influence industry performance through– 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 the strength of customer preferences in the form of customer demand and price elasticities.

• Customers influence industry performance through– 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 the strength of customer preferences in the form of customer demand and price elasticities.


Sources of Customer PowerSources of Customer Power

• Buyers are sensitive to prices, product quality, and/or product characteristics– Products sold to buyers are undifferentiated– Many substitute products are available– Products are a large fraction of customer’s final

costs– 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

• Buyers are sensitive to prices, product quality, and/or product characteristics– Products sold to buyers are undifferentiated– Many substitute products are available– Products are a large fraction of customer’s final

costs– 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


Sensitivity to PricesPrice Elasticity of DemandSensitivity to PricesPrice Elasticity of Demand

• The rate at which quantity demanded falls as price rises is defined by the price elasticity of demand.

• Demand elasticity defines sensitivity to price in terms of percentage changes.– Let the subscript 0 denote starting points, 1

denote new values, and denote changes in value.

– Then the elasticity is

• The rate at which quantity demanded falls as price rises is defined by the price elasticity of demand.

• Demand elasticity defines sensitivity to price in terms of percentage changes.– Let the subscript 0 denote starting points, 1

denote new values, and denote changes in value.

– Then the elasticity is

0

0

0

0

0

01

0

01

%

%

Q

P

P

Q

P

Q

PP

QQ

PPP

QQQ


Own Price Elasticity of DemandOwn Price Elasticity of Demand

• |< 1 implies inelastic demand | = 1 implies unitary elasticity | > 1 implies elastic demand

• Interpreting elasticity – a one percent increase in price results in an % decrease in quantity demanded

• Consider some examples– Textbooks – Water – Diamonds– Mercedes-Benz – Milk – Air

• |< 1 implies inelastic demand | = 1 implies unitary elasticity | > 1 implies elastic demand

• Interpreting elasticity – a one percent increase in price results in an % decrease in quantity demanded

• Consider some examples– Textbooks – Water – Diamonds– Mercedes-Benz – Milk – Air


Own-Price Elasticity of Demand and Total RevenueOwn-Price Elasticity of Demand and Total Revenue

• Elastic – an increase (a decrease) in price leads to a decrease (an increase) in total revenue

• Inelastic – increase (a decrease) in price leads to an increase (a decrease) in total revenue

• Unitary – total revenue is maximized at the point where demand is unitary elastic

• Elastic – an increase (a decrease) in price leads to a decrease (an increase) in total revenue

• Inelastic – increase (a decrease) in price leads to an increase (a decrease) in total revenue

• Unitary – total revenue is maximized at the point where demand is unitary elastic


Factors Affecting Own Price ElasticityFactors Affecting Own Price Elasticity

• Available substitutes – the more substitutes available for the good, the more elastic the demand.

• Time – demand tends to be more inelastic in the short term than in the long term because time allows consumers to seek out available substitutes.

• Expenditure share – goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

• Available substitutes – the more substitutes available for the good, the more elastic the demand.

• Time – demand tends to be more inelastic in the short term than in the long term because time allows consumers to seek out available substitutes.

• Expenditure share – goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.


Uses of ElasticitiesUses of Elasticities

• Pricing• Managing cash flows• Impact of changes in competitors’ prices• Impact of economic booms and recessions• Impact of advertising campaigns

• Pricing• Managing cash flows• Impact of changes in competitors’ prices• Impact of economic booms and recessions• Impact of advertising campaigns


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Elasticity CalculationsElasticity Calculations

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12

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11 22 33 44 55

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33

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PricePrice

QuantityQuantity

11

22


Example 1: Pricing and Cash FlowsExample 1: Pricing and Cash Flows

• According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64

• AT&T needs to boost revenues in order to meet it’s marketing goals

• To accomplish this goal, should AT&T raise or lower it’s price?

• According to an FTC Report by Michael Ward, AT&T’s own price elasticity of demand for long distance services is -8.64

• AT&T needs to boost revenues in order to meet it’s marketing goals

• To accomplish this goal, should AT&T raise or lower it’s price?


Answer: Lower price!Answer: Lower price!

• Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.

• Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.


Example 2: Quantifying the ChangeExample 2: Quantifying the Change

• If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

• If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?


AnswerAnswer

Calls would increase by 25.92 percent! Calls would increase by 25.92 percent!

%92.25%

%64.8%3

%3

%64.8

%

%64.8,

dX

dX

dX

X

dX

PQ

Q

Q

Q

P

QXX


Buyers Have Power When They Have Elastic Demand – sensitive to prices

Buyers Have Power When They Have Elastic Demand – sensitive to prices

• Increasing elasticity is caused by– Products with few unique features (undifferentiable)

– Buyers whose expenditures on our product are a large 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

• Increasing elasticity is caused by– Products with few unique features (undifferentiable)

– Buyers whose expenditures on our product are a large 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


Responding to Increasing Buyer PowerResponding 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

• 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


Summary and TakeawaysSummary and Takeaways

• Customers and substitutes threaten to reduce our prices; suppliers threaten to raise our costs.

• Their probable success can be measured using elasticity.

• General knowledge of elasticities is a good substitute for specific knowledge of the demand curve.

• What role will the Internet play in providing information about elasticities?

• Customers and substitutes threaten to reduce our prices; suppliers threaten to raise our costs.

• Their probable success can be measured using elasticity.

• General knowledge of elasticities is a good substitute for specific knowledge of the demand curve.

• What role will the Internet play in providing information about elasticities?

customer power economics of elasticity of demand david j. bryce copyright 2000, 2002 david j. bryce...

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