The demand curve shows how many customers are willing to buy your product or service at any given price. As such, the demand curve is central to every pricing and production decision a firm makes. In practice, managers hardly ever know the exact demand curve. However, the closer our assumptions are, the more likely are we going to be profitable.
- In this session, we are going to cover a very important concept in economics, the demand curve. The demand curve shows how many customers are willing to buy your product or service at any given price. Managers sometimes ask me, "How much can I charge for my product?" I typically tell them they can charge whatever they want. The real question is, how much can they sell at what price and still achieve their objectives? If the objective is market share, the price might be low to sell more.
But if the objective is profitability, a higher price is the way to go. A simple way to illustrate the nature of the demand curve is an experiment I frequently run in my classrooms. I ask 40 students to write down on a piece of paper how much they are willing to pay for the next not yet revealed iPhone. They should tell me the amount they are willing to put on the table right now to have the newest iPhone delivered to them on the very first day of its sale.
I then collect all the papers and rank them from the highest bidder to the lowest bidder. Let's assume I have one person who's willing to pay $1,200, two are willing to pay $1,000, five are willing to pay $900 and so on. We put all those offers on a two-dimensional chart. The horizontal dimension shows how many units we can sell and the vertical dimension shows how much we can charge for it. Using the numbers from the experiment, we know that at $1,200 we can sell one iPhone and at $1,000 we can sell three iPhones.
That means that the person who is willing to pay $1,200 would also pay $1,000. Actually, she would be quite happy to get it for that price. At $900 the total demand would be eight units. And now when we connect the dots the result is called the demand curve. It shows how many iPhones we can sell at any given price. Of course, this is not the global demand for iPhones. It just shows the demand curve for a very small group of customers, but it's a good example to illustrate how to build a demand curve.
Most managers tell me that it's impossible to ask all their customers about how much they are willing to pay. Furthermore, they have so many different products in the market, in so many different segments, with such a complex discount structure, that the demand curve is a purely academic exercise. Naturally, I tell them that they're wrong. While being Swiss, I would phrase this differently. While it is true that in the real world, we never really know the exact shape of the demand curve, we know for sure that it exists.
For any given price, there is a certain demand even if we never know exactly where that is, it is very important to collect data and insight to build an approximate demand curve and constantly improve our knowledge about its shape. The closer our assumption is to the reality, the better we are able to make meaningful, managerial decisions.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action