Review the important aspects of demand and cost theory, evaluating how they contribute to our understanding of how markets operate.

The overall effect is the sum of the income and substitution effects.

Demand is also affected by the other factors other than price.

Tastes: Tastes are affected by advertising, by fashion, by observing other consumers, by consideration of health and by the experiences from consuming the goods on previous occasion.

The number and Price of substitute goods (competitive goods): The higher the price of substitute goods the higher will be the demand for this good as people switch from the substitutes.

The number and price of complimentary goods: The higher the price of complimentary goods the fewer of them will be bought and hence the less the demand for this good, Eg; The demand for compact discs will depend on the price of CD players.

Income: For a normal good demand increases when income rises and for an inferior good the demand falls when income rises.

Distribution of Income: If national income were redistributed from the poor to rich the demand for luxury goods will rise. At the same time as the poor gets poorer they might have to return to buying inferior goods whose demand would also rise.

Expectations of future price changes: If people think that prices are going to rise in the future they are likely to buy more now before the price goes up.

Price Elasticity of demand

Price elasticity of demand compares the change in quantity demanded of a given product with the size of change in price.

It can be defined as follows:

Ped= Proportionate (or percentage) change in quantity demanded

Proportionate (or percentage) change in price

This can be categorized as elastic or inelastic demand.

In elastic demand (E>1) a change in price causes a proportionately larger change in quantity demanded. In inelastic demand (E<1) a change in price causes a proportionately smaller change in the quantity demanded. The Price elasticity of demand may vary from one good to other.

Consider salt which has a very low price elasticity of demand. This is because we spend such a tiny fraction of our income on salt, that we would find little difficulty in paying a relatively large increase in its price: the income effect of a price rise will be small. On the contrary if mortgage interest rates rise people may have to cut down substantially on their demand for housing.

When price rises people may take a time to adjust their consumption patterns and find alternatives. The longer the time period after a price change, more elastic the demand will be.

Robert Giffen a 19th century researcher carried out research into the Irish potato famine of the 19th century. The famine caused the price of potatoes to rise. In theory this rise should have led to a fall in demand for potatoes but in fact demand actually increased. The higher prices were of huge significance to the poorer Irish families and caused them to buy smaller quantities of more expensive foods such as meat. Despite the increase in price, potatoes were still the cheapest available food. Not being able to afford expensive foods, poor Irish families were forced to purchase more potatoes than previously to satisfy their survival needs. This made potatoes a Giffen good as the quantity increased as the price rose.

A similar argument also exists for bread as bread is an important food for low income families and an increase in the price of bread would leave them with less income to spend on more expensive foods.

This analysis of the data has been disputed but it does illustrate the theoretical possibility of Giffen goods. The Giffen good is just a theoretical possibility as economists are yet to find conclusive evidence for a product with an upward sloping demand curve.

So in answer to the question "Does an increase in price necessarily lead to a fall in demand?" the answer is in no way simple. Theoretically, there may be a situation where an increase in price does lead to an increase in quantity demanded. But realistically speaking this situation is so rare that it can be discounted. In general a rise in the price of a commodity will lead to a fall in the quantity demanded but the theoretical possibility of a Giffen good must never be forgotten.

b) Examine the article "GSK and Bayer's orange pill challenges Viagra". Using your economic understanding of demand and cost theory, propose a competitive strategy for Pfizer's in their fight with GSK and Bayer.

(40 Marks)

Viagra gained instant success as the first oral therapy for impotence in 1998 and continues to demonstrate solid growth, but the arrival of a competitive drug Levitra made by BAYER and GSK is a concern for the investors. While there are concerns regarding competitive drugs, the market these drugs address continue to expand. There is certainly enough room in these areas for more than one drug to prosper. Pfizer Inc. sold $1.7 billion worth of Viagra last year (guardian site). Viagra till now being the only drug available had its monopoly but now with the introduction of new drug (Substitute) has lost its monopoly.

Nothing can be predicted as of now that how market will respond to the new drugs. There can be two scenarios.

) If consumer remains loyal to the blue pill then competition is not enough and there will be a very little slump in the sales. Then Viagra can stick to their strategy and can take the stage of legendary blue pill which is still the same price.

2) If the competition offered is tough and there is a significant sale going to competitors then Viagra has to cut down on its cost and respond according to the market changes and tastes.

Marketing Strategy

In seeking the most effective way to achieve a particular market share Pfizer needs to decide upon the relative importance to attach to price and the various non-price marketing variables. Pfizer also need to assess competitor's reactions to its own marketing policies in order that the 'pay off' from any particular marketing action may be estimated. Games theory presents one such technique which may aid in this situation.

The internal factors (controllable factors) which may influence demand of Viagra are the product life cycle, the service level the business would like to maintain, the quality of the product as well as any other actions taken by the company to ensure quality.

In addition, the design and packaging of the product may influence the demand for the product.

The product life cycle comprises of four phases that usually display different demand patterns. These phases of the product life cycle can be incorporated while managing demand for a product. For example, in the growth phase competitive products will appear on the market, which will influence demand for the original product to some extent. Consequently an assumption will have to be made regarding the rate at which demand for the product will increase. Since the growth cannot continue at the same pace, the historic demand pattern must be adjusted to reflect the arrival of competitive products (Adendorff, 1997:94).

The external factors (outside the domain of business) largely stem from two sources, namely the characteristics and behaviour of potential customers and their action of the authorities. The characteristics of the market referred to prospective customers' tastes and perceptions, the demographic characteristics of the market (age), the image of the product as perceived by potential clients, the level of competition in the market and other random factors which may influence the behaviour and functioning of the market. The role of the authorities is characterised by actions such as deregulation and privatisation, which in turn play a direct part in the state of the economy. The business attempt to manipulate the behaviour of the market by means of advertising and sales efforts.

Pfizer said it believes it can handle the competition and plans no changes to its marketing of Viagra, "Our marketing strategy is to continue to communicate the benefits of Viagra and also to de-stigmatize the condition," said Janice Lipsky, Pfizer's U.S. team leader for Viagra.

References:

Begg, David (2003) Economics, London: McGraw-Hill

Sloman, John and Sutcliffe, Mark (1998) Economics for Business

Module-Business Economics

FT-MBA

Name-Archana Makroo

UB No-03014523