Techniques for Understanding Consumer Demand Behavior New

Techniques for Understanding Consumer Demand & Behavior New Products have no historical data – so surveys can assess interest in new ideas. Survey Research Center of U. of Mich. does repeat surveys of households on Big Ticket items (Autos) Surveys of Spending Plans Common Survey Problems • Sample bias-telephone, magazine • Biased questions-Ø advocacy surveys • Ambiguous questions • Respondents may lie on questionnaires EMBA Corporate Economics – January 24 th with Dick Marcus 1

Sources of information on demand • Consumer Surveys Ø Ø ask a sample of consumers their attitudes panel data of a sample of customers • Consumer Clinics Ø experimental groups try to emulate a market (Hawthorne effect), Laboratory experiments • Market Experiments Ø Ø get demand info by trying different prices, store audit, in store pricing experiments scanning data, uncontrolled studies of actual purchases • Historical Data EMBA Corporate Economics – January the Dick Marcus Ø what happened in 24 th withpast is guide to the future 2

Just Plot Historical Data • Look at the relationship of price and quantity over time • Plot it Q=a+b. P+ quantity Q Slope is a b 03 08 05 02 • Plotting is subject to difference of opinion on “best fitting line” EMBA Corporate Economics – January 24 th with Dick Marcus 07 04 06 Price P 3

OLS -ordinary least squares Simple Linear Regression • Qt = a + b Pt + t Time subscripts & error term Find “best fitting” line t = Q t - a - b P t Q a b is slope _ Q t 2= [Qt - a - b Pt] 2 • min t 2= [Qt - a - b Pt] 2 • Solution: Ø b = Cov(Q, P) / Var(P) Ø a = mean(Q) - b • mean(P) EMBA Corporate Economics – January 24 th with Dick Marcus _ P 4

Functional Forms: 1. Linear Demand Functions • Linear Form Q = a + b • P + c • I • The effect of each variable is constant • The effect of each variable is independent of other variables • Elasticities Ø Price elasticity is: E P = b • P /Q = DQ/DP)(P/Q) Ø Income elasticity is: E I = c • I /Q= DQ/DI) (I/Q) EMBA Corporate Economics – January 24 th with Dick Marcus 5

2. Multiplicative or Log Linear • Multiplicative Q=A • Pb • Ic Ø The effect of each variable depends on all the other variables and is not constant Ø It is log linear or also called double logged Ln Q = a + b • Ln P + c • Ln I Ø The price elasticity is b Ø The income elasticity is c • Proof: E P = D Q/D P) ( P/Q ) = (b A • P b-1 • I c)(P/ A • P b • I c) = b EMBA Corporate Economics – January 24 th with Dick Marcus 6

R 2 The Coefficient of Determination Q • R-square -- % of variation in dependent variable that is explained ^ • Ratio of [Qt -Qt] 2 ^ RSS [Qt -Qt] 2 = TSS [Qt - Qt] 2. • As more variables are included, R-square rises • Adjusted R-square, however, can decline, see page 101 EMBA Corporate Economics – January 24 th with Dick Marcus ^ Qt Qt _ Q _ P 7

Table 3. 9 Multiple Regression page 106 Linear Q = a + b. P + c. A + d. D PRICE, Advertising, & Distance to Campus N = 10 observations from ten apartments complexes of 100 units each run by FCI R-square =. 79, and Adj R-square =. 69 Coeff Std Err T-value Intercept 135. 15 20. 65 6. 54 Price -. 14. 06 -2. 41 Advertising. 54. 85 0. 85 Distance -5. 78 1. 26 -4. 61 1. What is the estimated demand curve? 2. Does this make economic sense? Which are significant? 3. Find the price elasticity and suggest if rents should be raised. Average Price = $420. Average Quantity Rented = 53. 1. Average advertising = $8 Average Distance = 2 miles Price Elasticity = -. 14 (420) / 53. 1 = - 1. 11 Advertising Elasticity =. 54(8) / 53. 1 =. 081 Distance Elasticity = -5. 78(2)/53. 1 =. 218 4. Characterize these elasticities. EMBA Corporate Economics – January 24 th with Dick Marcus 8

A Log Linear Example Dependent Variable: Ln Q Variable Coefficient Std Error Constant 14 7 Log P -1. 15. 5 Log A. 05. 06 Log D. 19. 04 T-value 2 -2. 3 0. 83 4. 75 R-sqr =. 567 N=10 1. 2. 3. Adj R-sqr =. 545 Do the signs of the coefficients make economic sense? Which form, linear or log linear fit the data better? What are three elasticities? EMBA Corporate Economics – January 24 th with Dick Marcus 9

Smoking and Smuggling Chapter 9 of MBN • Canada raised the tax on cigarettes. What do you expect would happen? Ø A 10% increase in price, lowers quantity 4%. Ø What is the price elasticity of cigarettes? • Are they elastic or inelastic? Ø What is impact on the income distribution of cigarette ever higher excise taxes? Ø What does history teach about a tax on tea? Ø Discussion questions on page 58 -59. EMBA Corporate Economics – January 24 th with Dick Marcus 10

Consumer Choice & Individual Behavior • Baye: Chapter 4 • De gustibus non est disputandum - of tastes, there is no disputing (or, there’s no accounting for tastes) • Nevertheless, we do display tastes as we rank movies, books, universities and travel spots • We can and do compare baskets of goods Ø Prefer apples to prunes Ø Dislike avocados Ø Pears and apples are similar EMBA Corporate Economics – January 24 th with Dick Marcus 11

Individual Choice • Economist think people do what they intend to do Ø Rational Decision -- maximizes what the person thinks is his or her self-interest Ø Irrational Decisions -- usually part of psychology • Adam Smith - 1776 - self interest maximizes the social interest -- led as if by an invisible hand Øfarmer’s decision on what to plant Øconsumer’s decision on what to buy Øalternative, is to assume an all knowing social planner to make decisions EMBA Corporate Economics – January 24 th with Dick Marcus 12

Measuring Pleasure or • Can we determine what Georgiana or Prakash would do over a set of choices, if we knew how they valued each choice? • We measure light in candles and power in horsepower, so need a unit of pleasure or pain, the util. Ø We need a utilometer. • Jeremy Bentham, teacher of John Stuart Mill, argued for the basis of ethics using utilitarianism: Ø Thou shalt not kill, based on highest social welfare using this rule. EMBA Corporate Economics – January 24 th with Dick Marcus 13

Cardinal vs. Ordinal Utility • Cardinal utility is measured, using some index. Ø Hard to compare two people’s utility Ø Can, nevertheless, develop measures Ø Expect to find Diminishing Marginal Utility in Bentham life size wax consumption • Ordinal utility simply assumes we can compare the happiness or satisfaction across objects or choices. Ø Using ordinal utility, we can construct Indifference Curves that show choices that tend to have the same level of happiness or satisfaction EMBA Corporate Economics – January 24 th with Dick Marcus 14

Cardinal Utility • Total Utility • Marginal Utility Diminishing Marginal Utility Pizza slices EMBA Corporate Economics – January 24 th with Dick Marcus Pizza slices 15

Indifference Curves • Consumers attempt to max happiness, or utility: U(X, Y) • Subject to an income constraint: U Uo I = Px • X + Py • Y • Graph in 3 dimensions Uo Y X EMBA Corporate Economics – January 24 th with Dick Marcus 16

Consumer Choice assume consumers can rank preferences (completeness), that more is better than less (nonsatiation), that preferences are transitive (transitivity), and that individuals have diminishing marginal rates of substitution. Then indifference curves slope down, never intersect, and are convex to the origin. U 1 X U 2 Uo 9 7 6 convex 567 Y give up 2 X for a Y EMBA Corporate Economics – January 24 th with Dick Marcus 17

Indifference Curves Using Ordinal Utility • Can graph all points candy of same utility, as in bars Uo, called an indifference curve. • As price changes, tend to buy more of the cheaper good P • Deriving the demand curve for sodas EMBA Corporate Economics – January 24 th with Dick Marcus B A C U 2 U 1 U 0 soda D soda 18

Uo Indifference Curves U 1 X a c b Y Py demand Y We "derive" a demand curve graphically from maximization of utility subject to a budget constraint. As price falls, we tend to buy more due to (i) the Income Effect (b to c) and (ii) the Substitution Effect (a to b). Similar to the example, on p. 144 EMBA Corporate Economics – January 24 th with Dick Marcus 19

Downward Slope in Demand • Two reasons that price and quantity are negatively related include: Øincome effect--as the price of a good declines, the consumer can purchase more of all goods since his or her real income increased. Øsubstitution effect--as the price declines, the good becomes relatively cheaper. EMBA Corporate Economics – January 24 th with Dick Marcus 20

A $600 Subsidy and Work • Use the labor-leisure tradeoff and suppose that you get more money from heaven. • Opportunity set shifts out. • The amount of leisure increases by the income effect. From A to B. Income EMBA Corporate Economics – January 24 th with Dick Marcus B A U 1 $600 Shift Up U 0 24 hours of Leisure 21

Labor – Leisure Choices • 24 hr/day • $10 to a $15 wage Income rate increase $15 income and the price of leisure • Leisure & income $10 tradeoff • When the wage rises, what is the ► Income effect? ► Substitution effect? EMBA Corporate Economics – January 24 th with Dick Marcus C B A U 1 U 0 24 hours of Leisure 22

Gifts versus Cash as Presents Sweaters • Recipient of a B C U 2 U 1 A U 0 All other things EMBA Corporate Economics – January 24 th with Dick Marcus sweater is improved from point A to B • Recipient of the cash equivalent of the sweater goes to point C, at a higher level of utility. • Why don’t we give cash rather than things? • Apply this to a grant of food stamps. 23

Utility Maximizing Rule • RULE: Consume until MU per dollar in each use is equal. • Suppose MU of bars is 30, and price is $1 • Suppose MU of soda is 10 and price is $. 50 • What should you do? ØA rational consumer maximizes satisfaction by reorganizing consumption until the marginal utility in each good per dollar is equal where: MUA/PA = MUB/PB = MUC/PC =. . . ØIf MU per dollar in A and B differ, the consumer can improve utility by purchasing more of the one with higher MU per dollar. EMBA Corporate Economics – January 24 th with Dick Marcus 24