HBX- Economics 1 Flashcards
Willingness to Pay (WTP)
The highest price a consumer is willing to pay for a product or service. One can think of it as the price at which the consumer is just indifferent between purchasing the product and not purchasing it.
You walk into a small grocery store with a list of 4 items to purchase. Having found every item on your list, you decide to purchase only 3 items: milk, cereal, and a pound of bananas. We can conclude that your willingness to pay for the other item was less than its price. True or False
TRUE If your WTP for the item were higher than its price, you would have purchased it. You may have decided not to purchase the item because it wasn’t the brand you like, or you remembered you already had the item at home, or for some other reason—but any of those reasons would lower your WTP for the item.
Two companies, A and B, are bidding to acquire a target firm. Their initial bids are $300 million by firm A and $350 million by firm B. The internal analysis done by each company indicates that the value of the target firm is $500 million to company A and $450 million to company B. In this example, which of the following values is likely to approximate company A’s willingness to pay?
$500 million Company A would be willing to pay up to $500 million, which is the approximate value it will derive from the target firm.
Under its original offering, customers of media company Netflix were charged $9.99 for a service that included a one-DVD-at-a-time plan and unlimited streaming of movies. In July 2011, Netflix announced a change to its pricing policy. The $9.99 plan would be eliminated. Instead, consumers could choose one of three plans—$7.99 per month for one-DVD-at-a-time, $7.99 per month for unlimited streaming, or $15.98 for both DVD and streaming. In October 2011, Netflix announced that it had lost 800,000 subscribers in the U.S. during the third quarter of 2011. Which of the following MUST be true for all subscribers that Netflix lost in the third quarter?
*Their WTP for streaming only is less than $7.99. *Their WTP for DVDs only is less than $7.99. *Their WTP for the two services together is less than $15.98.
Under its original offering, customers of media company Netflix were charged $9.99 for a service that included a one-DVD-at-a-time plan and unlimited streaming of movies. In July 2011, Netflix announced a change to its pricing policy. The $9.99 plan would be eliminated. Instead, consumers could choose one of three plans—$7.99 per month for one-DVD-at-a-time, $7.99 per month for unlimited streaming, or $15.98 for both DVD and streaming. Although Netflix had expected to continue to lose subscribers in the fourth quarter of 2011, in January 2012 the company announced that it had instead added 610,000 subscribers by the end of that quarter. Which of the following MUST be true for the subscribers that Netflix added in the fourth quarter of 2011? A- Their WTP for streaming only is more than $7.99. B- Their WTP for DVDs only is more than $7.99. C- Their WTP for a bundle is more than $15.98. D- A & B E- A, B, & C F- At least one of A, B, & C.
E. A, B, or C must be true of each customer, or that customer would not subscribe to any of Netflix’s services.
Differences in WTP for a Hockey Game
- Venue- 17%
- Teams Competing- 15%
- Date & Time- 15%
- Income- 12%
- Family & Friends attending- 10%
- Interest in Sport- 9%
- Weather- 8%
- Seat Location- 8%
- Importance of Game- 5%
- Demographics- 3%
According to research by HBS professor Max Bazerman and others, people’s perceptions of fairness can impact their purchasing decisions. Suppose that a hardware store in Harvard Square has been selling flashlights for $10, but on the day of a hurricane they raise the price to $20. Meanwhile Target, located in nearby Watertown, has kept the price of the same flashlight unchanged at $10. Based on what you know about factors that determine WTP which of the following is most plausible?
- A- People’s WTP for a flashlight at the hardware store will decrease after customers learn of this price increase.
- B- People’s WTP for a flashlight at the hardware store will be higher than at Target since they urgently need flashlights and will pay the higher price if necessary.
- C- People’s WTP for a flashlight at the two stores will be the same given that the flashlight they sell is exactly the same
A!
People’s WTP for the flashlight at the hardware store will likely decrease because of the perceived unfairness of the price increase. Note that even the decreased WTP might still be high enough for customers to make the purchase, if they really need flashlights.
The share price of a company is $20 at the beginning of the month, and $10 at the end of the month. Assuming that the company did not issue new stock during the month, which of the following statements is true? (Select all that apply) A-The WTP for the company’s stock fell by an average of 50% amongst all interested buyers. B-The WTP for the stock fell by an average of 100% amongst all interested buyers. C-Just because the price of the stock changed does not mean investor WTP for the stock has changed. D-The overall valuation of the company fell over the course of the month. E-Some investors may be willing to pay more than $10 for the stock.
A, D, & E A- True. The company is now valued at 50% of what it was originally, meaning that the average investor’s WTP for the company is 50% lower as well. B-The average investor is willing to pay $10 for a share, so average WTP fell by 50%, not 100%. C-Assuming that no new shares were issued, the price of a stock represents a market’s overall valuation of a company. Valuation and average WTP are then synonymous. D-True, since in this situation valuation and average WTP are synonymous. E-True. The $10 valuation represents the average investor valuation of the company’s stock. However, some investors may still be willing to pay more than $10 for the stock.
What does a demand curve look like? (what’s the on the x and y access)
- X access- # of Consumers/Demand
- Y access- Price These normally have a downward slope
What is the equation for Revenue?
Revenue = Price x Quantity!
Revenue increased by about 14%.
Eyeballing the graphs, we can see that revenue increases from about 3*175 (or $525 billion) to 4*150 (or $600 billion), a 14% revenue increase.
Choice 4
The table gives the billions of gallons that will be purchased at a given price. To obtain a demand curve, simply plot the price (on the y-axis) against the quantity (on the x-axis).
What happens to demand—and revenues—if people’s WTP changes?
As people’s WTP changes, the demand curve will also change. The demand curve will shift (left or right) in response. Why? Because now, at any given price the number of people with a WTP equal to that price will be different (higher or lower, depending on the event).
Can price shift the demand curve?
NO
price is not a factor that shifts the demand curve. By convention, price is on the y-axis of any demand curve. So a change in price will move us up or down along the existing demand curve but it will not shift the curve. (This is a very common mistake that is made about the demand curve.) In other words, price affects quantity demanded, but doesn’t change the underlying WTP or demand.
Most common factors that impact people’s WTP:
- Income
- Gender
- Geography
- Weather
- Age
- Service levels
- Brand
- Advertising
- Competing products
- Expectations
How would the factors below affect the demand curve for gasoline in the US? (Shift left, Shift Right, No Change)
- AN ECONOMIC BOOM RAISES NATIONAL INCOME
- LARGE INVESTMENTS IMPROVE THE AVAILABILITY OF PUBLIC TRANSPORTATION
- MORE COMPANIES ALLOW PEOPLE TO WORK FROM HOME, REDUCING THE NUMBER OF COMMUTERS
- THE PRICE OF GASOLINE FALLS DUE TO NEW SOURCES OF SUPPLY
- CAR COMPANIES DEVELOP MORE FUEL-EFFICIE-NT MODELS
- POPULATION GROWTH INCREASES THE NUMBER OF LICENSED DRIVERS
- THE GOVERNMENT PROVIDES A SUBSIDY FOR HYBRID CARS
- THE PRICE OF GASOLINE INCREASES
SHIFT LEFT (Decrease Demand)
- LARGE INVESTMENTS IMPROVE THE AVAILABILITY OF PUBLIC TRANSPORTATION
- MORE COMPANIES ALLOW PEOPLE TO WORK FROM HOME, REDUCING THE NUMBER OF COMMUTERS
- CAR COMPANIES DEVELOP MORE FUEL-EFFICIE-NT MODELS
- THE GOVERNMENT PROVIDES A SUBSIDY FOR HYBRID CARS
SHIFT RIGHT (Increase Demand)
- AN ECONOMIC BOOM RAISES NATIONAL INCOME
- POPULATION GROWTH INCREASES THE NUMBER OF LICENSED DRIVERS
NO CHANGE
- THE PRICE OF GASOLINE FALLS DUE TO NEW SOURCES OF SUPPLY
- THE PRICE OF GASOLINE INCREASES
See the graph below and then see below.
- Pampered Pets Resort has run an advertising campaign promoting its service, and consumer willingness to pay has increased as a result.
- Pampered Pets Resort has increased its price, and fewer customers have sent their dogs to the resort as a result.
- The city Pampered Pets Resort is based in has become more polluted, and pet owners are taking their dogs along on their vacations more frequently in order to protect them from the smog.
- Salaries in the city Pampered Pets Resort is based in have increased, giving pet owners more disposable income and increasing their willingness to pay.
Pampered Pets Resort has increased its price, and fewer customers have sent their dogs to the resort as a result.
- This graph represents a movement along the demand curve, rather than a shift in the demand curve. Prices have increased, and quantity has decreased as a result.
- Pampered Pets Resort has placed a television in each dog’s suite, and as a result, customer willingness to pay has increased.
- Minimum wage has increased in Pampered Pets Resort’s state, and as a result, the company’s costs have increased.
- Pampered Pets Resort has signed a long-term deal with a supplier of dog food and is now paying less for the food, decreasing its total costs.
- A recession has decreased salaries in the region, and as a result, fewer pet owners can afford to go on vacation.
A recession has decreased salaries in the region, and as a result, fewer pet owners can afford to go on vacation.
- This would decrease WTP, shifting the demand curve to the left.
Diminishing Marginal Returns
An economic relationship stating that a consumer’s willingness to pay for a product should decrease for additional units of a product (i.e. the tenth milkshake will not taste as good as the first).
Sarah
Sarah seems to get more of a high on the 2nd cup than the first.
16
Quantity demanded is calculated by summing up the quantity demanded by each consumer. Notice that even though Aaron’s demand curve doesn’t indicate strictly diminishing marginal returns, the market demand curve is downward sloping.
Between $1 and $2
If the price of scones is $2, Dan will purchase only five scones. If the price drops to $1, Dan will purchase the sixth scone. His WTP for the sixth scone must be between $1 and $2.
What factors determine whether the demand curve for a product is steep or flat?
- It depends on whether the product has close substitutes or not.
* Chocolate ice cream has a lot of close substitutes (cookie dough ice cream, chocolate cake, other desserts). If the price of chocolate ice cream suddenly rises, consumers will simply switch to the other products. Baby formula**on the other hand* has few close substitutes. - It depends on whether the product is a necessity or a luxury.
* Chocolate ice cream is a luxury good. (That is, despite what some of us may think, we can live without it.) On the other hand, baby formula is considered a necessity.* - The time horizon also matters.
* Consider the demand for gasoline. In the short run, the demand curve for gasoline is quite steep—there are few substitutes and, for many people, driving is a necessity. But over time, people can move closer to work, we can discover* alternate fuels, etc. This can cause the demand curve for gasoline to flatten out in the longer run.
Ex below: (a price increase for ice cream drives more customers away than baby formula)
We sometimes refer to steep demand curves as ____ curves, and to flat demand curves as _____ones
We sometimes refer to steep demand curves as “inelastic” curves, and to flat demand curves as “elastic” ones
Name 4 Important things about demand curves
-
They are summaries of the willingness to pay among consumers
(It will help a lot in thinking about the shape or shift of the curve & help your intuition) -
The curves can be flat or steep
- Flat Curves- Elastic
- Steap- Inelastic
-
Demand Curves Can Move around over time (Because WTP Can move over time)
Ex: A Key Player in a game is injured or Weather Changes (Warm to Freezing)!
These above are called DEMAND SHIFTERS (Weather, Injury of a player, big players last game)
*****Be careful whether you’re referring to shifts in the demand curve over time or how steep or flat the demand curve is at a point in time. - Demand Curves can be for a single individual as well.
C
This demand curve shows how many people would purchase a laptop at each of the prices displayed in the histogram.
$1500
If the producer charged $1500 per laptop, he would make ($1500)*(875) = $1,312,500.00 in revenue. Based on the demand curve, the producer should charge at some price close to $1500 to maximize revenue. Remember that revenue can be calculated as price charged* quantity sold and is equivalent to the rectangular area under the demand curve.
- Peter cannot eat more than 1 pizza (8 slices)
- Peter is willing to pay at most $12 for 1 pizza
- Peter will not pay more than $4 for a slice of pizza
- Peter’s willingness to pay for a 5th slice is between $2.00 and $2.50
Peter’s willingness to pay for a 5th slice is between $2.00 and $2.50
This is definitely true. Since Peter demands 4 slices when the price is $2.50 and 6 slices when the price is $2.00, his demand for 5 slices must be at a price somewhere in between.
At $1, quantity demanded is 6000, and at $2 it is only 2000. So quantity demanded has changed by 4000.
Quantity demanded would decrease by 62.5 cups.
Elasticity. What is it? Why do we need it? What’s the formula?
What it is: A measure of the responsiveness in one variable to a change in another variable. Mathematically, it is the percentage change in one variable, divided by the percentage change in another variable; for more details, see price elasticity of demand. Elasticity does not depend on the units in which variables are measured (unlike the concept of slope).
Why we need it: Because units matter when comparing, we need a method. (see photo below - 2 different units = confusing)
The slope of a market demand curve measures how responsive buyers are to changes in price.
- When the curve is steep or vertical, changes in price have little impact on the quantity demanded. Steep curves are often called “inelastic,”
- When the curve is flat or near-flat, a small dip in price sparks a large surge in the quantity demanded. flat curves are often called “elastic.” Demand is typically more elastic if a product is a luxury rather than a necessity, or if the product has many substitutes.
An important advantage of the elasticity measure over a slope measure is that elasticity is a unit-less measure: it doesn’t change as the units used to measure quantity demanded change. As a result, one can also more easily compare the elasticities of demand for different products; slopes do not enjoy this property.
Elasticity is different at each point on a demand curve with constant slope (i.e., a straight-line demand curve). However, that demand curve as a whole could be colloquially called “elastic” or “inelastic” depending on how flat or steep its slope is.
Formula: The percentage change in quantity demanded divided by the percentage change in price. Q (T) PIE!
(Percentage change formula is also below)
To calculate the elasticity of a curve:
- Calculate the percentage change in quantity demanded and the percentage change in price separately
-
Divide the former by the latter
(Notice also the one minor caveat: because increases in price are almost always associated with decreases in quantity demanded, the number you’d obtain is almost always negative. The elasticity formula takes the absolute value of this ratio just for convenience, so that we can speak in terms of positive numbers.)
What do you learn about the relation between revenue-maximizing prices and elasticity?
(My answer)
Revenues are maximized at an elasticity of 1. When the demand is elastic (above 1), you shouldn’t raise prices- you would lose money because the quantity would be reduced. When the demand is inelastic (below 1), you can raise the price of your product and receive more revenue in return.
Revenues are maximized at the price where elasticity equals 1 for any demand curve!
(Remember from our earlier discussion, we had referred to steep demand curves as inelastic and flat curves as elastic. Even though, as we now see, the elasticity varies along a linear demand curve, you can also see why we used those terms colloquially: for a steep demand curve, quantity demanded hardly changes as you raise prices; for a flat curve, quantity demanded decreases far more.)
So when demand is elastic (above 1) flat - you shouldn’t raise prices
And when demand is inelastic (below 1) steep- you should raise prices
????
Elasticity is just a shorthand way to describe ______
how sensitive your revenues are to price changes.
HOW TO USE: What would have if other competition enters the market? Or if YOU raise prices. It gives you an idea of what would happen to your revenues.
3/4
We can determine the total market demand at $3 by adding together the total number of cones at which Alex, Maria, and Raj’s WTP is $3 or higher. We can see that Alex will buy 3 cones at $3 or higher, Maria will also buy 3, and Raj will buy 2, which adds up to a total of 8 cones demanded at $3. Repeating the same process for $4 (or higher), we get 2 cones for Alex, 2 cones for Maria, and 2 cones for Raj, which adds up to a total of 6 cones demanded at $4. Once we have these quantities for demand at the new and old prices, we can plug them into the equation for price elasticity of demand = absolute value of [(6-8)/8]/[(4-3)/3] = 3/4.
