Theory of the Consumer Utility

- hypothetical quantitative value for

Consumer
satisfaction that a consumer receives
- someone who makes consumption from a pattern of consumption.
decisions for herself or for her household
unit. Marginal utility of the good
- If a consumer were to receive one more
Theory of the consumer unit of some good or service, the
- posits that a consumer plans her resulting increase in their utility
purchases, the timing of those purchases,
and borrowing and saving so as maximize Income effect
the satisfaction she and her household unit
- equivalent change in purchasing power
will experience from consumption of goods
is called the
and services.
- for goods and services that a consumer
- In this theory, consumers are able to
cannot substitute easily, a sizeable price
compare any two patterns of consumption,
change may have a significant income
borrowing, and saving and deem that
effect. For example, when gasoline
either one is preferred to the second or
prices jumped dramatically in the
they are indifferent between the two
United States, consumers may have
patterns.
reduced their driving somewhat but
- theory states that they will adjust their
were unable to find a substitute for the
consumption, borrowing, and saving to
essential needs served by driving their
restore the optimality under the newly
cars. As a result, consumers experienced
revealed prices.
a dramatic drop in wealth available for
- In fact, the theory identifies two effects of
other goods and services and consumed
price changes: the substitution effect and
generally less of all of those to
the income effect.
compensate for the greater expenditure
on gasoline.
Substitution effect

- based on an argument employing Giffen goods

marginal reasoning like the marginal - a situation where consumption of a good or
analysis service may increase in response to a price
- is the consumer’s response to a increase or decrease in response to a price
changing price to restore balance in the decrease.
ratios of marginal utility to price - This anomaly is explained by a strong income
- In most cases, the primary response to a effect.
price change is a substitution effect,
with a relatively modest income effect. Robert Giffen
- discovered that Irish consumers increased
the use of potatoes in their diet during the
 Irish Potato Famine of the 1840s, even The theory of the consumer
though the price of potatoes rose
dramatically. Basically, because potatoes - provides a supporting rationale for
were a staple of the Irish diet, when the expenditure on promotion: If a
potato price increased, the wealth available consumer is regarded as deciding how
to purchase other food items diminished and to allocate his wealth across available
Irish consumers wanted to purchase more goods and services, in order for your
potatoes to compensate for the diminished product to be included as a candidate in
purchases of other food items. that choice, the consumer has to be
aware that your product or service
Is the Theory of the Consumer Realistic? exists
Although our consumption decisions
Firm Competition and Market Structure
may not fully conform to the theory of the
- large firms often engage in promotion at
consumer, there have been some attempts to
expenditure levels well beyond what is
argue that we do approximate it.
needed to make your firm and product
Herbert Simon proposed a theory of bounded known to the consumer, as a tactic of
rationality. Bounded rationality and satisficing competition.
are discussed in Simon (1997).
Marketing mix
Bounded rationality
- The selection of price, promotional
- states that humans do behave rationally with activities, location, and channel are
a limited range of options. generally in the control of the business
- So, if consumers focus on a modest set of concern. In texts on marketing strategy,
important goods and services, they may be Kotler and Armstrong (2010) is a
able to achieve something close to the popular text on marketing principles.
theoretical optimum in terms of overall - For a marketing mix to be effective, the
utility. different elements need to be
- Simon also observed that human beings consistent.
may not optimize so much as they “satisfice”
Demographics
Satisfice
- Demand is also affected by the
- meaning that they work to meet a certain
demographics of the population of eligible
level of consumption satisfaction rather
customers.
than the very best pattern of consumption.
- How many people live in a region, their
ethnic and socioeconomic composition, and
Determinants of Demand
age distribution can explain variations in
Price
demand across regions and the ability to
- also the key determinant of demand in the forecast in the future as these
theory of the consumer demographics change.
 DIPC = the disposable income per
B. Modeling Consumer Demand capita, in dollars, as measured by the U.S.
Department of Commerce for that month.
o To develop a formal model of consumer
demand, the first step is to identify the most Using past data, they estimate the
important determinants of demand and following equation to relate these variables to
define variables that measure those number of broadband subscribers to their
determinants. service during a month, symbolized by Q:
Q = 25,800 − 800 P + 4 A + 200 CP + 0.4
o Ideally, we should use variables for which
DIPC.
data exist so that statistical estimation
techniques can be applied to develop an This relationship is called a demand
algebraic relationship between the units of a function.
good consumed and the values of the key
One application of the demand function
determinants. Techniques to derive these
is to estimate the consumption quantity Q for
algebraic relationships from historical data
specific values of P, CP, and DIPC. Suppose P =
are outside the scope of this text, but an
$30, A = $5000, CP = $25, and DIPC = $33,000:
interested reader may want to consult a text
on econometrics. Stock and Watson (2007) is Q = 25,800 − 800(30) + 4(5000) +
an established econometrics text. 200(25) + 0.4(33,000) = 40,000 subscribers

We will examine a simple example of a In Module 2 "Key Measures and

model of consumer demand. Suppose a Relationships", we introduced a demand curve
to describe the relationship between the
business is selling broadband services in a
quantity of items sold and the price of the item.
community. The managers of the business have
When there are multiple determinants of
identified four key determinants of demand: (a)
the price they charge for the service, (b) their demand, the demand curve can be interpreted
as a reduced view of the demand function
advertising expenditure, (c) the price charged
where only the price of the product is allowed
by the competition, and (d) the disposable
to vary. Any other variables are assumed to
income of their potential customers. They
remain at a fixed level. For the previous
define four variables to measure these
determinants: demand function for broadband service,
suppose we assume A is fixed at $5000, CP is
P = the price per month of their service, fixed at $25, and DIPC is fixed at $33,000. If you
in dollars, substitute these values into the demand
function and aggregate constant terms, the
A = advertising expenditure per month,
demand function becomes
in dollars,
Q = 64,000 − 800 P.
CP = the price per month of the
competitor’s service, in dollars, Recall that demand curves are usually
expressed with price as a function of quantity.
With some basic algebra the equation of the capabilities are usually not possible to achieve
demand curve can be written as overnight. For some goods, production is a
process that takes significant time from
P = $80 − $0.00125 Q.
initiation to completion, such as constructing
What happens to the demand curve if apartments or office space that will be leased
one of the other variables is a different value? to customers. Even businesses that provide
Well, in short, the demand curve would shift. products or services “made to order,” where
Suppose the competitor decides to increase its most of the direct organization or production
price to $35. Repeating the preceding steps, the activities occur after a purchase is made,
demand function simplifies to usually need to have supplies, trained labor,
and management structures in place in advance
Q = 66,000 − 800 P
of the order to be in a position to negotiate a
or, expressed with P as a function of Q, sale.

P = $82.50 − 0.00125 Q.
Figure 3.1 "Shift in Demand Curve for
Broadband Service Caused by Increase of
Competitor Price From $25/month to
$35/month" shows a graph of the demand
curve before and after the shift. Effectively, the
result is that the broadband firm would see its
demand increase by 2000 customers per
month, or alternatively, the firm could raise its
price to $32.50 and still maintain 40,000
customers per month.
Without some concrete estimate of
C. Forecasting Demand
what level of demand will result after these
Identifying the key determinants of planning, designing, and production activities, a
demand and developing demand functions business may find itself with an excess of
gives a business manager a better unused capacity or unable to serve the demand
understanding of his customers. A benefit of that follows. Excess capability is costly because
that understanding is an improved accuracy in idle resources have an opportunity cost but do
forecasting the demand levels for their not contribute to sales or revenue, especially
products and services in an upcoming period. when the unused resources spoil and cannot be
Most businesses need to plan production used at a later time. When businesses set
activities well in advance of when the goods production targets too low, they discover
and services are actually provided to the missed opportunities for profit and unmet
consumer. Businesses need to have an demand that is likely to discourage those
adequately sized operation, have a sufficient consumers from being customers in the future.
staff in terms of size and training, and obtain
any necessary resources for production. These
 To a limited extent, a business may be For variables where past patterns may
able to alter future demand to be more in line not continue into the future, like competitor
with its capacity because it has control over actions on pricing and promotion or
some determinants of demand, like pricing, unexpected climate events, a business can
promotion, and location. If the business is construct scenarios in which management
surprised by demand levels that are higher or postulates settings for these factors and then
lower than expected, these market strategy develops a demand forecast for each scenario.
elements can be adjusted to either stimulate or Although the future will almost certainly not
diminish demand to conform to its production conform exactly to any single scenario, the
capabilities. Still, the financial performance of exercise prepares them to monitor for changes
an enterprise is improved when the demand is in these factors and be ready to make a prompt
consistent with the levels anticipated in the response whenever a similar scenario emerges.
initial planning stages.
D. Elasticity of Demand
Further, most businesses are not in
Another use of a mathematical demand
control of all the key determinants of demand.
function is measuring how sensitive demand is
The business cannot control the direction of the
to changes in the level of one of the
overall economy and consumer incomes. The
determinants. Suppose we would like to assess
business may be able to guess at, but not
whether the demand for broadband service will
control, actions by other companies that sell
change much in response to a change in its
substitute and complementary goods and
price. One indicator of the level of response to
services. Anticipating the impact of these
a price change is the coefficient of the price
outside forces is critical.
term in the demand function equation, –800 P.
Businesses can improve demand The interpretation of the coefficient –800 is
forecasting with their demand functions using that for each increase of $1 in the monthly
the future values of determinant variables in subscriber price, the number of monthly
those demand functions. Forecasts for widely subscribers will decrease by 800 subscribers.
followed economic indicators like disposable
This observation provides some insight,
income are available from public releases or
particularly if the broadband firm is considering
private forecasting services. If the business has
a price change and would like to know the
a record of data for these uncontrollable
impact on the number of subscribers. However,
variables, they can apply quantitative
for someone who measures price in terms of a
forecasting techniques like time series analysis
different currency, say Japanese yen, a
or develop casual models that relate these
conversion to U.S. dollars would be needed to
factors to other variables that can be forecast.
appreciate whether the demand change
Readers are encouraged to look at a text in
implied by the coefficient value is large or
business forecasting for assistance in doing
modest. Another limitation of this approach to
quantitative forecasts. One business forecasting
measuring the responsiveness of demand to a
text is a book authored by Hanke and Wichern
determinant of demand is that the observation
(2009).
may not apply readily to other communities
that may have a larger or smaller population of Another important class of elasticities is
potential customers. the response of demand to changes in income,
or the income elasticity. For our broadband
Elasticity of demand.
example, if we were to calculate the income
- An alternative approach to measuring the elasticity at the same point where we
sensitivity of demand to its determinant calculated the price elasticity, we would have
factors is to assess the ratio of percentage found an elasticity of 0.33. The interpretation
change in demand to the percentage of this value is as follows: For an increase of 1%
change in its determinant factor. in income levels, demand for broadband will
increase by 0.33%.
Price elasticity / own-price elasticity
When income elasticity of a product is
- Assessing the elasticity of demand relative
greater than one, we call the product a cyclic
to changes in the price of the good or
good. The adjective “cyclic” suggests that this
service being consumed
demand is sensitive to changes in the business
cycle and will generally change more on a
Since the law of demand states that
percentage basis than income levels. Luxury
quantity demanded will drop when its price
goods that customers can do without in hard
increases and quantity demanded will increase
economic times often fall in this category.
when its price decreases, price elasticities are
usually negative numbers (other than special When income elasticity is between zero
cases like Giffen goods, described earlier in this and one, we call the product a noncyclic good.
module). Our broadband service falls in this category.
The demand for noncyclic goods tends to move
Goods and services are categorized as
up and down with income levels, but not as
being price elastic whenever the price elasticity
strongly on a percentage basis. Most of the
is more negative than –1. In this category, the
staple goods and services we need are
percentage change in quantity will be greater
noncyclic.
than the percentage change in price if you
ignore the negative sign. Normally we would expect demand for
a good or service to increase when incomes
When the computed price elasticity is
increase and decrease when incomes decrease,
between 0 and –1, the good or service is
other things being equal. However, there are
considered to be price inelastic. This does not
arguably some exceptions that do not behave
mean that demand does not respond to
this way. Low-cost liquor, which might see
changes in price, but only that the response on
increased use in hard economic times, is one of
a percentage basis is lower than the percentage
these possible exceptions. When income
change in price when the negative sign is
elasticity is negative, we call the product a
ignored.
countercyclic good.
In those rare instances where price
When elasticities are calculated to
elasticities are positive, the product violates the
measure the response of demand to price
law of demand. Again, these are similar to the
changes for a different good or service, say
Giffen goods discussed earlier
either a substitute product or complementary inelastic to changes in price, so why not), but
product, we call the calculated value a cross- the other three stations leave their price where
price elasticity. Cross-price elasticities tend to it was. If prices were clearly displayed, most
be positive for substitute goods and negative customers would avoid the station that tried to
for complementary goods. In our example, the increase the price and that station would see
competitor’s service is a substitute good. If we nearly all of its business disappear. In this
calculate the cross-price elasticity for changes situation where the competitors’ goods are
in the competitor’s price on demand for highly substitutable, the price elasticity for a
broadband service at the point examined single gasoline station would be very price
earlier, the result is 0.125. elastic.
Elasticities can be calculated for any E. Consumption Decisions in the Short Run and
factor on demand that can be expressed the Long Run
quantitatively. In our example, we could also
The main reason most consumers are
calculate an advertising elasticity, which has a
unable to respond very quickly to an increase in
value of 0.5 at the given settings for the four
gasoline prices is because there is not an
factors in our demand function. This value
effective substitute for automobile travel.
indicates that an increase of 1% in our monthly
However, if consumers were convinced that
advertising will result in a 0.5% increase in
gasoline prices were going to continue to rise
subscribers.
into the foreseeable future, they would
In interpreting and comparing gradually make changes to their lifestyles so
elasticities, it is important to be clear whether that they are able to reduce gasoline
the elasticity applies to a single business in a consumption significantly. They could purchase
market or to all sellers in a market. Some more fuel-efficient cars or cars that use an
elasticities, like price elasticities and advertising alternative fuel, or they could change jobs or
elasticities, tend to reflect greater sensitivity to change residences so that they are closer to
changes in the factor when an elasticity is their places of employment, shopping, and
calculated for a single business than when such.
assessed for the total demand for all sellers in a
Economists distinguish short-run
market. For example, we noted earlier that
decisions from long-run decisions. A consumer
consumers will be unable to decrease gasoline
decision is considered short run when her
consumption much, at least immediately, even
consumption will occur soon enough to be
if gasoline prices climb dramatically. This
constrained by existing household assets,
implies that gasoline is very price inelastic.
personal commitments, and knowhow. Given
However, this observation really applies to the
sufficient time to remove these constraints, the
gasoline industry as a whole. Suppose there
consumer can change her consumption
was a street intersection in a city that has a
patterns and make additional improvements in
gasoline station on every corner selling
the utility of consumption. Decisions affecting
effectively the same product at about the same
consumption far enough into the future so that
price, until one station increases its price
dramatically (believing gasoline was highly
any such adjustments can be made are called up $1.50 of their wealth. If not, they will walk
long-run decisions. away without making a purchase. If the
students instead decide to charge $1.80 per ice
Demand functions and demand curves
cream bar, the demand curve indicated that
can be developed for short-run or long-run
6000 fewer unit purchases would occur,
time horizons. Short-run demand curves are
meaning 6000 of those purchases were not
easier to develop because they estimate
worth $1.80 to the purchasers. However, some
demand in the near future and generally do not
of the customers would have been willing to
require a long history of data on consumption
pay over $2.00, and fewer even more than
and its determinant factors. Because long-run
$2.50 or $3.00.
demand must account for changes in
consumption styles, it requires longer histories When all consumers pay the same price,
of data and greater sophistication some of them get a kind of surplus because
they would have been willing to pay more for
Elasticities of demand in the short run
the ice cream bar. Sellers may wish they were
can differ substantially from elasticities in the
able to charge customers the maximum
long run. Long-run price elasticities for a
amount they are willing to pay, which would
product are generally of higher magnitude than
result in more revenue and no added cost. In
their short-run counterparts because the
economics, the term for charging different
consumer has sufficient time to change
prices to different customers is called price
consumption styles.
discrimination. Economists have actually
There is so much uncertainty about defined multiple types of price discrimination,
long-run consumption that these analyses are called first-degree price discrimination, second-
usually limited to academic and government degree price discrimination, and third-degree
research. Short-run analyses, on the other price discrimination.
hand, are feasible for many analysts working
First-degree price discrimination is an
for the businesses that must estimate demand
attempt by the seller to leave the price
in order to make production decisions.
unannounced in advance and charge each
customer the highest price they would be
willing to pay for the purchase. If perfectly
F. Price Discrimination
executed, this would meet the ideal of getting
In the ice cream bar summer business in the greatest revenue possible from sales.
Module 2 "Key Measures and Relationships", Unfortunately, anything close to perfect
we presumed that the student operators would execution of first-degree price discrimination is
decide on a price to charge. All ice cream bars unrealistic because customers have an
would be sold at that price. We reasoned that incentive to not reveal how much they would
more ice cream bars could be sold as the price be willing to pay and instead try to pay as little
is decreased. If the students decide to charge as possible. Attempts to sell using first-degree
$1.50 per ice cream bar, a potential customer price discrimination may be illegal as well, as it
will decide if the utility of the ice cream bar is may be deemed discriminatory in the legal
sufficiently high for them to be willing to give sense of the word.
 Some commercial dealings resemble products that employ new technologies, when
attempts at first-degree price discrimination. the initial seller has the market to itself, at least
Sometimes there is no set price, and the buyer for a while, and offers a got-to-have item for
and seller negotiate a price. This is the some customers. Of course, although these
customary way that automobiles have been eager customers may be willing to pay more,
sold in the United States. The process may start they may be aware of this pricing strategy and
with a preannounced price, but one that is delay their purchase, so this approach will not
usually higher than the seller actually expects extract the full value customers would have
to receive. This falls short of pure first-degree been willing to pay.
discrimination because the buyer is probably
When goods and services are sold
able to negotiate down from the most he
according to a preannounced price, the
would pay, possibly quite a bit if the buyer is a
customary arrangement is that the charge for
good negotiator. In addition, there is time and
multiple items is the price times the number of
effort expended in the negotiating, which is a
items. This is called linear pricing. However,
kind of cost to the transaction that the buyer
customers differ in the volume they are
may see as part of the purchase cost and the
interested in purchasing. A business may
seller may see as an added cost of business.
benefit by offering different prices to those
Goods and services are sometimes sold who purchase in larger volumes because either
or purchased via an auction. This is usually an they can increase their profit with the increased
effective means when the seller has a limited volume sales or their costs per unit decrease
number of items to sell. Run properly, an when items are purchased in volume.
auction will distinguish those willing to pay Businesses can create alternative pricing
more, although it probably will not manage to methods that distinguish high-volume buyers
get a bid as high as the maximum the buyer from low-volume buyers. This is second-degree
would have paid. Again, the cost of operating price discrimination.
an auction is expensive in comparison to selling
A donut shop might offer a free donut
using a set, preannounced price.
to anyone who purchases a whole dozen
Businesses that sell a product that is in because the purchase requires less clerk time
demand with no good substitute available will per donut sold and increases how many donuts
sometimes employ a sliding price, where they get purchased. However, since only those who
begin selling at a very high price that is buy at least a dozen donuts get a free donut,
attractive to relatively few consumers. After a the discount is limited to those people and not
time when presumably those high-value the customer who purchases just a donut or
customers make their purchases, the business two. This would be second-degree price
will drop the price somewhat and attract discrimination.
purchases from another group that was willing
Another nonlinear pricing scheme to
pay slightly less than the first group. Successive
employ second-degree discrimination is a two-
price drops can continue until it would be
part price. A customer pays a flat charge to be a
unprofitable for the seller to drop the price any
customer and then pays a per unit charge
lower. Sliding prices are sometimes used with
based on how much they consume. Some compact discs were more demanding of quality
services like telephone service are primarily and more price inelastic.
fixed cost and have a very small per unit
To apply third-degree price
variable cost. By charging telephone customers
discrimination, the seller must be able to
a flat monthly fee and low per unit charge, they
clearly identify and sort the customer by a
encourage more use of the service than if they
salient characteristic. For example, a cable
simply charged a linear price per unit and see
provider may be aware that existing subscribers
more revenue in relation to costs. Membership
are price inelastic relative to other households
stores that require customers to pay an entry
that are not existing customers. The cable
fee before being allowed to shop, but offer
provider will typically charge reduced rates to
lower prices than regular stores for purchased
attract new customers and is able to execute
items, is another example of a two-part pricing.
the price discrimination because it knows
Third-degree price discrimination is whether a customer is an existing customer or
differential pricing to different groups of not. A sports clothing retailer may know that
customers. One justification for this practice is fans of a team are more price inelastic in the
that producing goods and services for sale to purchase of apparel displaying the name or
one identifiable group of customers is less than mascot of that team than customers who are
the cost of sales to another group of customers. not fans. However, if the clothing retailer were
For example, a publisher of music or books may to attempt to charge differential prices, the
be able to sell a music album or a book in customers who are fans would have the
electronic form for less cost than a physical incentive to disguise that characteristic, so
form like a compact disc or printed text. third-degree price discrimination would not
work well in this case.
A second justification for charging
different prices to different groups of
customers is that one group may be more
sensitive to price than the other group. Earlier
we discussed elasticity of demand. If we
separated the demand for the two groups into
separate demand curves, at any given price the
more price sensitive group will have stronger
negative price elasticity. Sellers are able to
increase economic profit by charging a lower
price to the price-elastic group and a higher
price to the more price-inelastic group. As an
example, 25 years ago music was sold in two
formats: cassette tapes and compact discs. The
production cost of a cassette tape was roughly
equivalent to a compact disc, but music on
compact discs often retailed at a higher price
because it was perceived that customers of