To better understand how to apply the demand curve, decision makers need to learn how to distinguish between a shift on the demand curve and a shift of the demand curve. If WE change the price, the change of demand is a shift on the demand curve. However, if the demand changes for other reasons—weather, competition,our innovation—this signifies a shift of the demand curve.
- In this video, we want to solve a mystery that confuses many decision makers. We need to learn how to distinguish between a shift on the demand curve and a shift off the demand curve. I would like to use an example from the Swiss retail market where two large grocery chains, Migros and Coop, have been dominating the industry for decades. But, in 2009, two German discounters announced plans to aggressively enter the Swiss market by building their own stores outside of larger cities.
Everyone would assume that prices at Migros and Coop would decrease once they face competition from Lidl and Aldi. The question I have for you is, starting with the given demand curve for a typical product at Migros, how can you explain, in economic terms, why the market entry of competitors would lead to a lower price? Let's start with the current demand. At the price of 10 francs, Migros can sell 500 units in a given period of time.
Once the low cost competitor enters the market, some of those customers may switch to the new store. Hence, the demand will decline. For the sake of the argument, let's assume the demand decreases to 400 units. Now let's turn the question around. At what price point would Migros sell 500 units after the competitor's market entry? Market research indicates that at nine francs Migros would sell 500 units.
We now have two points that indicate the competitor's market entry. If we connect those two points, we see a shift off the demand curve. The new demand curve is on the left side of the old demand curve, which means that the demand is declining. Some customers will switch to the competition if the established stores do not lower their prices. It is very important to distinguish a shift on the demand curve, for example, you lower the price and sell more, from a shift off the demand curve.
I can demonstrate this with one example that seem to contradict everything we know about economics. Let's look at the room rates for a night at the Arizona Grand Resort in Phoenix, Arizona. If you check the offers for July, you find rooms for 174 dollars. Despite the fact that this is a good price, the hotel can only sell 50% of the rooms. But, in December, when the room rate increases to 262 dollars, the resort is fully booked. Does this imply a positive price elasticity, whereby an increase in price leads to an increase in demand? Certainly not.
Whoever has been in Phoenix, Arizona in July knows that that's not the best time to enjoy the Valley of the Sun. Phoenixians may call it a dry heat, but 120 degrees... It doesn't matter, it's just hot. What we see between July and December is not a shift on the demand curve, but, rather, a shift off the demand curve. We need to distinguish this because a shift off the demand curve changes our volume sold, even if we keep the same price. In contrast, when we change the price, causing a new demand, this is a shift on the demand curve.
But, sometimes, it's not just a competitor or weather that changes the demand curve. It's actually our own actions that can move the demand curve to the right. Over 60 years ago, management guru Peter Drucker said, "Because its purpose is to create a customer, the business has two - and only two - functions: marketing and innovation. Marketing and innovation create value, all the rest are costs." What marketing and innovation does, in economic terms, is a shift off the demand curve to the right, so that we can sell more at a given price or charge more for a given quantity.
By the way, this picture shows me and Peter Drucker when I met him in Zurich. And I still have a vision that, one day, students will look at this picture and say, "I know this guy, but who is Peter Drucker?" In conclusion, if we change the price, the change of the demand is the shift on the demand curve. However, if the demand changes for other reasons, weather, competition, our innovation, this signifies a shift off the demand curve. It is important for executives and entrepreneurs to identify the difference in order to make better 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