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Customer Power

Economics of Elasticity of Demand

Managerial Economics 387

The Economics of Strategy

David J. Bryce
copyright 2000, 2002

Exploring Industry Structure


Customer
Power &
Preferences
Threat of
Potential
Entrants

Rivalry
between
Competitors
Threat
of
Substitutes

Nile Hatch 1996, 2000, 2002

Bargaining
Power of
Suppliers

Customer Power & Preferences


Customers influence industry performance
through
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 the


strength of customer preferences in the form
of customer demand and price elasticities.
Nile Hatch 1996, 2000, 2002

Sources of Customer Power


Buyers are sensitive to prices, product
quality, and/or product characteristics
Products sold to buyers are undifferentiated
Many substitute products are available
Products are a large fraction of customers final
costs
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
Nile Hatch 1996, 2000, 2002

Sensitivity to Prices
Price Elasticity of Demand
The rate at which quantity demanded falls as
price rises is defined by the price elasticity of
demand.
Demand elasticity defines sensitivity to price in
terms of percentage changes.
Let the subscript 0 denote starting points, 1 denote
new values, and D denote changes in value.
Then the elasticity is

% DQ

%DP
Nile Hatch 1996, 2000, 2002

Q1 Q0
Q0
P1 P0
P0

DQ
Q0
DP
P0

DQ P0

DP Q0

Own Price Elasticity of Demand


||< 1 implies inelastic demand
|| = 1 implies unitary elasticity
|| > 1 implies elastic demand

Interpreting elasticity a one percent increase


in price results in an % decrease in quantity
demanded
Consider some examples
Textbooks
Mercedes-Benz
Nile Hatch 1996, 2000, 2002

Water
Milk

Diamonds
Air

Own-Price Elasticity of Demand


and Total Revenue
Elastic an increase (a decrease) in price leads to a
decrease (an increase) in total revenue

Inelastic increase (a decrease) in price leads to


an increase (a decrease) in total revenue

Unitary total revenue is maximized at the point


where demand is unitary elastic

Nile Hatch 1996, 2000, 2002

Factors Affecting Own Price


Elasticity
Available substitutes the more substitutes

available for the good, the more elastic the demand.

Time demand tends to be more inelastic in the short


term than in the long term because time allows
consumers to seek out available substitutes.

Expenditure share goods that comprise a small

share of consumers budgets tend to be more inelastic


than goods for which consumers spend a large portion
of their incomes.

Nile Hatch 1996, 2000, 2002

Uses of Elasticities

Pricing
Managing
Impact of
Impact of
Impact of

Nile Hatch 1996, 2000, 2002

cash flows
changes in competitors prices
economic booms and recessions
advertising campaigns

Elasticity Calculations

1 2
2
5 4
4

Price

2 .0

5
4
3

4 5
5
2 1
1

Nile Hatch 1996, 2000, 2002

0 .2

1
1

Quantity

Example 1: Pricing and Cash Flows


According to an FTC Report by Michael Ward,
AT&Ts own price elasticity of demand for
long distance services is -8.64

AT&T needs to boost revenues in order to


meet its marketing goals
To accomplish this goal, should AT&T raise or
lower its price?

Nile Hatch 1996, 2000, 2002

Answer: Lower price!


Since demand is elastic, a reduction in price
will increase quantity demanded by a greater
percentage than the price decline, resulting in
more revenues for AT&T.

Nile Hatch 1996, 2000, 2002

Example 2: Quantifying the


Change
If AT&T lowered price by 3 percent, what
would happen to the volume of long distance
telephone calls routed through AT&T?

Nile Hatch 1996, 2000, 2002

Answer
Calls would increase by 25.92 percent!

, PX

%DQXd
8.64
%DPX

% DQXd
8.64
3%
3% 8.64 % DQ Xd
% DQXd 25.92%

Nile Hatch 1996, 2000, 2002

Buyers Have Power When They Have


Elastic Demand sensitive to prices
Increasing elasticity is caused by
Products with few unique features (undifferentiable)
Buyers whose expenditures on our product are a
large 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
Nile Hatch 1996, 2000, 2002

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
Nile Hatch 1996, 2000, 2002

Summary and Takeaways


Customers and substitutes threaten to reduce
our prices; suppliers threaten to raise our costs.
Their probable success can be measured using
elasticity.
General knowledge of elasticities is a good
substitute for specific knowledge of the demand
curve.
What role will the Internet play in providing
information about elasticities?
Nile Hatch 1996, 2000, 2002