OUTLINE

1
Market Demand and the Pricing Decision
Session 3 Professor Dermot McAleese
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OUTLINE

• ? Rational consumer
• ? Market demand curve
• ? Elasticities of demand
• ? Estimating the demand curve
• ? Pricing decision

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WHAT IS A RATIONAL CONSUMER?
The rational individual behaves in a way which
most people would consider an acceptable
approximation of reality they maximise
utility ? Assumptions ? comparability ?
non-satiation ? consistency ?
convexity ? independent utilities ?
Challenges to assumptions ? insufficient
information to rank preferences ? uncertain
utility from the consumption of a particular good
or service ? satisfaction obtained from the
consumption of a good because others are unable
to afford it
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THE MARKET DEMAND CURVE

• The market demand curve is derived by the
  addition of individual demand curves in a process
  of lateral summation.

K
P1
K
P
O
R
S
J
O
J
O
H
H
Individual J
Market demand
Individual H
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PRICE ELASTICITY OF DEMAND
?Determinants ? range of available goods ?
definition of the product ? share of spending in
consumers budget ? time period
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INCOME ELASTICITY OF DEMAND

• ? luxury goods (E gt 1)
• ? necessities (0 lt E lt1)
• ? inferior goods (E lt 0)

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CROSS-PRICE ELASTICITY OF DEMAND

• ? substitutes
• ? complements
• within the relevant price range

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Table. 1 Price and income elasticities for the
service sector

• Source R.E. Falvey and N. Genmell, Are services
  income-elastic? some new evidence, Review of
  Income and Wealth, September 1996.

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Table. 2 Consumption of alcoholic beverages
short- run and long-run elasticities for beer,
spirits and wine in Canada
Source J. Johnson et al., Short-run and
long-run elasticities for Canadian consumption of
alcoholic beverages, Review of Economics and
Statistics (February 1992).
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ESTIMATING A DEMAND FUNCTION
Think of a demand function of general form Qi
?0 ?1Y - ?2Pi ?3Ps - ?4Pc ?5Z e where
Qi quantity demanded of good i Pi price
of good i Ps price of substitute(s) Pc
price of complement(s) Z other relevant
determinants of demand e error term
representing random factors
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Then follow these steps
? Identify independent variables income, own
price, price of substitutes and complements,
other influences ? Decide on form of
function linear, log linear, translog lag
structure prior constraints ? Determine
statistical estimation techniques ordinary
least squares is one of a large number of
possible estimation techniques ? Derive
parameters often reported as short-term and
long-term elasticities ? Evaluate results and
cross-check with other procedures surveys,
marketing tests, managers' opinions ? Set up
different scenarios of future Y, P, and Z and use
simulations to derive forecasts for Q
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WHY DEMAND ANALYSIS IS USEFUL TO BUSINESS
? Forecasting and projecting trends in demand ?
Price forecasting ? Estimating the incidence
of tax ? Market segmentation and pricing ?
Defining the market through cross
elasticities ? Understanding market structure
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PRICE ELASTICITIES AND THE PRICING DECISION
? Marginal revenue curve (finding the price that
will maximise revenue) ? Market
segmentation (separating high and low price
elasticity segments different prices to
different groups of consumers) ? Finding a
market niche (to escape constraints of prefect
competition and to make the demand curve
inelastic to some degree) ? Competitors
reactions (price wars and non-price competition)
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MARKET SEGMENTATION
P
10
E(P)gt1
E(P)1
6
E(P)lt1
D
5
O
Q
10
MR