Customer Analysis in

Business
CHAPTER 2
BUSINESS ECONOMICS
by Tran Thi Kieu Minh, MSc
Contents
1. Theories of Demand
• Indifference preference – budget theory
• Revealed preference theory
• Demand characteristic of good
• Asymmetric information and abnormal consumption
2. Estimating Demand
3. Forecasting Demand
Readings:
Trefor Jones, 2004, Business Economics and Managerial Decision
Making
Chapter 4, 5 and 6
1. Indifference preference – budget theory
2. Revealed preference theory
3. Demand characteristic of good
4. Asymmetric information and abnormal consumption

1 THEORIES OF DEMAND
Indifference preference – budget theory
• Basic Assumptions
1. Preferences are complete.
• Consumers can rank market baskets
2. Preferences are transitive.
• If prefer A to B, and B to C, the must prefer A to C
3. Consumers always prefer more of any good to less.
• More is better
• Consumer preferences can be represented graphically using
indifference curves
• Indifference curves represent all combinations of market
baskets that the person is indifferent to
• A person will be equally satisfied with either choice
Indifference Curves: An Example

Market Basket Units of Food Units of

Clothing
A 20 30

B 10 50

D 40 20

E 30 40

G 10 20

H 10 40
 • Points such as B & D have more of one good but less of

Example another compared to A. Need more information about consumer

ranking
• Consumer may decide they are indifference between B, A
and D. We can then connect those points with an indifference
curve

The consumer prefers

Clothing 50 B A to all combinations
in the yellow box, while
40 all those in the pink
H E box are preferred to A.

30 A

20 D
G
U1
10

Food
10 20 30 40
 Indifference Curves
 Any market basket lying northeast of an indifference curve is
preferred to any market basket that lies on the indifference curve.
 Indifference curves slope downward to the right.
 If it sloped upward it would violate the assumption that more is
preferred to less.
 To describe preferences for all combinations of goods/services, we
have a set of indifference curves – an indifference map
 Each indifference curve in the map shows the market baskets among
which the person is indifferent.
 Indifference maps give more information about shapes of
indifference curves : Indifference curves can not cross
 Violates assumption that more is better
Indifference Map
Clothing
Market basket A
is preferred to B.
Market basket B is
D preferred to D.
B A
U3

U2

U1

Food
 Indifference Curves
 We measure how a person trades one good for another using the
marginal rate of substitution (MRS)
 It quantifies the amount of one good a consumer will give up to obtain
more of another good.
 It is measured by the slope of the indifference curve.
 Along an indifference curve there is a diminishing marginal rate of
substitution.
 Indifference curves are convex
 As more of one good is consumed, a consumer would prefer to give up
fewer units of a second good to get additional units of the first one.
 Consumers generally prefer a balanced market basket
Marginal Rate of Substitution
Clothing 16 A

MRS   C
MRS = 6
14 F
12 -6

10 B
1
8 -4 MRS = 2
D
6 1
-2 E
4 1 -1
G

2 1
Food
1 2 3 4 5
Marginal Rate of Substitution
• Indifference curves with different shapes imply a different willingness
to substitute
• Two polar cases are of interest
• Perfect substitutes
• Perfect complements
Marginal Rate of Substitution
• Perfect Substitutes
• Two goods are perfect substitutes when the marginal rate of substitution
of one good for the other is constant.
Apple
4
Juice
(glasses)
Perfect
3 Substitutes

Orange Juice
0 1 2 3 4 (glasses)
Consumer Preferences
• Perfect Complements
• Two goods are perfect complements when the indifference curves for the goods
are shaped as right angles.

Left
Shoes
Perfect
4 Complements

0 1 2 3 4 Right Shoes
 Budget Constraints
 The Budget Line
 Indicates all combinations of two commodities for which total money
spent equals total income.
 We assume only 2 goods are consumed, so we do not consider savings
 Let F equal the amount of food purchased, and C is the amount of
clothing.
 Price of food = PF and price of clothing = PC
 Then PF F is the amount of money spent on food, and PC C is the
amount of money spent on clothing.
The Budget Line
• The budget line then can be written:

P FF  P C C  I
All income is allocated to food (F) and/or clothing (C)
Example:

Market Food Clothing Income

Basket PF = $1 PC = $2 I = PFF + PCC

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
The Budget Line
Clothing
A
(I/PC) = 40 C 1 PF
Slope   - -
B F 2 PC
30
10 D
20
20
E
10
G
Food
0 20 40 60 80 = (I/PF)
The Budget Line - Changes in
Income
Clothing
(units
per week) A increase in
income shifts
80 the budget line
outward

60

A decrease in
40 income shifts
the budget line
inward
20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)
The Budget Line - Changes in
Price
Clothing
(units
A decrease in the
per week)
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
An increase in the
40 price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
L3 L1 L2
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)
 Consumer Choice
• Given preferences and budget constraints, how do consumers choose
what to buy?
• Consumers choose a combination of goods that will maximize their
satisfaction, given the limited budget available to them.
• The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line
• They spend all their income – more is better
2. It must give the consumer the most preferred combination of goods
and services

20 Chapter 3
 Consumer Choice
Clothing
(units per
week)
•A, B, C on budget line
40 •D highest utility but not
affordable
A •C highest affordable
utility
30 D •Consumer chooses C

20 C

U3

U1
B
0 20 40 80 Food (units per week)
21 Chapter 3
 Consumer Choice
• Recall, the slope of an indifference curve is:

C
MRS  
F
Further, the slope of the budget line is: PF
Slope  
PC
 Therefore, it can be said at consumer’s optimal
consumption point,
PF
MRS 
PC
 Consumer Choice ©2005
Pearson
Education,
Inc.

• Optimal consumption point is where marginal benefits equal marginal

costs
• MB = MRS = benefit associated with consumption of 1 more unit of
food
• MC = cost of additional unit of food
• 1 unit food = ½ unit clothing
• PF/PC
• If MRS ≠ PF/PC then individuals can reallocate basket to increase utility
• If MRS > PF/PC
• Will increase food and decrease clothing until MRS = PF/PC
• If MRS < PF/PC
• Will increase clothing and decrease food until MRS = PF/PC

23 Chapter 3
 Consumer Choice ©2005
Pearson
Education,
Inc.

Clothing
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS = -10/10 = 1
is greater than the
B
30 price ratio = 1/2

-10C
20

+10F U1
0 20 40 80 Food (units per week)
24 Chapter 3
Consumer Choice
- In case of many goods and services:

MU1 MU 2 MU n
  ..... 
P1 P2 Pn
 Practice
 Connie has a monthly income of $200 that she allocates among two
goods: meat and potatoes
 Suppose meat cost $4/pound and potatoes $2/pound. Draw her
budget constraint
 Connie’s supper market has a special promotion. If she buys 20 pounds
of potatoes she gets the next 10 pound for free. This offer applies only
to the first 20 pounds she buys. All potatoes in excess of the first 20
pounds (including bonus potatoes) are still $2/pound. Draw her budget
constraint.
 (continue question a) Suppose that her utility function is given by U =
2M + P. What combination of meat and potatoes should she buy to
maximize her utility?
 Lagrange multiplier method

• Max U = u (X, Y)
• Subject to budget constraint

I  Px. X  Py. y
Joseph-Louis Lagrange
Lagrange function (1736 – 1813)

L  u( X , Y )   ( I  Px. X  Py.Y )
λ:Lagrange multiplier
Lagrange multiplier method
• Maximizing Lagrange function

 L  U
  Px  0
 X  0  X
 
 L  U
  0    Py  0
Y
 Y  
 L  I  Px. X  Py.Y  0
   0 



U
X  Px MU X Px
U
Y
Py


MU Y Py
Px. X  Py.Y  I
 Corner solution
• A corner solution exists if a consumer buys in extremes, and buys all of
one category of good and none of another
• MRS is notYnecessarily equal to PA/PB •Corner solution at B,
MRS of X for Y is
greater than slope of
A budget line
U1 U2 U3 •If consumer could
give up more Y for X,
would do so, but no
more Y to give up
•Opposite true if corner
solution at A

B X
29
Indifference preference – budget theory

• The affects of INCOME changes to individual demand

• An increase in income, with the prices of all goods fixed, causes consumers to
alter their choices of market basket

• When income increases, budget line will shift outward, then, optimal
consumption choice changes correspondingly
 Y

C
B
A

PX

E G H
P*
D3
D2
D1

QX
Change in income lead to the SHIFT in the demand curve
Y

Income – consumption curve

C
B
A

PX

E G B
P*
D3
D2
D1

QX
Indifference preference – budget theory

- Income-consumption curve: traces out the utility-maximizing

combination of X and Y associated with every income level

- The upward-sloping income-consumption curve implies

that an increase in income causes a shift to the right in the
demand curve
income-consumption curve
• When income-consumption curve has positive slope:
• Quantity demanded increases with income
• Income elasticity of demand is positive
• Good is a normal one
• When income-consumption curve has negative slope:
• Quantity demanded decreases with income
• Income elasticity of demand is negative
• Good is an inferior one
Engel curve
Y
Engel curve:
is built from the Income-consumption curve

slope of income – C

consumption
curve
B

XA XC XB X
Engel curve

• Engel curve:
I

- Relate quantity of good I3 Inferior

consumed to income
- If good is normal, Engel
curve is upward sloping
I*
- If good is inferior, Engel
I2
curve is downward sloping
Normal
I1

Q1 Q3 Q2 Q
Indifference preference – budget theory

• The affects of PRICE changes to individual demand

• A decrease in prices, with a fixed amount of income, causes consumers to
alter their choices of market basket
• When price decreases, budget line will rotate outward, then, optimal
consumption choice changes correspondingly
 Y

A B C
Change in price lead
to a movement in
the demand curve Q1 Q2 Q3 X
PX

P1 E

G
P2

H
P3
D

Q1 Q2 Q3 QX
Y

Price-consumption curve
A
B C

X
PX

P1 E

P2 G

P3 H
D

Q1 Q2 Q3 QX
 Price-consumption curve
• Price-consumption curve traces the utility-maximizing combinations of
2 goods X and Y associated with every possible price of food.

• Both X and Y consumption can increase because the decrease in the

price of X has increased the consumer’s ability to purchased both X
and Y (X increases, Y can either increase or decrease)
Income and substitution effects
• Change in price of a good has two effects: SE and IE
Substitution Effect
• Relative price of good changes when price changes
• Consumers tend to buy more of good that has become relatively cheaper, and less of good that is
relatively more expensive
• Substitution effect is the change in item’s consumption associated with change in price of item,
with level of utility held constant
• When price declines, substitution effect leads to increase in quantity demanded
Income and substitution effects
Income Effect
• Consumers experience increase in real purchasing power when price
of one good falls
• Income effect is the change in item’s consumption brought about by
increase in purchasing power, with price of item held constant
• When income increases, quantity demanded may increase or
decrease
• Even with inferior goods, income effect rarely outweighs substitution
effect
Income and substitution effects
• X is a normal good, Px declines

Original budget
Y** C
Y* A U2

YB B
New budget
U1

0 Xa XB Xc ¸X
SE IE

TE
Income and substitution effects
• X is an inferior good, Px increases
Y

B

New budget
Y* A
U1
Y** C Original budget
U2
0 xB Xc Xa X

SE
IE
TE
Income and substitution effects
Y • X is a Giffen good, Px increases

B

A

New budget

U1
Yc U2
C Original budget

0 Xb Xa Xc X
Exercise
A consumer has utility function U=X.Y. He decided to spend
60$ on X and Y, in which, Px is 2$/ unit and Py is 4$/ unit

a. Calculate MUx and MUy

b. Find optimum consumption point for this individual
c. The price of Y now is 8$. Build demand function for Y
Case study
In order to improve the living standard of consumer, who is
working in State sector, the government has 2 options:

- Subsidize the price of food, so that the price of food will be cheaper
- Increase the basic income for consumer in this sector from 630.000VND
to 750.000 VND, so that consumer can buy more food
- (Assume that in both options, consumer can buy the same level of
more food)

→ Which one bring consumer higher utility?

Indifference preference – budget theory

• Disadvantages
•  Assume that utility is measurable
•  Assume that marginal utility of money is constant
•  The principle of diminishing marginal utility is just a phenomenon of
psychology
1.1.2. Revealed
Preferences
Theories of demand
Revealed preferences
• Do not use indifference curve in analyzing consumer’s behavior
• Focus on consumer’s behavior – observable, but not preference -
unobservable
• When consumer chooses a combination of goods, he reveals his
preference to that combination of goods rather than other
combinations
Revealed preferences
• Assumption:

• With nominal income and fixed price of goods, consumer spend all of his
income on the goods

• With a certain price and income, consumer just choose one combination
of goods

• There exist one and only one price level and income for each chosen
combination of goods

• Consumer’s choice is consistent .

 Revealed preferences

Clothing l1
(units per •I1: consumer chooses A, not B.
month)
•Preference reveales at A
•l2: consumer chooses B, not D.
l2 •Preference reveales at B
A

B
D

Food (units per month)

Revealed preferences
Clothing l1
(units per
month)

l2

B
D

Food (units per month)

Revealed preferences
I3: E is revealed to be preferred to A
Clothing
l3
(units per
month)
Market baskets
in the pink area
are prefered to A
E
l1

l4
A
l2
B G

I4: G is revealed to be preferre

Food (units per month)

3. Demand
characteristic of
good
Theories of demand
Demand characteristic of good
Characteristic 2

O ◄
Characteristic 1
Demand characteristic of good
Demand characteristic of good

G1 ABC: Efficiency frontier/

Characteristic frontier
AC: Inefficient
G2
Succulence

A B
D G3
E
C
F
O X Y ◄
Sweetness
4. Asymmetric
information and
abnormal
consumption
Theories of demand
Asymmetric information and abnormal
consumption

• Asymmetric information : consume based on price

guidance

• Abnormal consumption: higher price, higher utility

(luxury items)
1.2. Estimating
demand
Chapter 1
Estimating demand

Demand estimating:

• On arc elasticity
• On empirical technique
• On marketing methods
Estimating demand

Price elasticity of demand (EPD)

- The percentage changed in quantity demanded resulting from 1%
change in price
-

%Q
E D

%P
P
ESTIMATING DEMAND

Income elasticity of demand (EID)

- The percentage changed in quantity demanded
resulting from 1% change in income
-
%Q I
EID   Q '( I ) .
%I Q
- EID <0: Inferior goods
- EID >0: Normal goods
- EID >1: Luxury goods
Estimating demand
Cross-elasticity of demand (EPyD)
- The percentage changed in quantity demanded resulting
from 1% change in price of related goods

%Q PY
E 
D
 Q'PY .
%PY
PY
Q

• EPyD > 0 : Substitutes goods

• EPyD < 0 : Complements goods
• EPyD = 0 : Independent goods
Exercise
T&M company has data about elasticity to their product as follow:

EP = -1,5; EI = 1,2; EY = 1,2 (Y is substitutes to company’s product)

In the year after, company wants to increase the price by 6%,
consumer’s income is expected to increase by 6%, price of
competitor’s product is expected to decreases by 3%

a. If sales volume of the company in current year is 1 million units,

estimate the volume for the year after.

b. How does the price of company’s product change if the company

wants to keep the sale volume constant from this year to next year?
Estimating demand
• Demand estimating on econometric technique (empirical technique)
- Using regression method with available data on quantity
demanded and determinants in demand function to estimate
demand function’s coefficients.
- General form of demand function:
- Qd=f(Px, Py, I, T, N, E, C, A....)
Estimating demand
• Demand estimating on econometric technique (empirical technique)
• Advantage: widely used, relatively accurate result
• Disadvantage:
 Depend on the availability of data
 Depend on the perfect assumption (BLUES)
 Demand function problem
Estimating demand
• Demand estimating on marketing methods
• Survey and observation on consumers
• Consumer clinics
• Market trial
Estimating demand
• Demand estimating on marketing methods
• Survey on consumers:
- To get consumer’s feedback on changes in determinants in demand
function
- Implemented by direct interview or questionnaires
- Disadvantage: High cost with large sample, incorrect answers...
Estimating demand
• Demand estimating on marketing methods
• Consumer clinics:
- Giving consumer a certain amount of money and observing their
behavior in a shop
- Advantage: More credible in comparison with survey
- Disadvantage: Not objective, small sample due to high cost
Estimating demand
• Demand estimating on marketing methods
• Market trial:
- Trial on real market
- Advantage: Objective, large sample
- Disadvantage: competitor’s interference, abnormal events (strike,
bad weather...), losing market share due to change in price
III. Forecasting
demand
Chapter 1
Forecasting demand

• Extrapolation
• Time-series analysis
• Root mean square error technique
• Smoothing technique
• Barometric method
Extrapolation

• Assume that future sale volume is the same

with the past’s one or trend in the future is
alike the trend in the past
• Advantage: Easy to calculate
• Disadvantage: Just regards to time, regardless
to determinant in demand function
Past Present Future Time
Time-series analysis
• Using 4 variables: Season (S), Trend (T),
Abnormal event (I), Circle movement (C)
• Xt=Tt+Ct+St+It or
• Xt=Tt.Ct.St.It
• Using empirical technique to draw
regression function
Root mean square error
technique
RMSE 
 (A  F ) t t
2

n
At: current value of time series at t
Ft: estimating value

- Smaller RMSE, better forecasting

Smoothing technique
• Depend on the value of At and Ft to forecast the value of Ft+1
• Ft+1=wAt+(1-w)Ft

• Barometric method:
• Depend on availability of current data to forecast future (depend on the
new born baby to forecast fresh pupils 6 years later)