CHAPTER 2

Consumer Behavior: The Law of Demand and its Effect on Pricing

The Law of Demand

This intent of this textbook is to introduce the manager to innovative pricing strategies that can increase a firm’s profit. We will begin by reviewing the basic economic concepts that lead to a single profit-maximizing price.This is based on the assumption that a firm produces a single good and is trying to determine the best price to charge. In setting a price, the firm must consider the law of demand. To derive the law of demand, assume that Moe is going to the local high school football game on a Friday night. He has $3.75 in his pocket. For simplicity sake, assume that hot dogs and Cokes are priced at $1.25 each. Moe goes to the concession stand in the middle of the first quarter and must decide whether to buy a hot dog or a Coke. Assume he buys the hot dog. Note that because the price of a hot dog is the same as the price of a Coke, we can infer that Moe gets more satisfaction from the hot dog than he would have obtained from the Coke. Suppose he returns to the concession stand during the second quarter. This time, he must decide between his second hot dog and his first Coke. Let’s suppose he buys a second hot dog. Again, by purchasing the second hot dog, he is indicating that he gets more satisfaction from the second hot dog than he does from the first Coke. In the middle of the third quarter, he returns to the concession stand with his last $1.25. Let’s assume that this time, he buys a Coke. Again, his buying behavior reveals his preferences; that he obtains more satisfaction from the first Coke than he would have received from the third hot dog.

Economists refer to the additional satisfaction Moe derives from each additional unit of a good as marginal utility. Given that Moe’s purchases reveal his preferences, we can conclude the following:

1. Moe prefers the first hot dog to the first Coke prefers the first hot dog to the first Coke prefers the first hot dog to the first Coke

2. Moe prefers the second hot dog to the first Coke

3. Moe prefers the first Coke to the third hot dog

Let’s examine the last two revealed preferences: Moe prefers the second hot dog to the first Coke, but he prefers the first Coke to the third hot dog. If both statements are true, the fourth statement logically follows:

4. Moe prefers the second hot dog to the third hot dog

Note that we don’t have to ask Moe if he prefers the second hot dog to the third hot dog. Rather, these preferences were revealed through his purchase decisions. The notion that Moe receives less satisfaction from the third hot dog than he does from the second is called the law of diminishing marginal utility. In general, economists assert that as more of a good is consumed, individuals get less satisfaction from each successive unit. If the law of diminishing marginal utility did not exist and Moe had brought $10 to spend on concessions, he would have spent all of his money on hot dogs. The fact that most people do not spend all of their money on one good is implicit proof that the law exists with all of us.

What does the law of diminishing marginal utility mean for firms? Clearly, if each additional hot dog brings less satisfaction to Moe, he would be willing to spend less for each additional hot dog. Suppose Moe would have been willing to spend as much as $2 for the first hot dog, $1.25 for the second hot dog, and $.50 for the third hot dog. Thus, if hot dogs were priced at $.50, Moe would buy three. If the price increased to $1.25, he would only be willing to buy two, and if the price rose to $2, Moe would only buy one. This illustrates the law of demand: the higher the price, the lower the quantity of hot dogs demanded.

Figure 2.1 illustrates Moe’s demand curve. The demand curve shows the quantities Moe is willing and able to buy at each price.

Figure 2.1. Demand curve.

The implications of the law of demand for the firm are inherently obvious. The higher the price of hot dogs, the fewer hot dogs Moe is going to buy. Conversely, the more hot dogs the concession stand wishes to sell, the lower the price it will have to charge.

In July 2011, Netflix created uproar over its announcement to split its DVD-by-mail services and online streaming. Netflix revolutionized the DVD rental business by mailing DVDs to consumers rather than having them browse a local retail outlet. As quality online video streaming developed, the demand for conventional DVD rentals took a steady nosedive. Indeed, Netflix found its own demand for online video streaming to be on the rise, increasing from roughly six million subscribers in 2007 to 25 million in 2011.1

But in 2011, Netflix made a strategic decision that incurred the wrath of many subscribers. It decided to separate the two subscription plans entirely. Consumers could subscribe to either the online service or the DVD-by-mail service. To facilitate the move, Netflix renamed its traditional by mail service, Qwikster. Unfortunately, Netflix was more forward-thinking than its customers. Its goal was to split the market segments into separate services and offer a lower price for those who chose to download films. From that perspective, the price of online subscriptions would remain unchanged while the price of DVD-by-mail subscriptions would fall by $2/month.

The subscribers in the dual plan did not see things that way. For $9.99/month, they were able to either rent or download DVDs. To continue with that flexibility, they would have to buy two subscriptions, for a total price of $15.98/month, a whopping 60% increase. With nearly half of its 24.6 million subscribers in the dual plan, the reaction from consumers was one of outrage. Within three months, in response to a marked decline in the number of subscribers, Qwikster was discontinued.

Factors that Cause Demand to Change

A demand curve, such as that illustrated in Figure 2.1, indicates the quantity demanded at any given price. However, the price of that particular good is not the only factor that determines the quantity demanded. We know, for example, that consumer tastes change. If Moe attends the football game on a particularly hot day, he may want more to drink. Given that he only brought $3.75 to the game, he may choose to buy two Cokes and one hot dog rather than two hot dogs and one Coke. We can illustrate the results of his changing tastes graphically. As shown in Figure 2.2, the demand for hot dogs shifts to the left. Whereas Moe had been willing to buy two hot dogs at a price of $1.25, he is now only willing to buy one.

Figure 2.2. Decrease in demand for hot dogs.

The impact of changing tastes on consumer demand explains why department stores frequently have sales on seasonal clothing. As temperatures fall at the end of the summer, the demand for summer clothing decreases. Thus, the quantity of summer clothing demanded at any given price decreases, forcing the firm to lower its price.

This also explains why firms advertise. Advertising can increase the demand for their goods. At any given price, more units can be sold. A classic example of the power of advertising lies in brand name pharmaceuticals. Many pharmaceutical firms obtain patents on drugs when they are first introduced. This gives them the exclusive right to produce and sell the drug for 20 years. Once the patent expires, other pharmaceutical companies can produce identical drugs. To retain its price position, the firm that holds the patent on the drug creates a brand name and spends millions of dollars on advertising to partially insulate its position once the bioequivalent generic brand hits the market. The strategy seems to work: according to the U.S. Food and Drug Administration, despite marketing identical products, brand name drugs are priced 80–85% higher than their generic equivalent.2

Changes in the prices of substitute goods can also cause demand to shift. As shown in Figure 2.3, as the price of DVD players decreased in the 1990s, the demand for VCRs decreased.

Figure 2.3. Effect of change in the price of a substitute good.

Similarly, when a competitor lowers its price, the demand for your product will decrease. Sometimes a firm manufactures two brands of the same product. Proctor & Gamble manufactures both Cascade and Dawn. Sony produces both laptops and tablets. When the same firm produces substitute goods, a change in the price of one good will affect the demand for the substitute.

If two goods are complementary, a change in the price of one good will affect the demand for the other. A decrease in the price of a laser printer, for example, will increase the demand for ink cartridges, as illustrated in Figure 2.4.

Figure 2.4. Effect of change in price of a complementary good.

Later in the text, we will explain the significance of complementarity on pricing. For now, let’s simply note the fact that in many instances, the price of a laser printer may be the same as the price of two or three ink cartridges refills. Likewise, whereas the price of a razor may be relatively low, the price of the razor-specific blades seems to be quite high. By lowering the price of one good, the demand for the complementary good increases. In the case of the laser printers or razors, the firm holds the price of one good down with the expectation that it will make up for the lost profit margin via the increased demand for the complementary product.

Changes in consumer incomes can also affect demand. An increase in incomes might boost the demand for NBA basketball tickets. Rising incomes do not always cause demand to increase. Increasing incomes may cause the demand for used cars to decrease because consumers would rather buy a new car and can now afford to do so. Economists refer to any good for which demand increases when incomes increase as a normal good. When the demand for a good is inversely related to consumer incomes, it is called an inferior good.

One should not be misled by the “inferior” tag. Inferior goods are not necessarily low quality products. Few persons would consider a Porsche 970 to be a low-quality car. But if a professional baseball player who currently drives a Porsche signs a five-year $100 million contract and chooses to buy a $387,000 Lamborghini as his next car instead of a Porsche, we can conclude that, for him, the Porsche is an inferior good.

Finally, demand can increase or decrease in response to changes in price expectations. Readers may recall the long gas lines that occurred in the hours following the 9/11 terrorist attacks. Drivers anticipated that the attacks would cause a dramatic spike in fuel prices and showed up en masse to fill up their tanks.

The Law of Demand and Consumer Surplus

A critical concept that arises from the law of demand is called consumer surplus. Consumer surplus refers to the difference between the price the consumer is willing to pay and the price he actually pays. Consumers enter the marketplace looking for bargains, which occurs when a consumer buys a good at a lower price than he is willing to pay. Thus, consumer surplus measures the dollar volume of bargains accruing to the consumer.

We can return to Moe’s demand curve to measure his consumer surplus. In our original example, each hot dog was priced at $1.25. Because Moe was willing to pay up to $2 for the first hot dog, his consumer surplus for the hot dog is $.75. Similarly, because he was willing to pay up to $1.25 for the second hot dog, he buys the hot dog, but does not gain any additional consumer surplus. Collectively, the value Moe placed on two hot dogs summed to $3.25, but he only spent $2.50, allowing him to retain $.75 in consumer surplus, as shown in Table 2.1.

Table 2.1. Calculating Consumer Surplus

Consumer surplus can be represented graphically. For each unit of output, the corresponding point on the demand curve shows the price the individual would be willing to pay for that unit. The vertical distance between the point on the demand curve and the actual price is the consumer surplus for that unit, as shown in Figure 2.5.

Figure 2.5. Graphical representation of consumer surplus.

We can expand our individual demand curve to derive a market demand curve. Suppose two other consumers (Larry and Curly, of course) also brought money to the football game. Their willingness to pay for hot dogs is summarized in Table 2.2.

Table 2.2. Individual Demands

Collectively, the consumers’ willingness to pay can be used to derive a market demand curve. For example, if the price of a hot dog was $2, Moe would be willing to purchase one hot dog and Larry and Curly would not be willing to buy any. If the price was $1.75, Moe and Larry would each buy one hot dog, but Curly would not purchase any. Hence, at a price of $2, the quantity demanded is one and at $1.75, the quantity demanded is two. Table 2.3 summarizes the market demand curve, which is depicted graphically in Figure 2.6.

Figure 2.6. Graphical representation of market demand.

We can use the market demand information to determine the concession stand’s revenue and the level of consumer surplus. If the concession stand charges $1 for a hot dog, five hot dogs will be purchased. The concession stand will collect $5 in total revenue and consumer surplus will be equal to ($2 − $1) + ($1.75 − $1) + ($1.50 − $1) + ($1.25 − $1) + ($1 − $1), or $2.50.

Let’s take the concession stand example to create a generic graph to illustrate market demand. Because the firm’s revenue is equal to price times the quantity demanded, this is represented on the graph by the vertical distance between the origin and the price, and the horizontal distance between the origin and the quantity demanded. Consumer surplus, which represents the consumer value that is not captured by the firm, is the area that lies underneath the demand curve, but above the price. This is illustrated in Figure 2.7.

Figure 2.7. Graphical representation of consumer surplus and total revenue.

Figure 2.7 succinctly illustrates the world of the single-price firm. At a given price, consumers are willing and able to purchase a given quantity. However, because some consumers would have been willing to pay a higher price for the good, a percentage of the overall value that consumers place on the good goes uncaptured by the firm. In the previous example, one-third of the overall value that Moe, Larry, and Curly placed on hot dogs was not captured. As the chapters develop, we will investigate innovative pricing strategies that attempt to capture consumer surplus.

Summary

• The law of demand is driven by the law of diminishing marginal utility, which states that consumers get less additional satisfaction from each additional unit consumed.

• Because each unit yields less additional satisfaction, the less the consumer is willing to pay consume it.

• The law of demand suggests that, all else equal, the more units the firm wishes to sell, the lower the price it must charge.

• The quantity that a consumer is willing to buy at each price is affected by changes in tastes and preferences, income changes, changes in the prices of substitute and complementary goods, and changes in price expectations.

• Consumer surplus is the difference between the price the consumer is willing to pay and the actual price paid by the consumer. It represents revenue that the firm did not capture that the consumer was, in fact, willing to pay.