Demand Analysis and Strategy

Paul C. Godfrey

Mark H. Hansen

Marriott School of Management

What strategists need to know:

• What determines demand?

• How sensitive is demand?

• How can managers work with/influence demand to create competitive advantage?

What determines (drives) demand?

The law of demand

• In general, the cheaper a product/service is, the more people will buy.

• Based on declining marginal utility

• Demand curves are downward sloping

Exceptions to the law of demand:

Will lower priced products always sell more?

No,

Veblen (conspicuous consumption) goods—price is a signal of quality and a direct determinant of utility

Giffen goods—consumption goes up in difficult times and price follows

Market demand curve

• A schedule of different consumers’ willingness to pay

• Shows response to change in price—and nothing else

• Shows the amount of a good that will be purchased at alternative prices.

Quantity

D

Price

Determinants of Demand

Own Price

Advertising

Commodity status

Consumer expectations

Income

Need

Population changes

Prices of substitutes

Prices of complements

Tastes and preferences

Technological changes

• these are all demand shifters

The demand function

The demand equation

Qxd = f(Px, PY , M, H,)

Qxd = quantity demand of good X

Px = price of good X

PY= price of a substitute/complement good YM = incomeH = all other variables affecting demand

Substitutes and Complements

Substitute goods: an increase (decrease) in the price of good Y leads to an increase (decrease) in the demand for good X

€

Qxd = β x + Px + Py + M + H

€

€

Qxd = β x + Px − Py + M + H

Complementary goods: an increase (decrease) in the price of good Y leads to a decrease (increase) in the demand for good X

Coke & Pepsi

Tortilla Chips & Salsa

Managing Demand: Price Changes

$

Quantity

D0

4

10A

7

6B

Graphic compliments of David Bryce

$

Quantity

D0

Managing Demand: Shifting Demand

6

7 13Graphic compliments of David Bryce

D1

BB1

Managing Determinants of Demand

Own Price

Advertising

Commodity status

Consumer expectations

Income

Need

Population changes

Prices of substitutes

Prices of complements

Tastes and preferences

Technological changes

Example: Estimating a demand curve

A retailer wants to know the demand curve for ties

• Observes that over the past 2 weeks, with prices at $20, 110 ties have sold

• Raises price to $25 for next two weeks without announcement; sells 100 ties

• Reduces price to $15 for following two weeks; sells 140 ties

Adapted from David Bryce © 2005

$0

$5

$10

$15

$20

$25

$30

80 100 120 140 160

Quantity of Ties Sold

Price of Ties Sold

Two Week Demand for Ties

Example: Estimating a demand curve

Adapted from David Bryce © 2005

Two-Week Demand for Ties

q = 197 - 4p

0

20

40

60

80

100

120

140

160

$10 $15 $20 $25 $30

Quantity of ties

sold

Price of ties sold

Example: Estimating a demand curve

Adapted from David Bryce © 2005

Total Revenue for Ties

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

$2,200

$2,400

$2,600

$5 $10 $15 $20 $25 $30 $35 $40

Based on q = 197 – 4pNote:To get total revenue from the demand curve, multiply p q

e.g.,

p q = p (197 - 4p)

p q = 197p – 4p2

• Total Revenue (R ) = p q• Thus,

R = p (197 – 4p) = 197p – 4p 2

• Now find where slope of revenue function is at a maximum by taking derivative and setting equal to 0

dR/dp = 197 – 8p = 0• Solve for p

-8p = -197

p = -197/-8 = $24.63

Maximizing Total Revenue for Ties

How can managers use/ influence demand to create competitive advantage?

Price discrimination

• The demand schedule represents willingness to pay of different customer groups, or segments

• If groups can be segmented according to discrete and identifiable benefits, and

• If products can be configured to contain (omit) features, then . . .

• Managers can increase total revenues and profits

Price issues—price discrimination

$0

$10

$20

$30

$40

$50

$60

Zealo

ts

Lay U

sers

• Pricing High: Selling 1 Million units to high value “zealots” = $60 Million

• Pricing Low: Selling 1 Million zealots and 1 Million units to the lay users = $40 Million

• Can you price for $80 Million in revenue?

Valu

e t

o c

usto

mer

Price discrimination strategies

• The internet/ flexible manufacturing allows ultimate product customization and personalized pricing (e.g., Dell)

• Differentiate versions based on product attributes (e.g., WSJ on-line edition, current vs. archival search)

• Differentiate based on customer behavior—supermarkets “fresh values” and airline “skymiles”

• Use promotions to measure price elasticity among and between groups

Isolate the demand curve

• Products that are commodities can be perfectly summed to a market demand curve

• Products that are customized cannot– Monopolistic competition (the demand for iPods is not the demand for

Zune)– Idiosyncratic markets (professional athletes, entertainers, high end

homes)

• Firms can take several steps to isolate demand from the general market– Brand building and advertising– Switching costs– Lock-in and legacy features– Quality of performance/ design issues– Supply chain integration (e.g., JIT)

Understand and look for consumer surplus

• The demand curve represents consumers’ willingness to pay

• The consumer paying P* at point A, is paying exactly what they are willing to pay

• All consumers above point A are paying less than they are willing to pay, and get a surplus

• Consumers below point A on the demand curve do not buy

• Remember, strategy is about creating more surplus for everyone

$

Quantity

D0

P* A

ConsumerSurplus

Understand the investment horizon

• Understand the only short-term tool is price– Price reductions– Price-based advertising

• The longer terms tools are all longer term– Technology development (you and your competitors)– Commodity status of your offering (brand or other differentiation)– Advertising/ marketing that changes (captures) tastes and preferences

• Build strategy around long term levers, tactics around short term

How sensitive is demand?(come back next time)