Daniel l. Rubinfeld

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1130 Part 2 Producers, Consumers, and Competitive Markets actuallv is. Thus the market demand curve is found bv joining the points on the cur~es O 2 , O~, 0 6 , etc, that actually correspond to the quantities 2000, 4000, 6000, etc The snob effect makes market demand less elastic To see "why, suppose the price \,\'as initially 530,000, "with 2000 people purchasing the good. What happens when the price is lo"wered to $15,0007 If there were no snob effect, the quantity purchased would increase to 14,000 (along curve O 2 ). But as a snob good, its value is greatly reduced if more people own it The snob effect dampens the increase in quantity demanded, cutting it by 8000 units; the net increase in sales is only to 6000 units. For many goods, marketing and advertising are geared to creating a snob effect (e.g., Rolex "watches). The goal is less elastic demand-a result that makes it possible for firms to raise price. Negative nehvork externalities can arise for other reasons. Consider the effect of congestion. Because I prefer short lines and fewer skiers on the slopes, the value I obtain from a lift ticket at a ski resort is lmver the more people there are who have bought tickets. Likewise for enhy to an amusement park, skating rink, or beach. 9 Chapter 4 accounted for the other half. Other shldies have shown that this process continued thl'Ough the follOWing decades. 11 In fact, this same kind of nehvork externality helped to fuel a rapid growth rate in the demand for personal computers. Today there is little debate about the importance of nehvork externalities as an explanation for the success of Microsoft's Windo-ws PC operatinO' o svstem _ , which by 1999 was being used in about 90 percent of personal computers world"wide. At least as significant has been the phenomenal success of the Microsoft Office Suite of PC applications (,which includes Word and Excel). In 1999, Microsoft Office had well over 90 percent of the market. Nehvork externalities are not limited to computers. In recent veal'S there has been explosive grmvth in the use of e-mail. Clearly a stronO' pO'sitive network externality is at work. Because an e-mail can only be tran~mitted to another e-mail user, the value of using e-mail depends cl:ucially on ho'l;",' many other people use it. By the mid-1990s, nearly all business offices in the United States used e-mail, and e-mail had become a standard means of Individual and Market Demand 31 The 1950s and 1960s v,'itnessed phenomenal growth in the demand for mainframe computers. From 1954 to 1965, for example, annual revenues from the leasing of mainframes increased at the extraordinary rate of 78 percent per year, while prices declined by 20 percent per year. Granted, prices were falling, and the quality of computers ,vas also increasing dramatically, but the elasticity of demand ,vould have to have been quite large to account for this kind of growth. IBM, among other computer manufacturers, wanted to know what was O'oinO' on. o 0 . 10 An econometric study by Gregory Chovv helped proVIde some ans"wers. Chow found that the demand for computers follows a "sahlration curve"-a dynamic process whereby demand, though small at first, grows slowly. Soon, however it O'rows rapidl)' until finallv nearly eVer)TOne likely to buv a product I b f ,.I", "' has done so, whereby the market becomes sahlrated. This rapid grm,\,th occurs because of a positive neh'\'ork externality: As more and more organizations own computers, as more and better sofhvare is written, and as more people are trained to use computers, the value of haYing a computer increases. Because this process causes demand to increase, still more sofhvare and better trained users are needed, and so on. This network externality was an important part of the demand for comput~ ers. Cho"w found that it could account for nearly half the rapid growth at rentals behveen 1954 and 1965. Reductions in the inflation-adjusted price (he found a price elasticity of demand for computers of -1,44) and major increases in power and quality, which also made them much more useful and effective, 9 Tastes, of course, differ. Some people associate a posith'e network externality with skiing or a day on the beach; they enjoy crowds and may even find the slope or beach lonely without them lOSee Gregory Chow, "Technological Change and the Demand for Computers," Americall Ecollol/Iic Review 57, no. '3 (December 1967): 1117-30. Later in this book, vve explain how demand information is used as input into a firm's economic decision-making process. General Motors, for example, must understand automobile demand to decide whether to offer rebates or belowmarket-rate loans for new cars. Knowledge about demand is also important for public policy ~ecisions. Understanding the demand for oil, for instance, can help Congress deClde whether to pass an oil import tax. You may wonder how it is that economists determine the shape of demand curves and hmv price and income elasticities of demand are aChlally calculated. In this starred section, we will.brie.fly examine some methods for evaluating and forecasting demand. The sectlOn IS starred not only because the material is more advanced, but also because it is not needed for much of the later analysis in the book Nonetheless, this material is instructive and will help you appreciate the empirical fOlmdation of the theory of consumer behavior. The basic statistical tools for estimating demand curves and demand elasticities are described in the appendix to this book Interview and Experimental Approaches to Demand Determination One way to obtain information about demand is through interviews in which c~nsum~rs are asked how much of a product they might be willing to buy at a glve.n pnc~. This approach, however, may not succeed when people lack informahan or mterest or even want to mislead the interviewer. Therefore, market researchers have designed various indirect survey tedmiques. Consumers might be asked, for example, what their current consumption behavior is and how they would respond if a certain product were available at, say, a 10-percent discount. See Robert J Gordon, "The Postwar b'olution of Computer Prices," in Dale W. Joraenson and Ralph Landau, eds, Tecizllology alld Capital Formotioll (Cambridge: MIT Press, 1989). b
132 Part 2 Producers, Consumers, and Competitive Markets They might be asked hm\' they vvould expect others to behave. Although indirect approaches to demand estimation can be fruitfuL the difficulties of the inter \'ie,v approach ha\'e forced economists and marketing specialists to look to alternative methods, In direct marketing experiments, actual sales offers are posed to potential customers. An airline, for example, might offer a reduced price on certain flights for six months, partly to learn how the price change affects demand for flights and partly to learn how competitors will respond. Direct experiments are reaL not hypothetical, but even so, problems remain. TI1e wrong experiment can be costly, and even if profits and sales rise, the firm CalU10t be entil"ely sure tl1at tl1ese increases resulted from the experimental change; oilier factors probably chal1ged at the same time. Moreover, the response to experiments-which consmners often recognize as short-lived-may differ from the response to pennanent chal1ges. Finally, a fil"m can afford to hT only a limited number of experiments. 25 20 15 10 Chapter 4 Individual and Market Demand 33 The Statistical Approach to Demand Estimation Finns often rely on market data based on actual studies of demand. Properly applied, the statistical approach to demand estimation can help researchers sort out the effects of variables, such as income and the prices of other products, on the quantity of a product demanded. Here we outline some of the conceptual issues involved in the statistical approach. Table 4.5 shows the quantity of raspberries sold in a market each year. Infonnation about the market demand for raspberries would be valuable to an organization representing growers because it would allow them to predict sales on the basis of their own estimates of price and other demand-determining variables. Let's suppose that, focusing on demand, researchers find that the quantity of raspberries produced is sensitive to weather conditions but not to the current market price (because farmers make their planting decisions based on last year's price). The price and quantity data from Table 4.5 are graphed in Figure 4.1S. If we believe that price alone determines demand, it would be plausible to describe the demand for the product by drawing a straight line (or other appropriate curve), Q = a - bP, which "fit" the points as shown by demand curve D. (The "leastsquares" method of curve-fitting is described in the appendix to this book.) o 25 Quantity Price and quantity data can be used to determine tl1e form of a demand relationship. But the same data could describe a single demand curve 0 or furee demand curves dl< dc, and d 3 that shift over time. Does c,urve 0 (given by the equation Q = 2S.2 - 1.00P) really represent the demand tor the product The answer is yes-but only if no important factors other than product price affect demand. In Table 4.5, howevel~ we have included data tor one other \'ariable: the average income of purchasers of the product. Note that income (1) has increased twice durinG the studv sUGGestinG that the d:l .' 0"' 00 0 c ema~1l curve h~s shltted twice. Thus demand curves d , 1 d , 2 and d 3 in Figure 4.1S gl\'~ a more hkely description of demand. This demand relationship would be descnbed algebraically as YEAR aUANTlTY (a) PRICE (P) INCOME (I) 1988 4 24 10 1989 7 20 10 1990 8 17 10 1991 13 17 17 1992 16 10 17 1993 15 15 17 1994 19 12 20 1995 20 9 20 1996 22 5 20 Q = a - bP + cI (4.4) The inco~e term in the demand equation allo\'\'s the demand curve to shift in a parallel tashion as income changes. (The demand relationship, calculated usinG the least-squares method, is gi\'en by Q = S.OS A9P + .SU.) 0 The Form of the Demand Relationship Because the demand relationships discussed above are straiGht lines the effect of a I G'.' . . 0' .. c 1anoe m pnce on quantIty demanded IS constant. However~ the price elasbc~y of de~1and varies with the price leveL For the demand equation Q - 17 - bP, tor example, the price elastiCity Ep is Ep (.1Q/.1P)(PIQ) = -b(PIQ) (4.5)
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Daniel l. Rubinfeld

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