The Economics of Business

The Economics of Business Class 11 OUTLINE Harvard Extension School E1600 Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

Complex and Multi-Characteristic Goods • Lancaster notes that the neoclassical theory of consumer behavior is elegant but sterile • Does not accommodate intrinsic characteristics of goods • No way of handling complementarity until Morishima (1959) • New good required resetting at n+1 Not complete without oral presentation

Neoclassical Consumer Behavior Not complete without oral presentation

Goods are Bundles of Characteristics Lancaster departed from the traditional neo-classical model by decomposing goods and utility into more basic elements: A good, per se, does not give utility to a consumer; it possesses characteristics and those characteristics give rise to utility. Goods generally possess multiple characteristics and many of those characteristics are shared by more than one good. Characteristics of an automobile might include horsepower, seating capacity, exterior color, etc. Combining goods may produce characteristics different from those possessed by the goods separately. Combining good food and good service may create a memorable dining experience. There are many examples of this in science. At normal temperatures both hydrogen and oxygen are gases but combined in 2:1 proportion they form a liquid called water. Not complete without oral presentation

Activity Analysis, Consumption Technology and Satisfaction Vectors Lancaster applied a form of activity analysis, long used in production analysis, to describe the transformation of goods into characteristics. He thus introduced the notion of consumption technology. • Goods then become satisfaction vectors defined in terms of the quantities of characteristics, z, intrinsic to them. • Consumption of good X gives rise to increasing levels of both characteristic Z1 and Z2. • The slope of the line (shown by our old friends rise and run) reflects the consumption technology, B, and displays the proportions of the characteristics intrinsic to goodX. • In the example on next slide, consuming an additional unit of good X increases the amount of characteristic Z1 somewhat more than characteristic Z2. • Goods, x, are transformed into characteristics, z, by consumption technology, B, where z=Bx. B can have any shape but life is easier if we restrict it to being linear. Not complete without oral presentation

Mapping Goods Vector to Characteristics Suppose characteristic Z1 is taste or yummy-ness and characteristic Z2 is healthiness or low-calorie-ness. Good Xis relatively high in yummy-ness and lower in low-calorie-ness. Then good X may be in the major (and my favorite) food group: high-fat, high-calorie ice cream. But, alas, man cannot live by cardiac-arrest- threatening ice cream alone so we observe that there are many food goods distinguished by their proportions of taste and healthiness. How can we choose how much of each to buy? Not complete without oral presentation

Comparing Goods • Introduce another good, X1, (and label our original good X0) a unit of which converts into relatively less characteristic Z1, yummy-ness, and relatively more Z2, healthiness. • This new good might be low-fat, sugar free ice cream (possibly the worst food ever invented). • With two goods to choose from, we need to establish the price line or terms of trade between the two goods. The price ratio line shows how much additional good X0 we can get if we give up some X1 and vice versa. • As shown on next slide, if the consumer spent all of her budget on food X0 she could buy the amount 0 with its associated characteristics of Z0 and Z1 and if she spent all of it on food X1 she could buy 1 with its different levels of Z0 and Z1. • Consumers can create their own bundles of goods X0 and X1 and corresponding sets of characteristics Z1 and Z2 by moving along the price line exactly as they did in the simpler neoclassical model – they find a point of tangency of the their utility curve and the price line. Not complete without oral presentation

Two Goods, Budget Line Not complete without oral presentation

Utility Maximization and Consumption Technology The introduction of the consumer utility curve and the determination of the efficient bundle are illustrated below. The point of tangency between the utility curve,U1, and the price line indicates the amount of each good the consumer will buy and, through the consumption technology B, enjoy characteristics Z1 and Z2. Not complete without oral presentation

Efficient Consumption Frontier • Next we introduce more goods and the price lines between them to illustrate the concept of the efficient consumption frontier which has implications for product design, marketing, and advertising. • Since there are four goods, there are six price lines, each connecting a pair of goods vectors. • The efficient consumption frontier is made up of the price lines that dominate in their region. • By dominance, we mean that any position on one of the dashed price lines could be improved by moving to a solid price line up and to the right. • For example, if you are at the point between goods 1 and 2 denoted by the open circle you could have more Z1 and just as much Z2 by moving to the point denoted by the shaded circle. Four (n) things taken two (r) at a time produce 6 combinations: n!/r!(n-r)! Not complete without oral presentation

Efficient Consumption Frontier… Not complete without oral presentation

Utility Maximization and Consumption Technology • Finally, we re-introduce the consumer’s utility curve and find the point of tangency that determines the bag of goods she buys in order to maximize her utility from their combined characteristics. • Lancaster’s complex or multi-characteristic goods make clear that consumption is an active process by which consumers achieve higher levels of utility by combining characteristics of the goods that they can acquire in the marketplace. • The notion of complex goods has a number of important implications in management especially in product design, marketing and advertising. • To understand customer choices, managers have to understand the weighting customers give to each characteristic. Choices are not between hotel A and hotel B so much as between location (near town or airport), amenities (free Internet or breakfast buffet), etc. • Discrete choice models, employing conjoint and logit analytical techniques, is used to estimate customer evaluations of alternative bundles of characteristics are consistent with Lancaster’s perspective. • Product design should focus on the underlying characteristics that the customer is seeking to create by combining products. Not complete without oral presentation

New Goods and Prices Three initial goods, G1, G2, and G3 with varying proportions of characteristics Z1 and Z2indicated by the slopes of their satisfaction vectors. The original efficient substitution frontier is ABC and some customers consume combinations of G1 and G2 while others consume combinations of G2 and G3 depending upon their utility functions. New good G4 is introduced with proportions of characteristics as shown. New consumption bundles will depend on the price and hence substitution ratios. If the new good’s price is too high – inside of point D – then the new good will be dominated by the existing efficient frontier and fail to sell If the new good price lies on AB – at D – then some people who previously used combination of G1 and G2 may now be indifferent between their old combinations or some new combinations of G1 and G4 or G4 and G2 If the price of G4 is a little lower, it will push the efficient frontier out, say to D1, and there new combinations of G1 and G4 or G4 and G2 will replace old combinations of G1 and G2 If the price of G4 is even lower, resulting in Dll, then combinations of G4 and G3 would dominate G2 which would be replaced in the market Finally, at a very low G4 price such as Dlll combinations of G4 and G3 would continue to dominate and eliminate G2 and G4 alone dominate all possible combinations with G1 (due to the positive sloped substitution line) Not complete without oral presentation

Product Proliferation and Advertising are Good for the Universe • Product differentiations that generate profitable sales improve welfare by pushing the efficient substitution frontier out, enabling customers to more efficiently combine desired characteristics • Lancaster points out that advertisingcan beefficient and productive; particularly when dealing with complex multi-characteristic goods that require more information to explain. • So long as the greater utility gained by making the customer aware of the option exceeds the cost of advertising, the customer and society are better off Not complete without oral presentation

Summary Not complete without oral presentation

Revealed Preference • Revealed preference introduced in 1938 by the late Nobel Prize winning economist Paul Samuelson • Motivated to explain consumer behavior without depending upon the vaporous notion of utility. • Didn’t succeed in removing psychology but set out a firm basis for empirical analyses of observed behavior. • “The discrediting of utility as a psychological concept robbed it of its only possible virtue as an explanation of human behavior in other than a circular sense, revealing its emptiness as even a construction. … • I propose, therefore, that we start anew in direct attack upon the problem, dropping off the last vestiges of the utility analysis. …(emphasis in original) • Samuelson summarized his concept with a common sense observation that evolved later into the Weak Axiom of Revealed Preference (WARP) • “. . . if an individual selects batch one over batch two, he does not at the same time select two over one.” Samuelson, Paul A., “A Note on the Pure Theory of Consumer’s Behavior” 1938, Economica, pp61-70 reprinted in The Collected Scientific Papers of Paul A. Samuelson, 1966, edited by Joseph E Stiglitz, MIT Press, Cambridge, Massachusetts, pp3-14 Not complete without oral presentation

Revealed Preference Following Varian* we can express Revealed Preference and WARP technically as: Revealed Preference Given some vectors of prices and chosen bundles (pt, xt) for t =1, . . . , T , we say xt is directly revealed preferred to a bundle (written xtRDx) if ptxt ≥ ptx. We say xt is revealed preferred to x (written xtRx) if there is some sequence r,s,t,...,u,v such that prxr ≥ prxs, psxs ≥ psxt,···,puxu ≥ pux. In this case, we say the relation R is the transitive closure of the relation RD. *Hal R. Varian, “Revealed Preference,” January 2005, Revised September 20, 2006, prepared for Samuelsonian Economics and the 21st Century, edited by Michael Szenberg. This is moderately accessible and available online at: people.ischool.berkeley.edu/~hal/Papers/2005/revpref.pdf Not complete without oral presentation

Weak Axiom Of Revealed Preference (WARP) • If xtRDxs then it is not the case that xsRDxt. Algebraically, ptxt ≥ ptxs implies psxs < psxt. • Assume the two relative price or budget lines for goods X and X1 illustrated next slide. • The consumer can buy any bundle or set of the two goods on the appropriate price line as well as any bundle or set of goods interior to the line. • If the consumer initially faces the less steeply sloping price line and chooses bundle a and behaves rationally, we can make certain observations about what happens when the relative prices of the goods change. • The steeper budget line indicates that the price of good X has increased relative to that of X1 (at the new prices, the consumer’s income could buy less of Xbut more of X1 than previously). • When faced with the new prices, the consumer could choose (among many others) bundle b or c. But c is inconsistent with the conditions of revealed preference. • Note that c is interior to the original price line and thus could have been purchased under the initial conditions but wasn’t. • On the other hand, point a is interior to the new price line and the selection of b is therefore consistent with the WARP. Not complete without oral presentation

Revealed Preference Graphically Not complete without oral presentation

Customer Relationship Value Bring together Williamson’s contract taxonomy, Demsetz’ “nexus,” and Alchian program Relational contracts are maintained by the mutual desire of the parties to preserve the relationship and their reputations. These sort of contracts are among a firm’s most valuable assets and special efforts are made to identify, acquire, and develop high value customer relationships. The value of these contracts (formal or informal) can be estimated analogously to a security. The model of customer equity employs an Alchian program framework where rate of contribution (margin) volume of contribution (units times margin) and delivery dates (duration of relationship). The valuation is based on standard NPV criteria. Not complete without oral presentation

The Volume, Margin, and Duration Model of Customer Equity Not complete without oral presentation

Probability of Purchase CRV Model Not complete without oral presentation

Management Implications of the CRV Model • From the graphical and algebraic representations of individual customer relationship value or customer equity the basic rules for optimizing investment in customer relationships can be easily derived: • Invest in acquiring a customer relationship if the net present value of the expected value of cash flows is equal to or greater than the acquisition cost • Acquisition costs are sunk costs and irrelevant after the customer has been acquired • The value of a customer relationship can be raised by increasing the volume of purchases per period, the margin on those purchases, and the duration of the period over which purchases are made • Invest in customer development and retention until, at the margin, the increases in customer value attributable to changes in volume, duration, and margin are equal to the costs of achieving them • An increase in any one of volume, margin, and duration increases customer relationship value so long as there is no offsetting decline in one or both of the other variables • Similarly, you cannot assume that a customer with one or two of the value drivers such as a larger expected duration, willing to pay a higher margin, or higher volumes per period is more valuable than another customer without calculating the full value using all three of the value drivers Not complete without oral presentation

Firm Value and CRV Not complete without oral presentation

Economic Portfolio Analysis and Segmentation All customers are not created equal. Focus efforts on two characteristics; customers with high relationship value and those with a potential propensity to purchase our good or service. i.e. those amenable to a relationship. Not complete without oral presentation

Economic Segmentation Not complete without oral presentation

Better Yield on Responsive Not complete without oral presentation

The Economics of Business