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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?