File: Strategy Ch 3 Demand v2

Chapter 3 Demand

Learning objectives....................................................................................................3Keywords...................................................................................................................3

Introduction....................................................................................................................3Box 1 The fable of Damien and Norah......................................................................4

Section A Individual consumer demand: three perspectives.........................................61. The direct utility theory of individual consumer demand..........................................6

Figure 1 A simplified product space.................................................................62 Demand for characteristics..........................................................................................7

Table 1 Characteristics of luxury sports saloon cars..........................................83. The household production function...........................................................................9

3.1 Prices in the HPF model.....................................................................................11Box 2 Stigler and Becker on social distinction................................................12

Section B Aggregate consumer demand: markets and market segments.....................134. Market demand.........................................................................................................13

4.1 What is market demand?....................................................................................13Figure 2 Car product space..............................................................................13

4.2 The market demand for mid-to high price luxury sports saloon cars................14Figure 3 The market demand for luxury sports saloon cars.............................14Box 3 A bidding process interpretation of the demand schedule.....................15Figure 4 Consumer surplus..............................................................................15

4.3 Determinants of demand other than price..........................................................15Figure 5 A strengthening of consumer preferences for wine...........................16

4.4 The nature and source of preferences.................................................................165. Customer segmentation............................................................................................166. Price Discrimination.................................................................................................177. Product differentiation.............................................................................................17

Section C. Implications for business strategy..............................................................188. Introduction..........................................................................................................189.1 What market are you in and who are your customers and your competitors?.. .199.2 Understanding customer preferences.................................................................209.3 Seeing markets in terms of characteristics space...............................................20

Insert Figure 6 here: Characteristics space, and product differentiation..........21Insert Figure 7 near here. Characteristics space and product space: their relationship.......................................................................................................21

9.4 Understanding the customer...............................................................................219.5 Product Innovation.............................................................................................21

Chapter 3 Demand

9.6 Who are your customers?...................................................................................229.7 Methods of competing........................................................................................229.8 Some other applications.....................................................................................239.9 Limitations.........................................................................................................239.10 Implications for strategy..................................................................................23

10.5.1 Think about consumer demand differently...............................................2410.5.2 Distinction between final and intermediate customers/demand................2410.5.3 Who are your competitors?.......................................................................2410.5.4 Role of information and advertising.........................................................2410.5.5 Innovation and product development........................................................24

10. Value, added value and consumers' surplus...........................................................2411. Conclusions............................................................................................................24

Learning outcomes...................................................................................................25Further Reading........................................................................................................25Questions..................................................................................................................25

Chapter 3 Demand

Learning objectives Understand the conventional economic theory of individual consumer

behaviour and how this is used to provide an explanation of market demand for a product

Recognise some of the limitations of the conventional theory of consumer behaviour as a vehicle for thinking about business strategy analysis

Appreciate two alternative models of consumer behaviour – the characteristics theory of demand, and the household production theory of demand – and compare and contrast these with the conventional model

Be able to link the alternative models of consumer behaviour to concepts from the business strategy literature, such as the offering, customer value frameworks, and understanding the customer and her needs

Recognise the benefits for business strategy analysis of the two alternative formulations

Understand the concepts of price, income and cross-price elasticity of demand for a product, and appreciate their strategic relevance

Keywordsdemand; individual (or household) demand ; market demand; utility; characteristics (or attributes); household production function; elasticity; segmentation; strategic groups; product differentiation; customer value frameworks, the offering; innovation.

IntroductionCustomers, potential and actual, are an important part of an organization’s environment. Unless an organization understands its customers, and responds in appropriate ways to their changing needs, there is little prospect of successful performance. This chapter shows how economic analysis can generate insights into consumer behaviour that have powerful strategic application. The ideas developed here will be taken up and applied later in the book.

We begin by outlining three perspectives on individual consumer behaviour, and show the implications for product demand which follow from each. Our first perspective is labelled the ‘direct utility’ model. In this view, individual consumers are seen as having preferences for, and obtaining utility directly from, the consumption of marketed products. A second perspective, developed by Kelvin Lancaster, argues that marketed products are combinations of characteristics. We purchase products in order to acquire these characteristics in desired quantities and combinations. It is not the goods themselves but rather their underlying characteristics that confer satisfaction on the buyer. The third perspective is Gary Becker’s household production function model. Here consumers purchase goods to produce utility. Purchased products in themselves confer no satisfaction. They are inputs to a household production process, the outputs of which are utility-generating.

At this stage the reader may think that these perspectives are merely different ways of describing the same phenomenon. However, even if that were true, we shall demonstrate that the distinctions are useful in providing rich insights into consumer behaviour. They also provide the foundation for much of modern business strategy analysis. For example, the second and third perspectives lead us to focus on the

Chapter 3 Demand

services that goods provide, rather than on the products themselves. This allows us to think about the search for competitive advantage in terms of offering products that provide services that generate customer added value in superior ways to those of one’s rivals, a linchpin of the modern business strategy literature.

We have chosen to avoid a technical presentation. The three perspectives are explained intuitively, and jargon is kept to the minimum. To fix ideas, we adopt a hypothetical illustrative example. The example – our fable, if you like – is briefly outlined in Box 1. Further details will be provided as we go along.

Insert Box 1 near here. Caption: Box 1 The fable of Damien and Norah

Box 1 The fable of Damien and Norah

Damien is a young financial analyst living with his partner, Norah, a finance manager of a major bank, in Paris, France. They have a high combined disposable income, and so enjoy a relatively high standard of living. Among the large variety of goods that Norah buys regularly are fruits (particularly oranges) and designer clothing. She also pays a substantial subscription for membership of a health and fitness centre. Damien shares many of his wife's pleasures, but also gets particular pleasure from drinking cognac and eating good food, listening to music, reading books, and going to the theatre and cinema. Norah shares with Damien his love music, film and cinema, and his penchant for luxury sports saloon cars. She does not, though, share one of Damien's passions: going with friends to watch sports car racing and, occasionally, racing his car on track days at famous race circuits. Norah and Damien have several holidays each year, sometimes in exotic jet-set locations, others more adventurous in remote forest or mountain areas. They also enjoy short weekend breaks with friends.

Although both Norah and Damien value their time alone, they are highly social animals. They give, and receive reciprocal invitations to, lavish dinner parties, and spend a great deal with friends and colleagues in work and leisure activities. Damien sees himself as a trend-setter. Each likes to be at the centre of various social networks, and Norah likes to feel that she is highly regarded for her bubbly personality and generosity.

An understanding of individual customer behaviour is important for effective strategy. But we also require some aggregate concepts. Organizations deal not only with individual customers, but also think in terms of collections of customers such as ‘markets’ and ‘market segments’. It is aggregates of these kinds that their products are aimed at, and their competitive strategies are directed towards. In the second part of this chapter, we briefly consider some of these aggregate concepts.

Chapter 3 Demand

At first sight, this seems to pose no particular problem. Surely the market demand for a particular product is simply the sum of all individual consumer demands for that good or service? While this is true, it does beg a number of very important questions that we begin to address in this chapter, and then revisit elsewhere in the book. The most important of these questions relate to boundaries. What constitutes a particular product? When are two offerings instances of the same product, and when are they different products? What defines the boundaries between one market and another? How does product differentiation fit into this picture? And what do people mean when they refer to market segments rather than markets per se?

Chapter 3 Demand

Section A Individual consumer demand: three perspectives

1. The direct utility theory of individual consumer demandAll models of consumer behaviour are set within the paradigm of the rational, value-maximising individual. The perspectives we shall examine differ in their conception of how the consumer obtains value from consumption choices. A set of goods or services – for simplicity, called 'goods' from now on – are available for purchase. We can envisage these goods in terms of the simplified product space depicted in Figure 1.

Insert Figure 1 here.Figure 1 A simplified product space

The large green oval represents all available goods. A few of these available products are depicted in the orange-coloured boxes, and listed in general terms such as wine and cars. It will suffice for now to assume that each box consists of more-or-less identical goods: individual consumers regard all items in any one box as being close substitutes for one another. Items in different boxes are entirely distinct goods: individuals regard them as being either very weak substitutes, or having no substitution potential at all. Later in the chapter we shall drop these very restrictive assumptions.

The key point about the direct utility perspective is that the individual obtains value (or utility in the jargon of economics) directly by purchasing and consuming bundles of goods to satisfy her needs and desires. So, for our particular couple, Damien has strong preferences for fast cars and for cinema visits, and gets satisfaction directly from consuming those items. Norah likewise gets much utility from going to her sports club and from wearing her designer clothing.

How does an individual decide how to allocate her total expenditure among the available goods? Three factors determine this choice:

1. the relative strength and pattern of her preferences for particular goods;2. the prices of the various products;3. her total spending possibilities, limited by the individual's disposable income.

Let us look at these factors a little more closely. Individuals are envisaged as having well-defined tastes or preferences for particular marketed goods. These preferences determine how much utility that individual obtains from various alternative bundles of marketed goods. This notion can be represented by means of utility functions. Norah's utility function, for example, might be written as

Chapter 3 Demand

(1)

where the letters in the bracketed expression on the right-hand side of the equation refer to fitness centre usage (F), designer clothing (C), and a composite of all other goods that affect Norah's well-being (Z). The subscript N on U (for utility) is used to make it clear that this is the utility function for one particular person, Norah.

Economic analysis typically proceeds from the premise that the objective of consumers is maximisation of utility. So how many goods of each type will someone purchase? The answer to this question depends in part on her utility function, but that does not by itself determine consumption choices. The reason for this is that the products that generate utility have to be purchased at the prevailing market prices. This brings us to the second of the three determinants of consumer choice we listed above: product prices. Other things being equal, if one good rose in price that would usually reduce consumption, while a lower price would tend to increase consumption.

Putting these first two points together, we note that a rational consumer will take account of both the strength of her preferences and prices in making her purchases. That is, the ‘value-for-money’ ratios of different products will shape her purchases.

Now we come to the third determinant. Each consumer has a limited disposable income. The individual's disposable income sets a 'budget constraint' on her consumption choices: total expenditure on goods and services cannot exceed disposable income (including net borrowing).

To summarise, utility maximisation implies that an individual arranges his or her consumption pattern to obtain the greatest amount of satisfaction, subject to a budget constraint. Solving this problem, we obtain the individual consumer's demand for each of the products available on the market (bearing in mind, of course, that for many of those products her demand will be zero).

Most standard economics textbooks provide a full account of the ‘solution’ to this kind of problem. However, that is outside our scope of interest, and so we do not cover it here. Some suggestions for further reading in that area are given at the end of the chapter. It is worth noting, though, that the utility function given in Equation (1) does not provide any information about the amounts of utility that would be obtained from particular bundles of those goods. To know that, a quantitative (as opposed to qualitative) function would have to be specified, reflecting the particular preferences of the individual in question. For the interested reader, in the Additional Materials we provide a worked numerical example of a quantitatively specified utility function, and use it to illustrate some basic results from consumer theory.

2 Demand for characteristicsThe conventional theory of consumer demand postulates that individuals derive utility directly from the consumption of particular goods. So, for example in the case of our young couple, the purchase, use and occasional racing of a luxury sports car is directly satisfying for Damien. But one may feel that there is more to it than this.

Chapter 3 Demand

Perhaps the car is purchased because of the various attributes that it confers. These might include mobility, feelings of exhilaration, the ability to indulge in a manageable form of risk, a sense of camaraderie, and the esteem of others that this form of car ownership is expected to give. Whether any or all of these apply in Damien's case is not important. What is important is that this suggests an alternative formulation of consumer demand theory.

The first systematic re-formulation of the economic theory of consumer demand along these lines was made by Kelvin Lancaster (1966, 1971). In essence, Lancaster argued that goods are demanded not for their own sake but rather for the characteristics they possess. Following this logic, goods should be defined not in terms of their physical properties but in terms of their characteristics (or attributes). Thus, any particular good is simply a collection of various characteristics.

Indeed, Lancaster argued that individuals do not have preferences for marketed goods or services as such; instead they have preferences for particular characteristics. The individual gets utility not from the consumption of goods directly but from the acquisition of these characteristics embodied in the goods. Labelling characteristics by the letter Y, an individual's utility can be written as

U = U(Y1, Y2, …, YN)

where the various items inside brackets are N characteristics that 'matter' to this person's subjective well-being.

Where do marketed goods and services enter in Lancaster's story? They are the means by which characteristics are acquired. Characteristics cannot be purchased or acquired directly. They have to be obtained from bundles of purchased goods and services. So we have here what Lancaster calls 'goods as transfer mechanisms.' He writes:

"…goods are simply a transfer mechanism whereby characteristics are bundled up into packages at the manufacturing end, pass through the distribution and marketing processes as packages, and are then, so to speak, opened up to yield their characteristics again at the point of consumption." (Lancaster, 1979, page 20).

To fix ideas, we go through an example that Lancaster did not use but could easily have done: the case of luxury sports salon cars. You will remember that this is one item that Damien – and to a lesser degree, Norah – enjoys.

Insert Table 1 near here. Caption:Table 1 Characteristics of luxury sports saloon cars

Chapter 3 Demand

Table 1 Characteristics of luxury sports saloon cars 1

Characteristic MercedesVFR

BMW916

JaguarDragon

LexusDream

PorscheBonneville

Performance 60 80 75 60 85Luxury 80 78 82 85 69Distinctiveness 70 65 65 55 75Engineering quality

70 75 70 80 80

Suppose that the chief designer of the Mercedes VFR is asked to list the main characteristics of his model and of its four chief rivals. We also ask him to give a percentage score to each model for each characteristic; scores should represent what he believes are the perceptions of actual and potential customers' of these models (rather than his own opinions). His responses are tabulated in Table 1.

If the designer has judged correctly, the amount of utility an individual would get from ownership of one of these models depends on the amount and mix of these four characteristics. So in the case of Damien, and considering only the utility he gets from sport car ownership, we could write

UD = UD (performance, luxury, distinctiveness, engineering quality).

There are five models available – shown along the top row – each of which contains a particular combination of the four characteristics. Damien's task, like that of other prospective buyers, is to decide which product to purchase so as to maximise utility given his disposable income and other non-car consumption choices. The answer to this question will depend on two things:

1. the relative importance of the four different attributes to him2. the relative prices of the 5 models

Our example so far has been one of choice between alternative offerings of the same product. But this approach can also be used to help understand consumption choices over different products. Then the problem can be stated in the following way. The individual arranges his or her purchases of marketed goods and services pattern so as to obtain that bundle of characteristics which yields the greatest amount of satisfaction, subject to a budget constraint. The demands for marketed products are indirect or derived demands: products are demanded as means of acquiring desired bundles of characteristics. Note that product prices still matter here, but only because changes in those prices alter the implied prices of the characteristics that consumers value.

3. The household production functionThe characteristics theory of consumer behaviour offers fresh and potentially creative insights into consumer behaviour, but a little reflection suggests that the characteristics model is incomplete. Lancaster seems to have recognised this when he

1 While manufacturers’ names are genuine, model names are fictitious in this example.

Chapter 3 Demand

writes that 'Consumers do not, of course, merely open their "packages' at home and consume the characteristics, except in rare instances." (page 21). He recognised that individuals or households (in terms of which Lancaster couched his arguments) undertake various activities to produce value from the attributes embodied in the purchased goods.

This is most readily seen in the case of food consumption. Much purchased food consists of ingredients that are combined together to make meals. Satisfaction depends on the quality of the meal produced, rather than on its ingredients per se. A production process – cooking, in this instance – is taking place that generates the gestalt which is of value to individuals, the meal itself.

Note that the process of cooking involves inputs other than the foodstuffs themselves. First, durable consumer goods are used in cooking, such as ovens, mixers, kitchen utensils and so on. These are items of capital equipment used by the preparers of the meal. Second, meal preparation uses up some time that could otherwise be given to leisure activities such as reading. So cooking time incurs an opportunity cost. Third, a cook will use her stock of human capital – learned skills, knowledge, routines – in this process. All of this suggests that households actually engage in 'production processes'. Moreover, it is the outputs from these production processes that generate consumer value. Neither the ingredients as such, nor the characteristics of purchased inputs, confer utility per se.

Gary Becker (1965) formalised this alternative characterisation of consumer behaviour in his 'household production function' (HPF) model. Let us go through his model a little more carefully by continuing to investigate the fable of Damien. Damien, as we have seen, is a convivial young man with a well-developed sense of status. We suppose that the things that matter particularly to Damien, and give him value, are sex appeal, social status, a fine social and cultural life with a good set of friends, and the admiration of others. Put another way, we take Damien's utility function to be of the form:

UD = UD (sex appeal, social status, social and cultural life, admiration of others, good company of friends)

It is very important to understand that the ‘commodities’ in brackets on the right-hand side of this equation are not intrinsic, or genetic, qualities of the individuals themselves.2 They are also not goods and services that can be purchased directly through markets. Nor are they characteristics of purchased goods. Rather they are goods and services 'produced' by households, through their household production function, just as was the home-made meal in our earlier example.3

2 Some may object that sex appeal is an intrinsic, inherited quality of some individuals, and is not and can not be produced. We shall assume that this is not true in Damien's case. He has to work at it, at least to some degree3 Meals can be purchased ready-made, as with restaurant meals or takeaway food. So sometimes individuals pay others to do the ‘production’ on their behalf. This can be regarded as a form of outsourcing. Alternatively, we might regard these kinds of meals as purchased inputs, which in combination with other inputs – such as pleasing friends and a convivial atmosphere – yield some other utility-generating ‘commodities’.

Chapter 3 Demand

As none of these commodities can be purchased in ready-made form, Damien must construct or produce them himself or with his partner.4 Each of them is produced through a particular household production function. Consider, for example, the admiration of others that Damien receives. This commodity might be produced through the HPF:

where DC, SC and AH are three purchased products (designer clothes, sports car owned, and adventure holidays taken, respectively). In conjunction with these purchased products, some other inputs are used by Damien’s household to produce social status. These comprise: T, the leisure time employed; H, the ‘human capital’ (acquired knowledge and skills) of the couple; and K, various durable consumer goods such as their Paris apartment. Moreover, the interaction between these inputs may be very important – and once again, this is the result of Damien's production process.

3.1 Prices in the HPF model

When thinking about prices, our minds quite naturally focus on the money required to purchase marketed goods and services. But there are actually two sets of prices in the HPF model. The first is the prices of the purchased goods that form the inputs into the HPF. Let us label this set of prices as P.

The second set of prices consists of 'prices' of the underlying, produced commodities that confer value directly. These commodities do not have market prices, for they are not bought and sold. But they do have implicit (or accounting) prices, determined by their cost of production to the household. We denote these prices by , the Greek letter lambda.

Both sets of prices are of importance, and understanding the role played by each of them is central to gaining strategic insight. The prices of commodities, λ, are fundamental because they determine the relative household demand for different commodities, via the utility function. So what matters to Damien when he is choosing how much sex appeal, social status, admiration of others, and the good company of friends to produce is their relative prices, together with his relative preferences for these commodities. Other things being equal, we would expect that the higher is the price of one commodity, the less of it will be demanded, and vice versa.

But what determines these commodity prices? It is here that the prices of marketed goods enter our story again. Marketed goods prices are important because, in making household production decisions, households minimise the cost of producing any given bundle of commodities. A change in the prices of a marketed good will change the minimised cost of making any commodity which uses that input heavily.

This argument is complex and subtle, so let us illustrate it with Damien’s choices. Suppose that the cost of purchasing a sports car rises sharply. Ownership of a fast sports car has been to date an important input to Damien’s production of his 4.

Chapter 3 Demand

admiration by others. The rise in the sports car input price will, other things being equal, raise the relative price of producing the admiration of others.

This has two consequences. First, he will produce less of that commodity as its price has risen. Damien will tend to substitute this commodity by others that contribute to his utility Second, as a producer of admiration, Damien’ s cost minimising behaviour will lead him to substitute relatively cheap inputs in place of relatively expensive ones. To do so requires that there be some other inputs which substitute for sports cars in the production of admiration of Damien. If such substitutes exist, he will use relatively more of those and relatively fewer of sports cars. (Buying ‘fewer sports cars’ in this context probably means decreasing the frequency of new car replacement, rather than having less cars in the household at any one time. It might also mean purchasing a less expensive model.)

This line of reasoning suggests two interesting points that we just note here, and take up again later. First, because purchased items are inputs into a production process, then the demand for any marketed good is sensitive to prices of substitute ‘inputs’ and to whether other inputs become more or less effective substitutes over time. This implies that goods compete not only with other similar goods but also potentially with other goods that appear at first sight to be sold in entirely different markets. Thus what constitutes a ‘market’ is considerably more complex than is often thought.

Second, once we regard cars (and other purchased goods) as productive inputs, we see that the demand for cars will also depend on the amount of available household time, the nature and stock of durable consumer goods that the household possesses, and on the composition of its human capital). These are joint inputs in household production, and shape the relative productivities of purchased goods. They change and evolve over time, and as they do so the relative productive efficiencies of purchased inputs will change. This will also change relative demands. Box 3.2 gives two examples discussed by Stigler and Becker. You should read this now.

Insert Box 2 near here. Caption:Box 2 Stigler and Becker on social distinction

BOX 2 Stigler and Becker, 1977. We briefly consider two examples that they discuss.

Social distinction:An unmarketed commodity called 'social distinction' is produced from the fashion goods purchased by households (but is reduced by those fashion goods bought by other households).

Advertising:Advertising and tastes. Traditional story: adverting can be informative or persuasive. Latter involves changing tastes.

Chapter 3 Demand

Section B Aggregate consumer demand: markets and market segments

4. Market demand4.1 What is market demand?

The theory of individual demand provides powerful insights into the driving forces behind consumer behaviour. In some special cases – such as where bespoke designer clothing is being made for a particular person – knowledge about the particular preferences of individuals is all that matters. But what drives business profitability in general is the aggregate quantity of products that can be sold (and the total revenue from those sales) in some given interval of time. That brings us to the notion of the market demand for a product.

Before exploring the idea of market demand, it will be useful to enrich our conception of the available product space. Figure 2 takes the broad grouping 'cars', and identifies several more narrowly defined product categories. The large orange oval represents all available goods in the aggregate 'car' group.5 Some more narrowly defined categories of cars are depicted in the pale-coloured boxes. One of these is super sports cars. Each box consists of goods that typical consumers regard as being close substitutes for one another. It is at this level of aggregation that we use the notion of a particular 'market'.

Note three things right away. First, collections of products in one market are not defined in terms of their technical similarity. It is customer perceptions of similarity (i.e. substitutability) that matters. Second, substitutability can be seen in different ways, and each implies a radically different concept of market. The direct utility perspective we looked at in Part A implies that the goods will be intrinsically similar; the characteristics perspective implies that the goods in one market have similar combinations of characteristics (so cinema and theatre offerings might be in one market if customers believe they possess very similar characteristics); and the HPF perspective implies that goods are in the same market if they are close substitutes in producing some ‘commodity’ such as sex appeal (hence Ferrari cars and Gucci suits might be in the same market). Third, the boundaries between one market and another can never be fixed with certainty. It is the property of closeness of substitutability that matters here – but there will always be some room for dispute about what constitutes close substitutes.

Insert Figure 2 near hereFigure 2 Car product space

4.2 The market demand for mid-to high price luxury sports saloon cars

5 The word ‘industry’ is often used to refer to a highly aggregate grouping such as cars. However, industry also implies similarity of technologies, which gives that term a rather special meaning that we do not wish to use in this chapter.

Chapter 3 Demand

To explore market demand a little further, we shall work with the example of mid-to-high price luxury sports saloon cars. Let us begin by looking at matters from the direct utility perspective. Doing so, it is appropriate to define a market in terms of intrinsically similar products. Conceptually, we can imagine that the market demand for a product is simply the sum of the individual demands for the good in question. Consider, for example, the market demand for mid-to-high price luxury sports saloon cars. We have in mind the set of cars which includes several of the models at the top of the ranges produced by Jaguar, Mercedes, BMW and Lexus.

Market demand is often reported as a single number, that figure being the total quantity sold (or, alternatively, the total value of sales) in some (usually recent) period. This is, however, a very restrictive notion of market demand, as it only records sales quantity (or value) at the particular set of prices which prevailed during that period. It is quite likely that different price levels would have led to different quantities being purchased. And there is no good reason to believe that the value of sales (unit price times quantity sold) will be the same at different prices.

Hence a more useful notion of demand is a schedule of aggregate purchase intentions at different prices. This could be obtained by commissioning a market research firm to obtain a reliable estimate of the market demand at various prices by means of a sample survey. The required information could be elicited in the following way. First, a representative sample of households is selected. Those selected for the sample are contacted and interviewed. Respondents are asked to state whether they would be willing to purchase a luxury car in the coming year at a particular offered price. The price being offered is randomly varied across those being surveyed, so as to encompass a reasonably wide range of prices around the typical current market price for items in this category.

Using a technique such as this – and provided that the sample survey is designed, implemented, and analysed according to sound statistical practice - it will be possible to make inferences about the probability of a luxury car purchase being made at each of a range of prices by a representative individual. Then, grossing up to the 'population', reliable estimates of the quantity demanded (and sold) over a wide range of prices will be obtained. Let us imagine that this exercise is carried out and the market demand information which it yields is as shown in Figure 3.

Insert Figure 3 near here. Caption: Figure 3 The market demand for luxury sports saloon cars

What we have here is called a market demand curve. It shows the aggregate quantity that would be demanded at each price over some appropriate range of prices. Note that this demand curve is downward sloping. This conforms with the intuition that the quantity demanded of a good will change in the opposite direction to its price. Economic theory also implies that there will be a negative relationship between the price of a good and the quantity demanded per period of time except in some very special circumstances. Indeed, economists sometimes refer to this as the law of demand.

A second thing worth noting is that the slope of the demand curve tells us something about the sensitivity of market demand to changes in price, known as the price

Chapter 3 Demand

elasticity of demand.6 Information about the sensitivity of demand to changes in price is a very important piece of information in the process of business strategising. But we must be careful at this point. Figure 3 describes a market level – not a single firm level - concept. It does tell us how market demand changes if the market price changes. But it tells us nothing about how one firm's demand would alter if that firm unilaterally changed its price, unless the single firm is a sole seller – a monopolist – in the market in question.

Another way of obtaining information about market demand curve is through a bidding process. We outline what this would consist of in Box 3. You are recommended to read this now.

Insert Box 3 near here. Caption: Box 3 A bidding process interpretation of the demand schedule.Use e-Bay for this?

Insert Figure 4 in Box 3Figure 4 Consumer surplus

4.3 Determinants of demand other than price

Each of the three perspectives on individual demand that we examined earlier suggests that the quantity demanded of a marketed product will depend not only on that good's price, but also on several other factors. Among these, three are often regarded as being of particular importance:

the strengths of consumers' preferences for the good relative to other available products

the prices of other goods available to consumers the total level, and distribution, of consumers' disposable income

These factors influence the position of the demand curve on the chart, and changes in any of them will usually shift the demand curve from one position to another. Such shifts are called an 'increase in demand' or a 'decrease in demand' depending on whether the change in income, other prices or preferences is causing more or fewer of the goods to be demanded at each price.

As an example of an increase in demand, consider a change in consumer preferences. Suppose, for example, that people choose to drink more wine as a result of a medical finding suggesting that moderate wine consumption can lead to improvements in health. Other things remaining equal, this increase in the strength of consumer preferences for wine results in a greater quantity of the good being demanded at each price, and the demand curve for wine shifts to the right, as in Figure 5.

6 More precisely, the price elasticity of demand (PED) for a good at a particular price is the rate of percentage change in quantity demanded per 1% change in price (measuring the price change from that particular price). It should be clear that this measure does depend on the slope of the demand curve. However, it also depends on the particular 'baseline' point on the demand curve from which the price changes.

Chapter 3 Demand

Insert Figure 5 near here.Figure 5 A strengthening of consumer preferences for wine

4.4 The nature and source of preferences

4.4.1 Preferences in the direct utility perspective

Consumer’s preferences play a key role in shaping the demand for goods. We now examine the nature of these preferences more closely. In the direct utility perspective, individuals have preferences for marketed goods and services themselves, and it is those things that directly give utility to customers. But where do these preferences come from? Are they stable? And can they be changed or shaped by business behaviour?

The origins and determinants of individual preferences seem to be a complex mix of inherited characteristics working in conjunction with a broad set of social and cultural processes in which we grow up and live our lives. Economists have conventionally treated individual preferences as being ‘stable’. This cannot mean that they are completely fixed, for if that were the case it would be difficult to see how change could ever take place except through the replacement of one generation by another. Rather, it means that preferences change only very slowly, and so over some reasonably short span of time can be treated as if they were stable.

But there are difficulties with such a concept of preferences. A distinction is often drawn between ‘informative’ and ‘persuasive’ marketing and advertising. Stable preferences leave little or no scope for persuasive advertising, and imply that advertising is largely informative, telling us about what is available and how one offering compares with another. Because the environment in which we live is always changing, there is still a role for competitive strategy by individuals firms, but that seems to be limited to developing effective market intelligence systems designed identify how preferences are unfolding over time as a result of environmental changes. Nevertheless, there is little scope here for active persuasive or promotional activity by individual organisations.

4.4.2 Preferences in the characteristics and household production function perspectives.

Many of the difficulties alluded to in the previous paragraph disappear when one switches to a view in which preferences are seen as being for characteristics of goods rather than for goods themselves, or when we adopt a household production function (HPF) perspective. These perspectives also help us to explain observed business behaviour; organisations very often act in ways which imply that they believe preferences can be shaped or even completely changed by their own behaviour, rather than just by exogenously-given environmental processes.

Consider household goods such as washing machines, microwave ovens, vacuum cleaners and dishwashers. While it would be naïve to deny that people do wish to purchase such items, it stretches plausibility to contend that individuals have ‘intrinsic’ preferences for them. But the recognition that individuals gain satisfaction

Chapter 3 Demand

from various attributes (or characteristics) of such goods is far more promising, and yields greater explanatory power.

The goods we have just listed are examples of what are often called ‘durable consumer goods.’ Such products are sometimes treated as items of capital. That is, their purchase constitutes a household investment that yields flows of utility-giving services to their owners over time. (In these instances, washing, cleaning, and food preparation services.) This is just what the characteristics and HPF perspectives imply. But using those perspectives explicitly brings additional insight.

For example, a key characteristic offered by each of those goods is time-saving in the carrying out of various household production activities. Looking at many durable consumer goods, though, shows that many durable consumer goods also possess a far wider or more diverse set of characteristics. Dyson vacuum cleaners are not just technically efficient at cleaning – important as this certainly is – but are also stylish and pleasant to use, as one might expect knowing that the company’s founder is an art school commercial design graduate.

Once we recognise that consumers might seek out goods with a bundle of quite heterogeneous characteristics, the notion of stable demand for products themselves can be jettisoned. Items of furniture might come under competitive attack from carefully designed Hi-Fi systems for example. At the very least, we can say that where style is an important characteristic in someone’s utility function, pure musical fidelity alone may not suffice to sell audio products.

Product innovation becomes far more understandable in the characteristics view. No longer do we have to conceive of organisations coming up with a completely new product for which preferences and demand have to be created from nothing. Rather, we can regard much product innovation as generating new, or superior, ways of meeting pre-existing demands for underlying preferences. Much of what is going on in consumer electronic goods can be seen in this light, for example. Advertising is also better understood in this light. It is no longer just about providing information about prices, quality and availability. Nor is it trying to generate an entirely new preference. Rather, advertising is a means by which firms argue that their products constitute particularly attractive bundles of characteristics that matter to customers. Finally, technological progress in this view does not create the potential for entirely new categories of products as such (although it certainly does do that). Instead, it generates new ways of satisfying various stable underlying characteristics preferences.

5. Customer segmentationTill now, treated all individuals as one aggregate group: the market. But may be sensible to distinguish between types of customer.Various bases:

Gender Age Location Income level

Chapter 3 Demand

Why?ChannelsMay know one group bestFind a segment poorly treated by competitors.

An important reason likely to be:

6. Price DiscriminationBased on ability to segment market: this requires

1. ability to identify, and deal separately with, different segments2. ability to prevent resale.

Charge different prices to different segments, where price differentials not in principle related to differences in costs.Covered in depth in Monopoly chapter

7. Product differentiationCharacteristics theory provides us with a powerful tool for understanding the phenomenon of product differentiation: product differentiation consists of changing the composition, the mix, or the intensity of attributes in the 'product' a business offers.

Suppose that at some time all models of luxury sports saloons are more-or-less homogeneous in the characteristics they offer. That is, each possesses the same set of characteristics, in similar proportions, and to the same degree. In effect, all offerings are identical. And provided that there are several providers, not acting in a collusive manner, one would then expect price competition to be fierce.

If all consumers of this type of product are identical in terms of their preferences, and those preferences are fully aligned with the bundling of characteristics offered by the various businesses, this situation may persist for some time.

But it is more likely that there is heterogeneity of tastes and preferences among potential consumers. Indeed, one might envisage a distribution of tastes that implies a spectrum of different relative weightings of the set of attributes embodied in the products.

In that case, an individual firm might gain an advantage by reconfiguring its product so as to offer more luxury, or more luxury but less performance, or some other mix of characteristics. In this way, it will develop a particularly strong appeal to those people whose preferences lie in this direction. We might expect to find that the market has a tendency for all firms to differentiate, until there is no longer any net advantage to be gained by any firm repositioning its offering in attribute-space. Alternatively, firms might become multi-product firms, each producing a range of models covering the attributes space. We do observe something like this in the car industry.

This notion of differentiation is similar to one that Lancaster himself had in mind. All products within a particular 'product group' contain the same set of characteristics, but

Chapter 3 Demand

in different relative proportions. Indeed, Lancaster went even further arguing that the characteristics found in one product group are not found at all (or, only to a very small degree) in other product groups. For Lancaster, this is what defines market boundaries.

But this notion is too restrictive. Differentiation can also take place by means of a business incorporating a new characteristic into its offering - new in the sense that no other business yet incorporates it in the bundle of characteristics which its product offers. Much product differentiation seems to be of this form, as we shall demonstrate shortly when looking at the implications of attributes theory for business strategy. We shall also show there that the attributes approach provides powerful insights into the process of product innovation.

Vertical vs horizontal differentiation. This approach provides basis of theory of product differentiationSee diagram on page 19 and 20 of Lancaster.

Section C. Implications for business strategy

8. IntroductionConventional story: ways of increasing market demand for a product:

Reduce its relative price Increase quality of the product Persuasive advertising (changing preferences)

Do we really believe that advertising can and does change people's preferences?If the latter, then competitive strategy requires, inter alia, know your customers' preferences and knowing how these change over time. (Is this the role of PEST?)Role of prices and value-for-money.

It should be clear from the previous section that there is still a role for price-based competition.

Changes in the prices of marketed goods and services will shift the pattern of household demand for commodities, Z, and so will shift the pattern of demand for firms' marketed goods and services.

But can now go much deeper. Change the price of commodities.How does price of commodities change?

Changes in prices of marketed goods and services (as before) Developments in consumer durables; particularly in so far as they imply time

saving possibilities Changes in human capital: education, internet, information, informative

advertising New technological possibilities: alter the HPF itself

Chapter 3 Demand

All of these alter cost-minimising techniques (and so prices) of commodities.

Quality changesChange what the product offers so that it is more useful/productive in the HPFChange attributes of the product offering so that it is a useful input in the production of other commodities

Leads on to product development and product innovation.

Summary to date (do I need this? Or just repetitive)

To summarise, the consumption of marketed products does not confer utility directly. Rather, these products are inputs (along with leisure time and human capital) to a 'household production process', the output of which is those special unmarketed commodities that do generate utility directly. Household production theory points to the dual role of the household: as producers and consumers. Households are 'producers' in their roles of investing in human capital and consumer durable goods, and in producing commodities that potentially yield utility. Households are consumers in their roles of obtaining utility from the consumption of those commodities, and in arranging the amounts of these commodities that they produce so as to maximise household utility.

Two central issues here:

9.1 What market are you in and who are your customers and your competitors?

The market that a business operates in consists on the supply side of all those businesses which sell a particular product (or

the set of products which customers regard as very close substitutes for one another)

on the demand side, of all those individuals whose preferences are such that they would purchase that product (or its close substitutes) at some positive price.

Your competitors are those businesses that offer for sale the same product as you (or very close substitutes).

But we have to extend this to take account of:1. market segmentation2. strategic group analysis.

9.2 Understanding customer preferencesCustomers have clearly defined preferences for particular marketed goods and services. Market demand is determined, in part, by the strength of consumer preferences. Market demand also depends on aggregate consumers' disposable income and its distribution, and the price of the marketed product relative to other goods and services.

Chapter 3 Demand

What a business offers to customers is marketed 'ready-made' products. These confer utility directly.

At the level of the individual business, competing is about providing products that fit as well as possible with consumer preferences, and providing its product at a price - price relative to that of other suppliers –

which offers customers a superior value-for-money ratio.

So both price and quality matter (where the latter is in terms of fit with customer preferences for goods).

Much of what is taught in marketing theory and business strategy derives from this kind of view.

9.3 Seeing markets in terms of characteristics space

A question which seems to perplex students of business strategy is what it is that defines the boundary between one market and another. The standard economic answer to this question is the degree of substitutability of two items: if two items are typically regarded as perfect, or at least very close, substitutes by consumers they are in the same product market (and so a change in the price of one relative to the other will cause large switches in demand from one to the other). In contrast, where substitutability is seen as being low, goods are in different product markets.

But this criterion has the weakness that it answers the question by posing another one: what exactly is meant by high or low substitutability of products? (The usual answer to this question is in terms of demand sensitivity to price changes; but it is still not clear whether this is a useful measure in practice).

The characteristics model of consumer behaviour provides an alternative approach. Two products compete within the same market if they embody the same set of characteristics, or at least share very similar sets of characteristics. In Figure 2, you will recall, we included one broad category called "cars". Clearly, this is too broad to be thought of as a single market. Then, in Figure 3, we disaggregated the car sector into separate markets, two instances of which were super sport cars and estate cars. Ferrari is generally regarded as being a member of the former, and several Volvo models are examples of the latter. During the 1970's and 1980's, an important pair of characteristics of Volvo estate cars were safety and carrying-capacity. Very few commentators (or customers) would include those as characteristics thought valuable by Ferrari owners, and so this suggests that the two manufacturers sell into different markets.

This suggest that we might get valuable analytical insight by thinking in terms of characteristics space rather than in terms of product space. Figure 6 gives one such example. Here three offerings within the sports saloon car market are shown as

Chapter 3 Demand

possessing the same set of four characteristics. Here the three offerings, although being within the same market by virtue of possessing the same characteristics, are each differentiated products by having different characteristics weightings.

Figure 6Insert Figure 6 here: Characteristics space, and product differentiation

Figure 7Insert Figure 7 near here. Characteristics space and product space: their relationship.

9.4 Understanding the customer. It is a standard tenet of the strategy literature that a business can only be successful if it understands its customers: knows what they value, and what they want. The characteristics model gives us a way of operationalising this notion. Understanding ones customers means identifying the characteristics or attributes of marketed goods which gives them utility (value). The important point here is to recognise that customers may not want products as such. Instead, what they want are attributes. A successful design is one that offers attributes in combinations, and to the degrees, that customers wish for, and are willing to pay premium prices for.

This begs the question of whether the characteristics that consumers want are immutably fixed, or whether they change over time? We address this question in the next section.

9.5 Product InnovationEconomic theory has conventionally assumed that individual preferences are stable over time: they do not change or evolve. This is in stark contrast to the business strategy literature, which views the processes of identifying and understanding changes in tastes and values as being of the essence for attaining a competitive advantage, and which advocates the use of a variety of environmental screening tools (such as PEST analysis) to assist in this comprehension.

In the conventional economic theory of consumer behaviour, preferences are for goods themselves. So stability of preferences implies that demands for goods do not change. Moreover, that approach clearly has major conceptual difficulties in handling the processes of product innovation and advertising. Where does the demand for new products come from if preferences are stable? And if the demand for new products does come from advertising ('persuasive' advertising of new products, presumably), where does that leave the notion of stable preferences?

The model of characteristics can get us a lot further forward. Here, preferences are still seen as being stable, but those preferences are for attributes not products. There is no reason, however, why products have to remain the same through time in this framework. First of all, and rather trivially, technical progress can lead to new product offerings which yield the same characteristics, but to a greater extent or at lower cost per unit of characteristic. Perhaps this is what we see happening in the motor cycle industry?

Chapter 3 Demand

We have also seen that differentiation is a means through which product change takes place. The kind of differentiation we investigated in section x above did not involve the addition of new characteristics to product offerings. But, as we alluded to earlier, much product differentiation is precisely about that. Consider now Figure 7.

Discuss Figure 7 here.

Note that we no longer have to assume that demands have to be created for new products. They are already there; but are demands for attributes.

Do we have to go with the stability of preferences for attributes?This may seem to be something that must be jettisoned.Some 'characteristics' only seem to make sense in particular technological eras (such as the speed of an computer processor)But if we move to a higher level of abstraction – upframing – perhaps there are fundamental characteristics are stable: status conferral; sexual attraction; luxury; time saving? (See the latter for personal computers, and laptops, and for cars, and what else?)

The usefulness of this distinction: phenomena change over time as environmental and technological change takes place; but fundamental characteristics remain stable?

So what is product innovation?

9.6 Who are your customers? Who are your competitors?(In terms of products and firms)? Technically similar things may be almost entirely unrelated in a market sense. Technically very dissimilar things may be highly related in a market sense/strong competitors. Whole idea of markets now changes.

9.7 Methods of competing

Providing what the customer wants (at a price that is good for seller and buyer).Back to luxury sports car example: But suppose the truth is

Ability to impress womenAbility to impress friendsLots of toys to play withLeg room in the back

Intelligence/information vitalComputer software/hardwareAmazon: cookiesDownstream vertical integration?

Price and quality based competitionPrice

Chapter 3 Demand

Quality via differentiationInnovation

9.8 Some other applications1. Norah's demand for fruits: a simple application of attributes theory.

Relate to food technology, plant selection/selective breeding. Where does demand for organic food enter into the food story. Attribute: good health. But also self-respect, respect of others?

2. Norah's demands for health club membership and for designer clothes. Attributes gets us a long way here.

3. Music gives entertainment. But so does television. And what else? The leisure industry. Active leisure, adventure holidays. Manageable risks?

9.9 LimitationsConsumption technology.Packaging occurs either for technical or for economics reasons"Consumers do not, of course, merely open their "packages" at home and consume the characteristics, except in rare instances." (page 21)

Instead, he suggests that the conversion of purchased commodities into utility-giving attributes is governed by a 'technology of consumption'. We will just note that the kinds of things he has in mind here include properties of sets of goods purchased, such as whether they can be combined or not, and whether satisfaction from them is additive in a simple way or not.

But basic difficulty: how are the attributes unlocked from the product?What kind of combining process takes place?Individuals are active not passive. They use the goods they purchase tp produce something with.

And so …

9.10 Implications for strategy

Switch now to business level.

Michael Porter suggests that there are two fundamental ways of seeking a competitive advantage (two generic strategies):

Cost leadership (and so, in essence, competing in terms of price) Product differentiation (and so essentially, competing in terms of quality)

(Compare this with the Strategy Clock conception: involves positions in the 2-dimensional space formed by price and quality.)

We can now generalise this, using HPF model.

Chapter 3 Demand

Change your price relative to others in same product group (and other product groups)Quality: all previous comments apply. But now at a within product-group level too.

10.5.1 Think about consumer demand differently

In terms of the items that directly affect their utility. Your product: how can it help customers produce utility?What do customers value? What is it that you offer which gives them value?Examples: role of time saving; mobility; flexibility.Help customers produce more effectively. (See notion of 'solutions')Bundling/outsourcing

10.5.2 Distinction between final and intermediate customers/demand. Selling to businesses/intermediate buyers: for long time you are seen as providing inputs they use.But this now generalizes to final demand too.

Who are your strategic customers? Can I weave this in anyway?

10.5.3 Who are your competitors? Those who produce marketed goods that generate same commodity. What are 'competitive markets'?

10.5.4 Role of information and advertising

10.5.5 Innovation and product development

10. Value, added value and consumers' surplus

11. Conclusions

Box 1 A bidding interpretation of a market demand curve

Use e-Bay for this?Auction systemImagine that the only way these can be bought is through an auction system like e-bay. Elicits bids for maximum WTP. Individuals can bid for more than one PC, but must make an individual bid for each PC they wish to purchase.

Chapter 3 Demand

Auction repeated weekly.The auctioneer collects all bids; when all are collected, the individual bids are ranked in order from highest to lowest. (2) Market research: questionnaire/survey(3) Market research: statistical analysis

Point out consumer surplus here

Figure 2End of Box 1

Learning outcomes

Further Reading

Bibliography

Becker, G. S. (1965) A theory of the allocation of time. Economic Journal, Vol. 75, pp. 493-517.Gorman, W.M. (1956) A possible procedure for analysing quality differentials in the egg market. Ames: Iowa State College mimeo. (Reprinted in Review of Economic Studies, Vol. 47, 1980, pp. 843-56.Lancaster, K.J.: 1966 A New Approach to Consumer Theory. Journal of Political Economy, 74, April 1966, pages 132-157.Lancaster, K.J. 1971 Consumer Demand: A New Approach. Columbia University Press, New York.Lancaster, 1979, Variety, Equity and Efficiency. Columbia University Press, New York.

Stigler, G.J. and Becker, G.S. (1977) De gustibus non est disputandum. American Economic Review, Vol. 67, pp. 76-90.

QuestionsEdit this stuff to get some useful Q&As? (Which explore some details in more depth than chapter itself.)

Question 1 Explore the effects of changes in the following on market demand.

Changes in the potential total size of the market

Free tradePopulation growth

Changes in consumers’ income

Chapter 3 Demand

Budget constraint alters.

Changes in the level of consumers’ income are likely to affect the demand for goods. The direction and magnitude of this effect will depend upon the good in question and the size of the income change. For most goods, an increase in income results in an increase in demand; these are known as normal goods. Other goods - known as inferior goods - are those for which an increase in income results in a decrease in demand.

When goods are defined in broad classes, statistical evidence suggests that few goods are inferior in this sense. However, when product categories are defined more narrowly, the likelihood of finding inferior goods increases. For example, although cars as a whole appear to be normal goods, particular types of cars (such as small, low powered, low quality cars) might be inferior goods, particularly in an economy in which average income levels are relatively high.

Changes in the prices of other goods

If the price of another good changes, the effect will mainly depend upon the relationship between the two goods. If consumers feel that the two are substitutes for one another, then we expect a positive relationship between demand for one good and the price of another. For example, fuel users may consider oil and coal to be substitutes. Then a fall in oil prices induces customers to switch, wholly or partially, from coal to oil consumption, and so lead to an decrease in the demand for coal. We would expect, therefore that the demand curve for coal would shift to the left if oil prices were to fall. Indeed, this is what has happened in recent years as oil prices have fallen relative to coal prices.

On the other hand, if two goods are complements - they are jointly consumed - there will tend to be a negative relationship between the demand for one and the price of the other. For example, large increases in crude oil prices in 1974-75 and again in 1979 were associated with a substantial decline in the sales of large cars. This reflects the complementary relationship between fuel (extracted from crude oil) and the use of cars.

Goods may not be related in any direct way for these kinds of price effects to take place. Consider, for example, energy prices and confectionery demand. Even if energy and confectionery are neither substitutes nor complements for one another (which seems likely), changes in energy prices can alter the demand for confectionery by altering the real purchasing power of consumers’ money incomes. This leads us on to the next point.

Substitution effects and income effects of price changes

In discussion the effects of a price change on quantity demanded of a good, it was said that the effect will in general be negative. Why was the caveat 'in general' adopted? The answer to this lies in the presence of so-called income effects of price changes. A change in the price of a good will in general have two distinct effects on demand. The first of these is known as the substitution effect. When the relative prices of goods change, rational consumers will substitute from the relatively more

Chapter 3 Demand

expensive to the relatively less expensive good. This effect is always 'negative' in the sense that if the price change were the only relevant effect, then a fall in the price of good x would always result in an increase in the quantity demanded of good x.

But there is a second effect at work too. A change in the price of a good, with money income unchanged, alters the real income of consumers. Real income refers to the purchasing power of money income. If the price of a good that a person buys increases then the real purchasing power of his or her income falls. (Think about the effect on the real income of a person with a house mortgage when there is a rise in mortgage interest rates.) Because a change in price changes real income, an income effect may induce further changes in the quantity demanded.

Now drawing together all these threads, we can reach the following conclusion. If a product is an inferior good, then a rise in its price will reduce real income and so reduce the quantity demanded of it. If the magnitude of this effect is sufficiently large to dominate (or outweigh) the substitution effect, a positive relationship will exist between price and quantity demanded! Suffice to say that while this possibility exists, it is very unlikely to be realised in practice.

Price and income and cross price Elasticity

Chapter 3 Demand