12.4 Demand and buyers’ willingness to pay

To decide what price to charge and how much to produce, a firm must understand demand.

demand

Demand refers to the relationship between a product’s price and how much buyers are willing and able to buy at each possible price. See also demand curve (firm) and quantity demanded.

demand curve (firm)

A firm’s demand curve is a graph that shows how much of the firm’s product people want to buy at different prices. See also demand and quantity demanded.

quantity demanded

Quantity demanded is the amount of a product people are willing to buy at a particular price. It refers to a specific point on the demand curve where price is fixed at a given level. See also demand and demand curve (firm).

differentiated product

A differentiated product is a product with some unique characteristics compared to similar products produced by other firms.

The firm’s demand curve illustrates the quantity of a product buyers are willing to purchase at different prices. In this section, we explore how firms selling differentiated products face a downward-sloping demand curve. When CORE Brewing Co. sets a high price for its beer, only buyers with a strong preference for the brand will purchase it, resulting in low quantity demanded. As you lower the price, more buyers, who might have otherwise chosen a different craft beer, will be willing to buy CORE’s beer, leading to an increase in quantity demanded.

The firm’s demand curve

willingness to pay

Willingness to pay is an indicator of how much a buyer values a good, measured by the maximum amount they will pay to acquire a unit of that good.

The firm’s demand curve provides an answer to the hypothetical question “For each possible price that might be charged, how many kegs of beer will be purchased?” Potential buyers answer this question based on their willingness to pay, denoted as WTP. For CORE Brewing Co.’s beer, willingness to pay depends on how much buyers value the beer: If you value it more, then you are willing to pay more for it. If you value it less, then you are willing to pay less for it. Firms often conduct surveys of potential buyers or experiment with different prices to determine how much buyers are willing to pay for their products.

demand

Demand refers to the relationship between a product’s price and how much buyers are willing and able to buy at each possible price. See also demand curve (firm) and quantity demanded.

Buyers’ willingness to pay constrains how much profit the firm can make. In doing the best you can, you need to consider the price that buyers are willing to pay for a keg of your beer. You might want to charge a high price for your beer, but not all buyers are willing to pay a higher price. To maximize your profit, you need to balance your pricing strategies with the reality of buyer demand.

Let’s assume that based on the information you gather from a small survey of potential customers, you estimate the demand for your beer that is shown in Table 12.5. For simplicity, we use the data we have been working with throughout this chapter and assume that you produce just one type of beer.

Data Extension 12.4 How do firms determine willingness to pay?

Firms can use several different methods to determine how much buyers are willing to pay for their products and services. Surveying potential buyers is one method. Figure E12.6 shows the percentage of buyers surveyed who are willing to pay various prices for a Netflix subscription. As the figure shows, very few people are willing to pay $20 or more per month to subscribe to Netflix. Those who are willing to pay that amount may believe that Netflix programming is unlike the programming available on any other streaming service. It is not until the price falls to around $5 to $10 a month that a substantial number of buyers are willing to pay for the service. Once firms survey potential buyers, they can then scale their survey responses to be representative of the entire U.S. population.

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https://books.core-econ.org/uoe-101/12-04.html#figure-e12-6

Figure E12.6 Willingness to pay for Netflix.

The figure shows the share of people surveyed who are willing to pay less than $5 per month, $5 per month, $10 per month, $15 per month, and $20 or more per month for a Netflix subscription.

Economist Jerry Hausman analyzed cash-register data on weekly sales of breakfast cereals from US grocery stores in large metropolitan areas. Based on that data, he estimated how the weekly quantity of cereal that buyers in a typical city are willing to buy varies with each cereal’s price per pound (Table E12.2). This approach differs from surveys of buyers, as in the Netflix example above, in that Hausman’s data was based on what consumers actually paid for a product as opposed to what they are willing to pay. In other words, Hausman used real price and quantity data generated from transactions at the checkout.

Brand	Company	Average price ($) per pound
Cheerios	General Mills	2.644
Honey Nut Cheerios	General Mills	3.605
Apple Cinnamon Cheerios	General Mills	3.480
Corn Flakes	Kellogg	1.866
Raisin Bran	Kellogg	3.214
Rice Krispies	Kellogg	2.475
Frosted Mini-Wheats	Kellogg	3.420
Frosted Wheat Squares	Nabisco	3.262
Raisin Bran	Post	3.046

Table E12.2 Sales of major ready-to-eat breakfast cereals in the United States (1992).

Jerry A. Hausman. 1996. “Valuation of New Goods Under Perfect and Imperfect Competition.” In Timothy F. Bresnahan and Robert J. Gordon (eds). The Economics of New Goods. University of Chicago Press. pp. 207–248.

Firms can also use price experiments to better understand what buyers are willing to pay. For example, on March 15, 2011, shoppers at Gap had an opportunity to name the price they were willing to pay for a pair of men’s khaki pants. Buyers logged onto the Gap website, were able to name their price, and win exclusive store coupons at their winning price. The promotion was intended to offer a discount to buyers, but there is no doubt that The Gap collected a lot of data about buyers’ willingness to pay that can help it price its products in the future.

Often, firms are not sure what buyers are willing to pay until they change prices and see how buyers respond. Firms experiment with the prices of their products to determine if buyers are willing to pay more. If consumers are willing to pay a higher price, then firms will be able to cover the higher costs of producing their products, which may be due to rising inflation. If consumers are not willing to pay a higher price, then firms might see their profits shrinking and will need to find other ways to manage rising costs.

See the article “How Much More Will Your Oreos Cost? Companies Test Price Increases”, which explains how firms that are dealing with higher input costs are experimenting with prices to determine if buyers are willing to pay more for their goods and services.

Willingness to pay and quantity demanded

We can also visualize the relationship between quantity and price graphically by plotting the demand curve for CORE Brewing Co. using data from Table 12.5. By plotting the data from the table and connecting the points with a line, we illustrate the firm’s demand curve, which shows the quantity demanded at different price levels.

This curve, shown in Figure 12.5, shows us that zero buyers are willing to pay $400 for a keg of CORE’s beer (point A). A firm cannot simply charge any price it wants: if you set your price too high, buyers will not be willing to buy your beer.

At a price of $360, buyers are willing to purchase 1 keg of beer per day (point B), because their willingness to pay (WTP) is equal to or greater than $360 per keg. When the price (\(P\)) drops to $320, buyers are willing to purchase 2 kegs of beer per day (point C), because their WTP is equal to or greater than $320 per keg.

We can draw the following conclusions:

• When \(P\) is high, the quantity demanded is low because the only buyers who will buy your beer are those who strongly prefer it over other beer.
• When \(P\) is lower, a larger number of people are willing to buy, so the quantity demanded is higher. These buyers may be individuals who would have bought beer from a different firm, but who are now attracted to your beer because the price is lower.

The inverse relationship between price and quantity demanded explains why the demand curve in Figure 12.5 slopes downward. In an inverse relationship, if one variable increases, the other variable decreases.

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https://books.core-econ.org/uoe-101/12-04.html#figure-12-5

Figure 12.5 CORE Brewing Co.’s estimated product demand for its beer.

We can draw the demand curve for CORE’s beer using data from Table 12.5. CORE’s demand curve is a downward-sloping line, which shows that at lower prices buyers demand more beer, and at higher prices, buyers demand less beer.

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https://books.core-econ.org/uoe-101/12-04.html#figure-12-5a

CORE Brewing Co.’s estimated product demand for its beer: showing just one point

Let’s start by labeling the y-axis (vertical axis) as price per keg (\(P\)) and the x-axis (horizontal axis) as quantity (\(Q\)). Once we have labeled the axes, we can plot the first point, which we will label as point A. At point A, \(P\) = $400 and \(Q\) = 0 because no consumer is willing to buy a keg of CORE’s beer at that high price.

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https://books.core-econ.org/uoe-101/12-04.html#figure-12-5b

CORE Brewing Co.’s estimated product demand for its beer: showing two points

Let’s add another point, point B. At point B, when price is $360, the quantity of kegs demanded is 1 because there are consumers whose willingness to pay (WTP) is equal to or greater than $360 and who will therefore purchase a keg at that price.

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https://books.core-econ.org/uoe-101/12-04.html#figure-12-5c

CORE Brewing Co.’s estimated product demand for its beer: showing all points

Let’s add all the other points using the data from Table 12.5.

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https://books.core-econ.org/uoe-101/12-04.html#figure-12-5d

CORE Brewing Co.’s estimated product demand for its beer: showing all points connected.

When we connect the points, we have CORE’s demand curve for its beer. The demand curve is downward-sloping, illustrating the law of demand. We know the curve is downward-sloping because it runs from the top left to the bottom right of the graph.

Demand curves are often drawn as straight lines, as in this example, but there is no reason to expect them to be straight in reality. Figure 12.6 illustrates a non-linear demand curve. The demand curve is still downward-sloping, indicating that as price decreases, quantity demanded increases. However, the shape of the curve suggests that buyers’ willingness to pay decreases more quickly at higher prices and decreases more slowly at lower prices. For example, a small number of beer enthusiasts might be willing to pay a high price for your beer, but as the price decreases, more casual users purchase your beer.

law of demand

According to the law of demand, a decrease in the price of a good will result in an increase in the quantity of the good demanded.

Whether they are straight lines or not, demand curves slope downward: As the price rises, the quantity demanded falls. Conversely, as the price falls, the quantity demanded rises. This relationship between price and quantity demanded is known as the law of demand.

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Non-linear demand curve.

In the next section, we combine demand and costs to learn more about the price you should charge. Deciding what price to charge is important because that price, in combination with the amount of beer you produce, determines how much profit you earn.