Demand Analysis
INTRODUCTION TO MARKETS
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APPENDIX. TRADITIONAL DEMAND AND SUPPLY IDEAS
Let’s talk about demand. What is demand?
Demand is the relationship of how many units of a product consumers as a group want to buy at a given price over a given time period.
Is it really true that consumers as a group will buy more of a product at a lower price?
Yes. Well, usually. An exception might some luxury goods. Some consumers will buy the product at a higher price. They are buying the brand name and status. The peculiar case of Apple’s iPhone will be discussed in a later post.
Another exception might be addicts. They want to buy the same amount of the addictive product (cigarettes) or service (gambling) even at a higher price.
Does anyone besides economists really believe this?
Yes. Retailers and service providers to consumers. That is why they run sales, to sell more units in a given time period. Amazon’s algorithms that lower price when you appear uncertain about buying a product. Auto manufacturers who lower prices, give rebates and below-market interest rates on car loans on slow-selling cars. Just about everyone runs some kind of sale on slow-moving goods. Lower price, higher unit sales.
Notice what has happened. A retailer orders a given amount of goods based on its sales forecast of so many units sold in a given period of time. If its forecast is too high, the retailer often marks down the price to clear out unwanted inventory. The scarce resource is space. The sale makes room for new and faster-moving inventory. This is another example of opportunity cost.
But why does a lower price lead to higher unit sales?
Three reasons. First, some price-sensitive consumers who would not buy the product at the existing price will buy it at a lower price. Second, some consumers will buy more units of the product at a lower price. But the most important reason (for an economist) is that the relative price of the product has fallen. That is, the price of the product has fallen compared to (relative to) the prices of competing products (called substitutes in economic theory). Some consumers will switch from another product to the now relatively cheaper product.
How do I know whether to raise or lower prices?
The concept of Price Elasticity of Demand.
Price elasticity of demand tells you something more about demand, about consumer behavior, about when the price of a product changes.
Say you are a product or sales manager. You are worried because the sales of the product you manage is below budget and you might lose your job. You must increase sales revenue, and fast. One way is to change the price of the product. But do you raise the price to increase revenue or do you lower the price? The answer depends on your estimate of the price elasticity of demand for your product.
Total revenue equals price times quantity sold. The law of demand says that if you raise price, you sell fewer units. More revenue per unit, fewer units sold. The opposite happens if you lower price. Less revenue per unit, but more units sold. Offsetting effects. But this knowledge about demand curves does not help you answer the question of whether to raise or lower price to increase revenue.
Assume that most of your customers really believe that your product is a superior value compared to competing products. This could be a consequence of superior design, innovative technology or effective advertising. So, if you raise the price, very few of your customers will switch. Demand for your product is insensitive to the price increase. Total revenue rises. This indicates that demand for your product is price inelastic.
The opposite is price elastic demand. This means customers in your market are sensitive to changes in relative prices. So, to increase revenue, do you raise prices or lower prices? Lower prices. Why? Because if you do, a lot of those price-sensitive consumers who were buying the dirty competitors’ products will switch to your product. Lots more customers, unit sales way up. Total revenue up.
If you want to increase revenue, the pricing rules are:
...if demand is price inelastic, raise price.
...if demand is price elastic, lower price.
How do I know if demand is price sensitive (elastic) or price insensitive (inelastic)?
Think like a consumer. What is important is consumers’ evaluation of the "closeness of substitutes." If there are close substitutes for your product, in the eyes of consumers, then you are in a price elastic market. If not, a price inelastic market. Most sales and marketing people would prefer to sell a product or service that their customers viewed as having no close substitutes.
Price elasticity ideas are usually applied to commodities or similar competing branded products. Price elasticities are unstable and difficult to estimate statistically.
But what about profit? Does changing price lead to more profit?
It depends.
If demand is price inelastic and you raise price, yes. Total revenue goes up, total cost goes down because you are producing fewer units. Result - more profit.
Producers spend money on advertising and marketing to convince consumers their products are different or better than competitors’ products. They are willing to spend money to make demand more price inelastic. So even if demand for a product does become more price inelastic, profit (revenue minus cost) may not go up because of the added marketing costs.
If demand is price elastic, maybe. Total revenue goes up when you lower price but so does total cost because you are producing more units. Total profits could go up or down.
OK. That seems reasonable. Are there other factors that influence demand?
The first part of demand analysis is what happens to the number of units consumers want to buy when prices change. This is shown on a graph as movement up or down a given demand curve.
The second part is what happens when some other factor that influences consumer behavior changes. This “shifts” a given demand curve on a graph. A shift up means that consumers as a group want to buy more of the product at the existing price. It means that something else besides the product’s price has changed.
The most important factor besides price that influences demand for most products is consumers’ real income (changes in monetary income over time adjusted for inflation). When real income rises, consumers as a group are able to buy more of most goods and services. The demand curve - the price-quantity demanded combinations - shifts up or to the right in graphs.
Other factors can affect demand for a particular product. One is interest rates that influence demand for products such as housing, cars and consumer durables bought on credit. This changes the price (total cost) of a product. For products like housing, the price a consumer is willing to pay may be complicated by an estimate of uncertain future costs of ownership. In a word, risk. Another is exchange rates, the price of the dollar relative to other currencies, which influences the domestic price of imports.
Changes in the level of these factors and real income are determined in the economy as a whole, the study of which is called macroeconomics. The division in economic theory between macroeconomics and microeconomics, the study of individual behavior and markets, often obscures our understanding of how an economy works.
Another thing that could shift a demand curve for a product is that the price of a competing product – called a substitute in economics - goes up or down. Assume coffee prices go up because hotter temperatures kill coffee plants in Brazil. Some coffee drinkers will switch completely or partly to tea; Twinings and Snapple will sell more tea even if they charge the same price. This adds to the list of factors that influence demand for a particular product.
A dynamic economy creates new substitutes. New information or knowledge is applied by new or existing companies to develop new products and services. The effect on existing companies is often to lower their sales or sales growth. Another common effect is to force companies to lower prices. Demand curves for older products shift in or to the left. With more choices that give a better expected benefits/cost ratio, consumers demand less at any given price.
New information can also shift a demand curve. In the 1960s, a rumor that roasted banana peels gave consumers benefits similar to marijuana increased demand for bananas in many college towns. The finding that aspirin reduces the chance of a heart attack reversed the decline in aspirin sales among aging baby boomers who survived smoking banana peels. For hundreds of years Europeans refused to eat tomatoes because they thought tomatoes were poisonous. New information about health and wellness may change some consumers’ buying habits.
Real income is an important influence on demand. What is Income Elasticity of Demand?
This is a useful concept. It gives you a rough idea of the percent increase in your unit sales for a given increase in real income. You can estimate this ratio using past sales data. Say that over the last 10 years Pepsi case sales rose an average of 4% a year. Also assume that real income went up an average of 2% a year. Income elasticity is 2; for every 1% increase in income, there was a 2% increase in Pepsi case sales. This relationship can be used for forecasting. If your corporate economist forecasts that next year’s real income will go up 2% (and he is never wrong), then you can expect case sales to rise by about 4%.
Most years, total output and total real income go up. So most companies can expect an increase in unit sales most of the time. Dollar sales also go up most of the time for most companies. Corporate managers often take credit for increased sales when the real cause is economic growth.
Are there any other pricing strategies besides raising or lowering the market price of a product?
In the real world, retailers sell branded products at a range of prices.
A market price divides demand into consumers willing and able to pay the price and buy the product, and potential customers who would buy the product only at the lower price. A retailer could lower the price to increase unit sales but this means that existing customers can now buy the product at a lower price. Revenue is lost. This suggests a pricing strategy of charging one price to one group of customers and a lower price to another group of customers. Is this possible? Yes. In economics, this strategy is called price discrimination. It is a very common strategy used by retailers and other suppliers. It will be discussed in later posts.
COMMENTS
There are long-run factors that influence demand and shift demand curves. One is changing demographics, which also affects supply, partly by the change in the size of the labor force. Demographics and economic growth will be discussed in a later post.
Demographics also influence the demand side of economies. Companies use demographic information when planning marketing and advertising strategies. Changing demographics are analyzed when developing new products, changing product mix, and segmenting markets. The explosion of detailed demographic and customer information about smaller and smaller segments, including individuals, combined with online marketing technology and almost real-time data analysis algorithms, is revolutionizing marketing and advertising.
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