Bus 687 Week 1 journal
need help with journal
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Jorg Greuel/Gey Images
Consumer Demand Analysis
Learning Objectives
Aer reading this chapter, you should be able to:
Understand that indifference curves can depict the consumer’s tastes and preferences in product space
and predict the consumer’s reacon to changes in price, income, and other variables that enter the
consumer’s decision funcon.
Explain that the price effect is always negave, such that demand curves slope downwards.
Disnguish between the income and substuon effects of a price change, and explain why the income
effect is posive for superior goods and negave for inferior goods.
Disnguish between changes in demand (i.e., shis of the demand curve) and changes in quanty
demanded (i.e., movements along a demand curve).
Explain that choice between compeng brands can be modeled as deriving from the different aribute
combinaons inherent in differenated products.
Discuss how the firm can increase its value proposion to consumers by changing one or more of the
four “P” markeng variables.
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A consumer’s preference for Coca-Cola over Pepsi can be beer
understood through brand-based analysis, which evaluates
consumer reacon to changes in product design, promoon, place
of sale, and packaging and service quality.
ASSOCIATED PRESS/AP IMAGES
Introduction
Managers make many of their decisions based on what they expect their customers to do. By tradion, economists call these customers consumers,
meaning the ones who purchase (and typically also consume)1 (hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/ch03introducon#ch03txt1) the firm’s products.2
(hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/ch03introducon#ch03txt2) Managers can influence the purchasing behavior of consumers by adjusng one or more
of the variables that enter the consumer’s decision purchasing processthese variables are known as decision variables and include product price, product
design and packaging, product availability, and product promoon. It is important for managers to understand how consumers are likely to respond to
changes in these variables because changes cost money to implement and have subsequent cost and revenue impacts. In this chapter, we examine
consumer decisions using a predicve model that indicates how consumers are likely to react to changes in both a firm’s controllable decision variables, such
as those menoned above, as well as to changes in uncontrollable variables, or variables that are not controlled by the firm, such as consumer income
levels and changes in compeve behavior by rival firms.
Consumers make choices within product categories (between different brands of so drinks)
and between product categories (between taking a vacaon or buying a new car). Within
product categories the products are close substutes, meaning they are differenated but
qualitavely similar, and the customer will choose one brand in preference to the other
brands. Across different product categories, the products are dissimilar but are gross
substutes, meaning that if one buys one product this limits the amount of money le to buy
products in other categories. In this chapter we will consider the consumer’s decision problem
in both scenarios. We first consider the consumer’s choice problem in the context of different
product categories For example, the consumer is choosing between his or her preferred so
drink (Coca-Cola) and his or her preferred brand of cheese (Swissco’s Gruyere). In this context,
we will examine the impact on quanty demanded of these two products for changes in
prices and consumer incomes. The main issue here is to understand how consumers, with
limited income and unlimited wants and needs, allocate that limited income among the
available product and service categories such that they maximize their ulity.
In the laer half of this chapter we ask what is it about products that cause the consumer to
want to buy a parcular brand within a product category. Thus, we will shi our level of
analysis from between products to within products to consider what characteriscs of a brand are desirable to the consumer. So, whereas our analysis is
inially product category basedthe choice of so drinks versus cheesewe shi to brand-based analysis within a parcular categorythe choice of Coca-
Cola versus Pepsi. This allows us to consider the consumer’s reacon to changes in the firm’s controllable decision variables such as changes in product
design, promoon, place of sale, packaging, and service quality. For example, one brand may gain sales by improving the quality of its product, adversing
more, offering it for purchase online, and so on. You may note that these are tradionally considered markeng decisions, and indeed we want to examine
the underlying economics of these markeng decisions in the context of managerial economics, as an aim of this book is to integrate managerial economics
with other business disciplines.
1. In some cases the purchaser of the firm’s product buys it for someone else to consume, such as dog food or children’s clothes, in which case we say there is indirect demand for the
firm’s product from the end consumer (i.e., the dog or the child). In other cases of indirect demand, such as in business-to-business (B2B) retailing, one firm buys the firm’s products in
order to re-sell them to the end consumer. In general, the purchaser buys the product expecng to best serve the end consumer’s wants and needs. [return
(hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/ch03introducon#return1) ]
2. We use the term “product” to mean the outcome of the firm’s producon process. Thus “products” might mean either goods or services, and indeed are generally a combinaon of
the two, such as a haircut with flaery, a meal with aenve service, or a baseball game with a hotdog. [return
(hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/ch03introducon#return1) ]
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3.1 Consumer Choice Between Product Categories
The model we will use to predict consumer behavior is the ulity-maximizing model. This is the same model that was introduced in Chapter 2 to explain
how managers make decisions that include risk and uncertainty. The ulity-maximizing model of consumer behavior says that individual consumers make
decisions to buy products based on the expectaon that the purchase will allow them to gain the most psychic sasfacon, or ulity, from their limited
incomes. In Chapter 2, we saw that the individual’s ulity can be depicted by indifference curves, which are curves joining combinaons of items that give
equal ulity to the individual. In Chapter 2, we considered indifference curves in risk and return space, where the individual gained ulity from return and
disulity (i.e., negave ulity) from risk. In the riskreturn applicaon, the indifference curves were posively sloping because, to stay at the same level of
total ulity, a combinaon that had more risk must also have more return. However, when we analyze consumer choice in product space we generally
consider only items that give the consumer ulity, since people would not willingly purchase products that would give them disulity (such as garbage).3
(hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/sec3.1#ch03txt3) When both the items under consideraon generate ulity, we will have negavely-sloping
indifference curves, since there must be reduced consumpon of one item to stay at the same level of total ulity when consumpon of the other is
increased. Indifference curve analysis allows us to predict the choices that a consumer will make in response to changes in product prices and consumer
incomes, as we shall see.
Let us illustrate this in the context of Bob Goodguy, who likes to spend his discreonary income (what is le from his pay check aer paying for his
necessary expenditures, such as accommodaons, food, and commung expenses) on entertainment. He loves to go to baseball games and watch new
movies in the theater. Using indifference curve analysis we can plot out his preferences in baseballmovie space, as shown in Figure 3.1. The number of
movies is shown on the vercal (or Y) axis and the number of baseball games is shown on the horizontal (or X) axis. Each indifference curve shows
combinaons of baseball and movies that Bob considers equivalent in terms of total ulity.
Figure 3.1: Indifference curves in product space
In Figure 3.1, point A represents 5 movies and 2 baseball games. Because point A and point B are on the same indifference curve (I3), Bob must consider 5
movies and 2 games to be equally sasfying as 4 movies and 3 games. Note that point C, represenng about 2.6 movies and 3 baseball games, offers less
total ulity than point B since it has the same number of games but fewer movies.4 (hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/sec3.1#ch03txt4) Also note
that point C offers more ulity than point D since it has the same number of movies but more games. Finally, note that since points A, B, and E are superior
to point C, and since point C is superior to point D, then points A, B, and E must also be superior to point D.
Indifference curves depict the preference structure of the individualthat is, what products the person likes and how much they like the various products.
Indifference curves show what combinaons of two products are considered equal to, inferior to, or superior to any other combinaon. Figure 3.1 shows the
indifference map for Bob Goodguy in baseballmovie space, but necessarily shows only a few of his indifference curves. Because every point in the space
would have an indifference curve passing through it, the complete indifference map showing every indifference curve would totally black out the space and
we would see nothing, so we show only selected indifference curves to illustrate the consumer’s choice problem that we wish to explain.
It is important to note four specific properes of indifference curves. First, points on higher curves are preferred to lower curves, because we assume that,
all other things being equal, consumers always prefers more rather than less of any product. Second, indifference curves in product space are negavely
sloped throughout, because we assume that the consumer always gains posive ulity from both goods. Giving up one unit of product Y (in this case
movies) must require gaining more of product X (baseball games) to stay at the same level of total ulity. Third, indifference curves neither meet nor
intersect, due to the assumpon of transive preferences. For example, in Figure 3.1, if B is preferred to C, and C is preferred to D, then B must be preferred
to D. Fourth, indifference curves are convex from below. Convexity means that the slope of the indifference curve becomes increasingly flaer as we move
down that indifference curve. This convexity is due to the phenomenon of diminishing marginal ulity.
Diminishing Marginal Utility
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Diminishing marginal ulity is commonly
observed for virtually all goods and
services including water. Economists
assume that marginal ulity decreases for
all products for all people.
Comstock/Thinkstock
In Figure 3.1 we see that the consumer is willing to substute movies for baseball games, or vice-versa, to stay at the same level of ulity on a parcular
indifference curve. The rate at which Bob Goodguy substutes movies for baseball games can be seen in Figure 3.1moving from point A to B, he gives up
one movie for one addional baseball game (rao 1:1), but moving from point B to point E he gives up 1.4 movies (from 4 movies to 2.6 movies) for an
addional 1.7 baseball games (from 3 games to 4.7 games) which is a rao of 0.8235:1. It is clear that the rate at which he is willing to substute movies for
games changes as he sees fewer movies and more games. We call this rate the marginal rate of substuon (MRS), which is defined as the amount of
product Y (movies in this example) that the consumer will be willing to give up for one more unit of product X (baseball games) while remaining at the
same level of total ulity. The spulaon that the consumer remains at the same level of total ulity makes it clear that we are talking about a movement
along a parcular indifference curve and by convenon we define the MRS for a movement down a parcular indifference curve. Since a movement down
an indifference curve must follow the slope of that indifference curve, it is clear that the MRS is equal to the slope of the indifference curve at any point.
Because we have drawn the indifference curves to be convex to the origin, the slope becomes increasingly flaer as we move down an indifference curve,
illustrang that the MRS declines as we move down an indifference curve.
As indicated above, the convexity of an indifference curve is due to the assumpon of diminishing marginal ulity.
The marginal ulity (MU) of a product is defined as the change in total ulity that is due to the consumpon of
one more unit of that product, holding constant the consumpon of all other products (i.e., with all other things
being equal). Consumers normally find that their perceived MU declines progressively as consumpon of any
parcular product increases, other things being equal. For example, suppose you have just finished exercising and
really want a drink of water. You might expect to gain a lot of ulity, say, 20 uls (i.e., 20 units of ulity) from that
bole of water. Suppose aer you drink this bole you then consider drinking another bole. You might sll be
quite thirsty but would certainly expect to gain less ulity from the second bole than from the first, say 10 uls.
A third bole is likely to promise even less ulity, say 5 uls, and a fourth bole only 2 uls, and so on. Note that
addional boles of water would make you feel uncomfortable or sick and we assume that people stop
consuming a product before MU becomes negave. Diminishing marginal ulity is commonly observed for virtually
all goods and services, so economists assume that MU decreases for all products for all people.5
(hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/sec3.1#ch03txt5)
To understand why diminishing marginal ulity causes indifference curves to be convex, note that moving down an
indifference curve means the consumer is consuming more of product X and less of product Y but total ulity is
not changing. Thus, the loss in total ulity due to giving up units of Y must be equal to the gain in total ulity
from the addional units of X as the consumer moves along the indifference curve. Since the consumer is giving
up units of Y, the MU of the units of Y being given up must be geng progressively higher, and conversely, since
the consumer is gaining units of X, the MU of these units of X must be geng progressively lower. So to remain
at the same level of total ulity the amount of product Y must be decreasing and the amount of product X must
be increasing, and thus the indifference curve is convex.6
(hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/sec3.1#ch03txt6)
The Consumer’s Budget Constraint
Using indifference curves, we have modeled the consumer’s preferences, so we now know what the consumer wants. Next we have to consider what the
consumer can afford. For simplicity we will assume that the consumer earns a salary each week and can spend that money on goods and services. This
analysis is easily extended to recognize credit cards, bank loans, and previously accumulated wealth on the one hand, and nondiscreonary expenditures on
the other, but a simple introducon is provided by assuming that the consumer has a limited budget equal to his or her weekly wage or salary income.
How far will the consumer’s income stretch? That depends on the prices, of course. Let’s go back to Bob Goodguy and assume that Bob’s budget is $120 per
week, that the price of a baseball game is $20, and the price of a movie is $23 (these prices include extra items like a hotdog at the baseball game and
popcorn at the movies). If Bob spent all $120 on baseball games, he could afford to go to 6 games a week (120/20 = 6), or if he spent the enre $120
budget on movies he could go to 5.22 movies a week (120/23 = 5.22). While diminishing marginal ulity suggests he will not want to do either of these two
extreme budget allocaons, these boundaries define the points where the budget constraint line intercepts the X and Y axes, at 6 baseball games and 5.22
movies, respecvely, as shown in Figure 3.2. A straight line drawn between these points joins all the combinaons of baseball and movies that will cost $120
in total.
In Figure 3.2, we see that Bob’s ulity-maximizing combinaon of these two products is to aend baseball games at the rate of 3 per week and movies at
the rate of 2.6 per week. Any combinaons that offer more total ulity must lie on indifference curves that lie above I2 and are not affordable given Bob’s
budget constraint. The ulity-maximizing combinaon of products that the consumer can afford is thus found at the point of tangency between the budget
line and the highest aainable indifference curve. Any lower indifference curve would cut the budget line twice and points on that curve would be an
inefficient way to spend his income. Any combinaon that lies on a higher indifference curve would not touch the budget line at all, and thus would be
unaffordable. Thus, the model predicts that Bob will allocate his income between baseball and movies such that he maximizes ulity from his limited
income.7 (hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/sec3.1#ch03txt7)
Figure 3.2: The ulity-maximizing combinaon of products given
a budget constraint
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When baseball club management wants to increase profits they
need to know whether raising prices to get more money from
those who already come to the games or reducing prices to ence
more people to aend the games will generate greater profits.
Eric Thayer/Reuters/Corbis
Price Changes and the Individual’s Demand Curve
The consumer’s demand curve shows how much the consumer will demand at various prices that the firm might set. Managers oen consider changing
their prices to gain more profit, and they would like to know by how much individuals would change their quanty demanded as a result of the change in
price. We know that the consumer’s budget constraint line is located according to his or her budget constraint and the prices of the two products.
Accordingly, we should expect that if any one of these three variables changes, the budget line must change and a new combinaon of the two products
will become ulity-maximizing. We shall illustrate with the price of baseball ckets. Suppose a baseball club’s management is trying to increase profits so
they can buy beer pitchers for the team. They first need to know whether they should raise cket prices (to get more money from those who already
come to the games) or reduce prices (to ence more people to come to the games). Suppose they start doing market research and interview our typical
baseball fan, Bob Goodguy. They ask Bob how many mes a week he would come to the games if the cket price (including Bob’s hot dog and other
incidentals) were $10, $15, $20, and $30, respecvely. To predict Bob’s answers, we can look at his preference map and the impact of the price changes on
the affordability of the baseball games at these four different prices, as shown in Figure 3.3.
As you can see in the upper half of Figure 3.3, we have rotated the budget line around to the
right to reflect the four different price levels, while holding the price of movies the same as
before. The intersecon points on the horizontal axis must be the income constraint ($120)
divided by the price of baseball games in each case, and so are 120/30 = 4 (for the steepest
budget line); then 120/20 = 6; then 120/15 = 8; and finally 120/10 = 12 (for the flaest
budget line shown), respecvely. Note that one of Bob’s indifference curves is tangent to each
of these budget lines, indicang that Bob would maximize ulity if he consumed 1.5, 3, 4.5,
and 6 baseball games per week under each of the different price scenarios, respecvely. Note
that the number of movies chosen varies according to the price of the baseball ckets as well.
It does not follow that Bob will necessarily choose more movies when the price of baseball
rises; it also depends on the MRS at various levels of consumpon of the two products.
Figure 3.3: The price effect and the consumer’s demand curve
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Now, look at the lower part of Figure 3.3 where we have ploed the price of the baseball games on the vercal axis but retain the same horizontal axis
showing the quanty of baseball games per week that Bob could aend. The line joining the pricequanty combinaons, labeled d, is Bob’s demand curve
for baseball games, other things (including his income, his preference structure, and the prices of other products) being constant.
Thus, the individual’s demand curve demonstrates the price effect, that is, when price is higher, the individual will demand fewer units of the product, and
conversely, when price is lower, the individual will demand more units of the product. The price effect will differ across individuals and across different
products because people have different incomes and different preferences.
The Income Effect
Managers must also be aware that changes in consumer incomes will change the demand for their products. Generally, when consumers have more income,
they will buy more of the focal product (i.e., the product we are focusing on). In those cases where consumers buy more units of a product as their incomes
rise, we say that the product is a superior good.8 (hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/sec3.1#ch03txt8) In some cases, however, the consumer will
buy less of the focal product when incomes rise because the consumer can now afford a beer product, and in this case the focal product is called an
inferior good. It is important for managers to know whether their products are generally considered superior or inferior goods because changes in consumer
income may happen suddenly and are outside their control. Such changes might occur due to an economic downturn, a natural disaster, a global financial
crisis, changes in foreign exchange rates, or because some of the firm’s customers have lost their jobs, for example.
When the consumer’s income increases, the budget line will shi outward in a parallel fashion; that is, its slope will stay the same. The slope of the budget
line does not change because its slope is equal to the rao of the two prices and those prices have not changed. Note that the vercal intercept of the
budget line is the number of units of product Y that can be afforded, so it is equal to the budget (B) divided by the price of product Y, or B/PY. Similarly, the
horizontal intercept is equal to the budget divided by the price of product X, or B/PX. Since the slope of any line is equal to the rise over the run, the slope
of the budget line is equal to B/PY (the “rise,” with the negave sign reflecng the fact that the “rise” is actually a fall) over B/PX (the run) which simplifies
to PX/PY, or the negave rao of the two prices. Thus, when the consumer’s income increases, with prices unchanged, the budget line has a new higher
intercept on each axis (because B increases) and the slope is unchanged. Accordingly, we can say that the budget line shis outward in a parallel fashion,
meaning that the consumer is able to buy more of both products X and Y.
In Figure 3.4 we show a budget increase for two other consumers who have different indifference maps reflecng their differing preferences for movies and
baseball. On the le-hand graph we show a person who regards both products as superior goods, and thus the move from point a to point b illustrates an
increase in purchasing both products when income is increased. On the right-hand graph we show a different person who regards baseball as an inferior
good, and so the move from point a to point b illustrates a decrease in purchasing baseball ckets (product X) when his income increases. With greater
income this person decides to shi expenditure away from baseball and towards other products that he views as more consistent with a higher income
lifestyle. This is easier to understand if we view product Y on the vercal axis not as single product but as represenng a “basket of all other goods” and
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Real income is the purchasing power of
monetary income and is equal to
monetary income divided by some
measure of the price level.
George Doyle/Thinkstock
that this basket includes, for example, caviar. At a higher income level the consumer might want to shi expenditure away from baseball ckets and towards
caviar as part of adopng a more “refined” lifestyle.9 (hp://content.thuzelearning.com/books/AUBUS640.12.1/secons/sec3.1#ch03txt9)
Figure 3.4: The income effect for superior and inferior goods
Conversely, the demand for inferior goods will increase when income levels fall. This is because people shi their consumpon expenditure from higher
quality goods (steak) to lower quality goods (sausages) when incomes fall and they are unable to afford to maintain the consumpon paern associated
with their former standard of living. Similarly, people might switch from used cars to new cars when incomes increase, but later revert to buying a used car
if they experience a fall in their income. It is important for managers to understand whether their products are generally regarded as superior or as inferior
goods so they will know which way the demand for their product will go in the event of a change in consumer incomes. For example, a food store in a
suburban area that is currently undergoing gentrificaonmeaning that higher income people are moving in and renovang the housesmight increase its
sales and profit by stocking food items that are considered “higher class,” such as grass-fed steaks and caviar, since the newer residents are likely to
substute these superior goods for cheaper cuts of meat and regular snacks.
The Income and Substitution Effects of a Price Change
We have seen that the demand for a product will increase (1) when its price is reduced (the price effect); (2) when consumers’ incomes rise (if the focal
product is a superior good); and (3) when the price of an inferior substute good increases. What we are seeing is a combinaon of income and substuon
effects. The income effect, as we have just learned, is either posive or negave depending on whether the focal product is a superior or inferior good, and
is equal to the change in the demand for the focal product that is due only to the change in income. The substuon effect is always negave, and is due
to the change in the demand for the focal product that is due only to the change in its own price. We will see that the price effect (i.e., the change in
consumer demand due to a change in the price level) is made up of two separate effectsan income effect and a substuon effect.
To beer understand the income eff
