Micro-economic Analysis

Structure of Demand for Software

Author: Rosie Ojo

1 INTRODUCTION.....................................................................................................2
2 INDUSTRY: PUBLIC RELATIONS AND MARKETING SOFTWARE
PRODUCTION ............................................................................................................2
3 TYPES OF CONSUMERS.......................................................................................2
3.1 COMPANIES WITH IN-HOUSE MARKETING DEPARTMENTS ..................................................2
3.2 PR CONSULTANCIES AND PR SERVICE COMPANIES .........................................................2
3.3 INTERNET START-UPS ................................................................................................2
3.4 WEB DESIGN COMPANIES ...........................................................................................2
3.5 GENERAL SMALL AND MEDIUM SIZED ENTERPRISES .......................................................2
3.6 INDIVIDUALS TRYING TO BREAK INTO ENTERTAINMENT INDUSTRY.....................................2
4 FACTORS INFLUENCING PATTERN OF DEMAND FOR PRCONTACTS
SOFTWARE.................................................................................................................2
5 DERIVATION OF LINEAR DEMAND FUNCTION FOR PRCONTACTS
SOFTWARE.................................................................................................................3
6 CONSUMER PRICE SENSITIVITY ANALYSIS................................................4
6.1 PRICE ELASTICITY OF DEMAND...................................................................................4
6.2 THE LERNER METHOD OF ELASTICITY OF DEMAND.......................................................6
6.3 CROSS-PRICE ELASTICITY OF DEMAND........................................................................6
6.4 INCOME ELASTICITY OF DEMAND................................................................................6
7 CONCLUSION..........................................................................................................9
8 REFERENCES..........................................................................................................9
1 Introduction
This assignment considers the Public Relations and Marketing software product, PRContacts. We
describe the structure of demand for PRContacts, including the types of its consumers, the pattern of
demand, the sensitivity to prices, and the possibility of estimating the elasticity of its demand.

2 Industry: Public Relations and Marketing Software Production

PRContacts is a knowledge management, contact management, and press release management software
product serving the public relations industry. It enables users to conduct key public relations processes
such as identifying and evaluating appropriate media channels (publications, radio, television),
electronic real-time messaging of media contacts, and press release construction through use of
templates. It contains a UK media database including full contact details, circulation statistics,
frequency of publication, advertising rates, summary of content, and target audience demographics.

3 Types of Consumers
The interested consumers in this market are described below:

3.1 Companies with in-house marketing departments

Generally, this consumer type uses more established, competing products, or mixes of products that
ultimately achieve the same result. Their main interest in the product was in obtaining alternative
knowledge sources such as up-to-date media contact information with current email addresses.

3.2 PR consultancies and PR service companies

Professional companies, using very advanced operational processes and software. Their main interest
in the product was in the experimental possibility of obtaining an advanced e-product to streamline
existing processes, or as addition to their repertoire of public relations tools.

3.3 Internet start-ups

These are companies and groups deploying an Internet presence promoting their products, services, or
agendas. Their main interest in the product was having a cost-effective way of obtaining media
exposure through press releases and cost-effective advertising channels that they had not thought of,
and the flexibility to control that exposure.

3.4 Web design companies

Their aim was to use the tool to promote themselves, as well as providing a cost-effective pr/marketing
service for their clients using the tool.

3.5 General small and medium sized enterprises

Interest was limited due to lack of targeting of publicity-oriented companies and access to their
corresponding decision-making publicity contact.

3.6 Individuals trying to break into Entertainment Industry

These included people whose goals were to be models, actors, singers, comedians, TV presenters, and
so on. Their main interest was for the media contact details and the press release construction facilities,
but they generally wanted a PR service rather than a do-it-yourself PR product.

4 Factors Influencing Pattern of Demand for PRContacts Software

The number of units of the PRContacts Software demanded is influenced by a number of factors:

• The price of the PRContacts product;

• The sensitivity of the consumers to the price, such as
o The income of consumers;
o The demand for alternative goods which could be used (substitutes);
o The demand for goods used at the same time (complements);
• Whether people need or prefer the product (consumer taste).
• Whether the product satisfies consumers’ challenges.

Author: Rosie Ojo 2

In the following sections, we will discuss the actual pattern of demand observed for PRContacts, and
derive the optimum price, the optimum demand, and the maximum total revenue. Also, we will discuss
the sensitivity of consumers to prices and discuss the possibility of estimating the elasticity of demand.

5 Derivation of Linear Demand Function for PRContacts Software

PRContacts was set at prices £200 for 30 days, and then £400 for a subsequent 30 days to test demand
fluctuation. We will use a demand curve to chart the number of units of Protects Software purchased
against the prices of P1 = £200 and P2 = £400 respectively. We can reasonably assume that all other
parameters remained constant, i.e. ceteris paribus.

Figure 1

The demand curve labeled DD in the figure above shows the quantity of units of Protects Software that
one or more consumers are willing and able to buy at different prices. An increase in price from £200
to £400 results in a movement up the demand curve so that less units of the Protects Software are sold;
in this case reduction from Q1 = 70 units to Q2 = 25 units. The fall in the quantity demanded from Q1 to
Q2 is called a contraction in demand.

Using the equation for the Linear Demand Function, P = a – bQ, we calculate gradient -b using points
(P1, Q 1), (P2, Q 2) on the curve:

-b = (P1 - P 2) / (Q1 - Q 2)
= (200 – 400) / (70 – 25)
= -200 / 45
= -4.4444

Therefore, P = a – 4.4444Q

Substituting the point (P1, Q 1) into the equation gives:

a = 400 + 4.4444 * 25
= 511.11

Hence, Linear Demand Function becomes:

P = 511.11 – 4.4444Q. ……(1)

The total revenue is TR = P*Q. We want to find the price Pmax and demand Qmax that maximises the
total revenue. Substituting in the Linear Demand Function into TR = P*Q, and finding the derivative of
the Total Revenue, TR, with respect to Price, P, gives us price Pmax and demand Qmax when dTR/dP = 0:

Pmax = 255.55 and Qmax = 57.5005

Therefore, Maximum Total Revenue = PmaxQmax = £14694.25

Author: Rosie Ojo 3

We can deduce from Total Revenue calculations, of the demand curve for PRContacts, that the price is
maximised is at £255.55p.

6 Consumer Price Sensitivity Analysis

Two important aspects, which determine consumer sensitivity to the price of PRContacts, are the
weight a customer attaches to price relative to other attribute (price importance), and consumers
proctivity to search for better prices (price search). Studies suggest that consumers, who use the
Internet regularly, as do most PRContacts consumers, are more price sensitive. Bakos (1997) argues
that because online markets reduce customer search costs, even for differentiated products, they are
likely to increase competition between sellers and lead to lower prices.

We can measure how sensitive consumers are to changes in the price of products using price sensitivity
analysis, which will give us a feel for:

• The price thresholds of PRContacts consumers

• How prices should change in order to boost revenues

As a general rule, if consumers are price sensitive, prices should be lowered to boost total revenue, but
if consumers are not price sensitive, then prices should be raised to boost total revenue. There is a
strong correlation between consumer sensitivity to pricing, through measures of consumers’ elasticity
of demand for a product.

We will seek to explore the price importance to the consumer, by investigating the possibility of
estimating the elasticity of demand using each of the following elasticity methods:

1. Price Elasticity of Demand

• Point Elasticity
• Arc Price Elasticity
2. Cross-price elasticity
3. Lerner Method
4. Income Elasticity with use of Engel and Income Consumption curves

A less sophisticated way of approaching consumer sensitivity to pricing is by analysis of survey data,
which determine consumers’ price-related attitudes e.g. intent to purchase, price search propensity.
This approach is problematic because:
• Consumers maybe be reluctant about answering hypothetical questions
• Consumers are likely to give inaccurate responses to hypothetical questions
• Such data can be very expensive to correlate

6.1 Price Elasticity of Demand

The most common elasticity measurement, which we will investigate, is that of Price Elasticity of
Demand. The price elasticity of demand is a measure of the sensitivity or relative responsiveness of
quantity demanded to a change in price. It measures how much consumers respond in their buying
decisions to a change in price. The basic formula used to determine price elasticity is

% change in quantity demanded

E Qx , Px =
% change in price
Factors that affect the Price Elasticity of Demand for PRContacts are outlined below:

• Available substitutes: The more/better the substitutes, the more elastic the demand.
• Time: The more elastic the demand the longer the time period required to respond to the
change.
• Expenditure share: The larger the fraction of the budget, the more elastic the demand.
• Necessity: The more necessary, the more inelastic the demand.
• Commodity definition: The more narrowly defined the more elastic the demand.

Author: Rosie Ojo 4

6.1.1 Point Elasticity of Demand
Point Elasticity measures elasticity of an exact point on a demand curve, and is defined by:

dQ / Q dQ P 1 P
E Qx , Px = = • = •
dP / P dP Q Slope Q

In the case of PRContacts, the linear demand curve was defined as:

P = 511.11 – 4.4444Q.
=> Q = 511.11/4.4444 – P/4.4444
=> dQ/dP = -1/4.444

From historical data, PRContacts was sold 70 units at £200, and 25 units at £400. Therefore, the point
elasticity of demand can be estimated to be:
• EQx, Px = (-1/4.444) * 200/70 = -0.643, at P = 200
• EQx, Px = (-1/4.444) * 400/25 = -3.6, at P = 400

This implies that when PRContacts is priced at £400 the demand is elastic as the following condition
holds true

EQx, Px < -1
Which implies,

∆ Q ∆ P
> or %∆ Q > %∆ P
Q P

If demand is elastic, price and total revenue move in opposite directions. This implies that if we
increase the price of PRContacts to a value greater than £400 it will lead to a more than proportionate
fall in demand, causing revenues to fall, and leaving little opportunity to make further profit.

When PRContacts is priced at £200 the demand is inelastic as the following condition holds true

-1 < EQx, Px < 0

∆ Q ∆ P
< or %∆ Q < %∆ P
Q P

If demand is inelastic, price and total revenue move in the same direction. This implies that at £200,
PRContacts is priced incorrectly, as the product is not maximising revenue. If we increase the price of
PRContacts, since the demand is inelastic, demand will fall in percentage terms by less than the price,
and this will cause the overall revenue to rise.

6.1.2 Arc Price Elasticity of Demand (price elasticity between two points)
Arc Elasticity of Demand calculates the elasticity between two points on a demand curve. As the two
points get closer together, Arc Elasticity approaches Point Elasticity. The formula for Arc Elasticity of
Demand is defined below:

From historical data, PRContacts sold 70 units at £200, and 25 units at £400. Hence, the arc elasticity
of demand can be estimated to be:

EQx, Px = (70 – 25)/(200 – 400) * (200 + 400)/(70 + 25) = -1.421

This implies that the demand for PRContacts was elastic, since EQx, Px < -1.

Author: Rosie Ojo 5

As a rule, revenue is maximized at the price and quantity for which marginal revenue is zero or,
equivalently, the price elasticity of demand is unity (-1), and so we can deduce from the calculations of
Arc and Point Elasticity that pricing of PRContacts needs to be reviewed in order that total revenue,
TR, may be maximised. These findings are consistent with the calculations we did in section 5
(Derivation of Linear Demand Function) where we deduced that the total revenue, TR, for sales of
PRContacts are maximised at a price of £255.55p

We have derived values for the Price Elasticity of Demand for PRContacts Software, but statistically
this information is unreliable, as we have not utilised accounting data, and other factors, which could
impact pricing, have not been taken into consideration.

6.2 The Lerner Method of Elasticity of Demand.

The Lerner method of estimating elasticity is based on the principle that a profit-maximizing company
will price so that the inverse of its margin will equal its elasticity of demand. Thus, to measure the
elasticity of demand for the PRContacts Software, one need only find the margin, which is defined as
the difference between price and marginal cost as a share of price, and then invert it.

The Lerner method, however, presents a number of potential problems. Measuring marginal cost is
difficult using the accounting data we have available. Moreover, the method makes many assumptions,
including that a company operates with perfect information concerning its costs and the demand for its
products. These assumptions will not hold perfectly for our company; the accuracy of the Lerner
method will depend on the extent to which they are violated.

6.3 Cross-Price Elasticity of Demand

Cross-Price Elasticity, often simply called just Cross-Elasticity, measures whether goods are substitutes
or complements. It looks at the response of people in buying one product when the price of another
product changes. The formula for cross-price elasticity is:
% ∆ Qxd
E Qx , Py =
% ∆ Py
= % change in quantity of our PRContacts demanded
% change in price of substitute or complementary product

= ((Qx1 – Qx2) * (Py1 + Py2)) / ((Py1 - Py2) * (Qx1 + Qx2))

where, Pyi is the price of a specific substitute or complementary product for PRContacts, and Qxi is the
corresponding demand for PRContacts. If we had numerical data on the price of a substitute, or
complementary product, when the demand for PRContacts was 75 units and 25 units respectively, we
could estimate the Cross-Price Elasticity of Demand for PRContacts.

Note:
• If the cross-price elasticity is positive, the goods are substitutes. For example, sales of
PRContacts will fall if the price of a software solution similar to PRContacts declines because
some consumers will switch from PRContacts to the rival software.
• If the cross-price elasticity is negative, the goods are complements. For example, if the prices
of computers fall, the sales of PRContacts will rise. The negative change in the denominator is
matched with a positive change in the numerator of the equation. Therefore, the result is
negative.

6.4 Income Elasticity of Demand

Income Elasticity of Demand measures the responsiveness of consumers to purchases of products with
respect to changes in their income.

We can use income elasticity measures to ascertain whether PRContacts is a normal or inferior good. A
product is a normal good when its income elasticity is positive, indicating that a higher income causes
people to purchase more of the product. For an inferior good, income elasticity is negative, indicating
that an increase in income causes people to buy less of the product.

Author: Rosie Ojo 6

Considering the customers of PRContacts: public relations consultancies and the companies with in-
house marketing departments generally consider PRContacts to be an inferior good, due to their
relatively high available income, with respect to the price. The higher their income, the lower their
demand. The Internet start-ups and individuals ambitious for success in the entertainment industry also,
in general, consider the PRContacts to be an inferior good since as their relatively low available
income increases, with respect to the price, they are more likely to employ agents and specialised pr
consultancies. The higher their income, the lower their demand. The other consumers of PRContacts
generally consider it to be a normal good.

We will look at the possibility of estimating income elasticity of demand for the PRContacts product
using:

• Income Elasticity Formulae

• Indifference, and Engel Curves

We can calculate the Income Elasticity of Demand using the formula:

% change in quantity demanded ∆ Q/Q

E Qx , M = =
% change in income ∆ M/M

= ((Q1 – Q2) * (M1 + M2)) / ((M1 - M2) * (Q1 + Q2))

If EQx , M > 1, (highly sensitive to income), sales are said to be cyclical.

If EQx , M > 0, sensitive to income and normal.
If EQx , M < 0, (move opposite to income), sales are said to be counter-cyclical.

Mi is the income of a specific consumer and Qi is the corresponding demand for PRContacts when the
income is Mi. If we had numerical data on the incomes of the consumers of PRContacts when the
demand was 75 units, and 25 units respectively, we can estimate the actual Income Elasticity of
Demand for PRContacts. However, through observation of the behaviours of consumers of
PRContacts, we could assume that:

• EQx , M < 0, for PR consultancies, in-house marketing departments, and individuals targeting
the entertainment industry; viewed as an inferior good.
• EQx , M > 0, for all the other consumers of PRContacts; viewed as a normal good.
6.4.1 Income Elasticity measurements using Indifference, Income Consumption and Engel
Curves
We will now look at an alternative way of deducing Income elasticity through use of income
consumption and Engel curves.

Indifference curves graphically connect

y “bundles of goods” (Aidt 2000). The
consumer is indifferent about the goods
Indifference curve
on the indifference curve. Any of the
goods on the indifference curve present
the consumer with the same amount of
utility. Budget lines are indications of
Equilibrium taste and preferences, and show
combinations of goods that the
consumer can afford to buy with a
Budget line
fixed level of income. The two curves
y*
combine and the point where the
indifference curve is tangent to the
u budget line depicts the optimal choice
between the goods (point y*, x*
x below). At this point the consumer is
x* maximising his utility, whilst not over
or under spending in relation to his
Figure 2 budget.

Author: Rosie Ojo 7

As we have discussed in earlier sections, PRContacts is an inferior good, as increase in income will
cause people to buy less units of the PRContacts Software. By increasing income and shifting the
budget lines to the right (see Figure 3), we see that the optimal choice point shows a decrease in
consumption of PRContacts (assuming ceteris paribus). By mapping the optimal choice points for
different levels of income, we create an income consumption curve. We can then extrapolate the
information from an income consumption curve and plot an Engel Curve. Engel Curves simply
measure the demand for goods as a function of income. As we see in Figure 3 below, an increase in
income causes a decrease in consumption for inferior goods, thus the Engel curve is negatively sloped.
However for normal goods an increase in income causes an increase in consumption, thus creating a
positively sloped Engel curve.

Figure 3 shows the situation with PRContacts consumers working in the entertainment industry. The
slope of the Engel Curve is negative, and the elasticity is negative.

y Figure 3
Income consumption curve
m2/py
B
m1/py

A
x
m
disposable income
Engel Curve for PRContacts Software
(an inferior good)
m2 E<0
msubstitution
An inferior good may have an inelastic curve as it is less responsive to price movements as a result of
the opposing income and 1 effects.

We know that when the price of PRContacts changes, it affects purchasing power. Since PRContacts is
an inferior good it has a positive substitution effect. When the price of the software decreases the
x
change in the relative price causes consumers to switch over to another product. If the substitution
effect outweighs the income effect then the good is inferior (a price decrease still causes a rise in
demand), but if the income effect outweighs the substitution effect then the good is a Giffen good.

Table 1 defines what we mean by a normal and an inferior good. The budget share of good x is: pxx/m.

Table 1
Classification of good x Elasticity Effect on the budget Slope of Engel
share Curve
Normal good em>0 Ambiguous Positive

Normal good, luxury good em>1 Increases Positive

Normal good, necessity good 0>em>1 Decreases Positive

Inferior good em<0 Decreases Negative

Author: Rosie Ojo 8

7 Conclusion

The PRContacts product had six main categories of consumers, ranging from individuals to PR
companies. We investigated the structure of demand for PRContacts over a period of sixty days, where
it was priced:

• £200 for 30 days, selling 70 units

• £400 for a subsequent 30 days, selling 25 units.

We derived a Linear Demand Function, P = 511.11 – 4.4444Q, from which we obtained the optimal
price of £255.55, and optimal expected demand of 57.5005 units (58 units), in order to earn a
maximum attainable total revenue of £14, 694.28, over a 30 day period.

We then sought to explore the sensitivity of consumers to pricing by investigating the possibility of
estimating the elasticity of demand using each of the following elasticity methods:

1. Price Elasticity of Demand

• Point Elasticity
• Arc Price Elasticity
2. Cross-price elasticity
3. Lerner Method
4. Income Elasticity with use of Engel and Income Consumption curves

With Point Elasticity, we found that demand was inelastic at a price of £200, but elastic at £400. With
Arc Elasticity, we found that demand was elastic. We concluded, from both methods, that price had to
increase above £200 for overall total revenue to be maximised. This was consistent with the Linear
Demand calculations.

We explored how The Lerner Method, which uses actual accounting data, could be used in order to
make estimates of elasticity of demand for PRContacts.

We then showed how Cross-Price Elasticity, could be used to ascertain whether a product is a
substitute for, or a complementary to, PRContacts.

Next, we demonstrated how a quantitative value for income elasticity could be derived, during the
periods in question. We noted that some categories of consumers considered PRContacts an inferior
good, whereas the other categories consider it a normal good. Finally, we examined ways of deriving
values of income elasticity by use of Income Consumption and Engel Curves.

8 References
Bakos, J. Yannis (1997), "Reducing Buyer Search Costs: Implications for Electronic Markets",
Management Science, 43(12), 1676-92

Begg, D., Fischer, S. and Dornbusch, R. (1994), "Economics", 6th Edition, McGraw-Hill

Besanko et al (2000), "Economics of Strategy", Second Edition, John Wiley and Sons

Cabral LMB (2000), "Introduction to Industrial Organization", MIT Press

Stiglitz, J.(1997), “Economics”, 2nd Edition, Norton

Szymanski, S. and Shepherd, D (2002), "Economics for Business" Units 1 - 4, Imperial College
Management School.

Leontief, Wassily (1933), "The Use of Indifference Curves in the Analysis of Foreign Trade," Quarterly
Journal of Economics 57, (May), pp. 493-503. See community indifference curve.

Author: Rosie Ojo 9