Wireless Network Pricing Chapter 3: Economics Basics
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1 Wireless Network Pricing Chapter 3: Economics Basics Jianwei Huang & Lin Gao Network Communications and Economics Lab (NCEL) Information Engineering Department The Chinese University of Hong Kong Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
2 The Book E-Book freely downloadable from NCEL website: http: //ncel.ie.cuhk.edu.hk/content/wireless-network-pricing Physical book available for purchase from Morgan & Claypool ( and Amazon ( Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
3 Chapter 3: Economics Basics Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
4 What is Economics? Definition (Economics) Economics is the study of how individuals and groups make decisions with limited resources as to best satisfy their wants, needs, and desires. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
5 Firm and Consumer Follow the convention of economics, and use the terms firm and consumer Example of firm: wireless service provider, wireless spectrum owner; Example of consumer: wireless user, lower tier wireless service provider. Definition (Firm) A firm is an organization involved in the production and trade of goods, services, or both to consumers. Definition (Consumer) A consumer is a person or group of people, such as a household, who are the final users of products or services. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
6 Examples: Economics Ballard Farmers Market (source: Internet) Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
7 Examples: Economics Sao Paulo Stock Exchange (source: Internet) Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
8 Examples: Economics Christie s Auction (source: Internet) Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
9 Section 3.1: Supply and Demand Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
10 Supply and Demand Supply and Demand in a market are both functions of market prices. Demand (of consumers) often decreases with prices, as consumers have less incentives to purchase under higher prices. Supply (of firms) often increases with prices, as firms have more incentives to produce under higher prices. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
11 Market Demand Function Example: A consumer subscribes to a wireless cellular data plan. Consumer s demand is 50 Gigabytes, if the price is $1 Per Gigabyte; Consumer s demand is 1.5 Gigabytes, if the price is $20 Per Gigabyte. Price Per Gigabyte Wireless Data Demanded Per Month $1 50 Gigabytes $2 22 Gigabytes $10 4 Gigabytes $ Gigabytes Table: A consumer s monthly data demand vs the data price Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
12 Market Demand Function Market Demand Function: The relationship between the aggregate demand (of all consumers) and the market price. Definition (Market Demand Function) The market demand function D( ) characterizes the relationship between the total demand quantity Q d and the product price P as follows: Q d = D(P) Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
13 Market Demand Function Illustration of Market Demand Function Price P 1 P 2 D Q d = D(P) Movement along demand function D 0 Q 1 Q 2 Quantity Figure: The market demand function Q d = D(P). When the price decreases from P 1 to P 2, the demand increases from Q 1 to Q 2. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
14 Market Demand Function Market demand function itself may shift due to the change of consumers income; the price change of other products; the change of consumers tastes; Price P 1 D D Shift of demand function D D 0 Q 1 Q 2 Quantity Figure: The shift of market demand function from Q d = D(P) to Q d = D (P). For example, under the same price P 1, the demand changes from Q 1 to Q 2. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
15 Market Supply Function Market Supply Function: The relationship between the aggregate supply (of all firms) and the market price. Definition (Market Supply Function) The market supply function S( ) characterizes the relationship between the total supply quantity Q s and the product price P as follows Q s = S(P) Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
16 Market Supply Function Illustration of Market Supply Function Price S P 2 P 1 Movement along supply function S Q s = S(P) 0 Q 1 Q 2 Quantity Figure: The market supply function Q s = S(P). When the price increases from P 1 to P 2, the supply increases from Q 1 to Q 2. Market supply function itself may shift when the price of a raw material (used for production) or the production technology changes. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
17 Market Equilibrium Market Equilibrium: A market stable state under which the market is unlikely to change. A prediction of how the actual market will look. A market (or market price) is unstable, when The aggregate demand is higher than the aggregate supply, as consumers are willing to pay more to secure the limited supply (hence the market price will increase); The aggregate demand is lower than the aggregate supply, as firms are willing to charge less to attract the limited demand (hence the market price will decrease); Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
18 Market Equilibrium Illustration of Market Equilibrium When either market demand or supply function shifts due to factors other than the price, market equilibrium will change accordingly. Price D S P 1 Excess supply P e P 2 S Excess demand D 0 Quantity Q e Figure: The market equilibrium price P e and equilibrium quantity Q e. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
19 Market Equilibrium Definition (Market Equilibrium) At the market equilibrium, the aggregate demand equals the aggregate supply. Market equilibrium price P e and the aggregate demand/supply Q e : Q e = D(P e ) = S(P e ) Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
20 Section 3.2: Consumer Behavior Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
21 Consumer Behavior Focus on the behavior of a particular consumer, and understand how the market demand function Q d = D(P) is derived from the consumer s utility maximization behaviour. Basic Concepts Market Basket Consumer Utility Indifference Curve Budget Constraint Consumer Demand Function Price Elasticity Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
22 Market Basket How a consumer evaluates the benefit of consuming products? For example, how would a consumer evaluate the satisfaction level of watching a 60-minute action movie and playing 30 minutes of video games on his ipad? Definition (Market Basket) A market basket (also known as commodity bundle) specifies the quantity of different products. For example, watching a 60-minute movie and playing 30 minutes of game can be represented by the market basket (60, 30). Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
23 Consumer Utility Consumer Utility Function: Characterize a consumer s satisfaction level of consuming a certain market basket (x, y), i.e., U = U(x, y) Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
24 Indifference Curve Indifference Curve: Characterizes how a consumer trades off two different baskets of products Definition (Indifference Curve) An indifference curve represents a set of market baskets where the consumer s utilities are the same. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
25 Indifferent Curve Illustration of Indifference Curve Basket 1 (60, 30), basket 2 (45, 40), and basket 3 (30, 60) are on the same indifference curve (benchmark); Basket 5 (75, 65) is on an indifference curve with a higher utility; Basket 4 (25, 25) is on an indifference curve with a lower utility. Minutes of Playing Games (75,65) (25,25) Minutes of Watching Movie Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
26 Budget Constraint Definition (Budget Constraint) The budget constraint characterizes which market baskets are affordable to the consumer. Example: Watching one minute of movie will cost 1 unit of energy, and playing one minute of game will cost 2 units of energy. Then, the constraint of 100 units of energy leads to the budget constraint: More generally, x + 2y 100 P x x + P y y I Here Px and P y are the unit prices, and I is the budget. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
27 Budget Constraint Illustration of Budget Constraint y Minutes of Playing Games 50 x + 2y = 100 x 100 Minutes of Watching Movie Figure: Illustration of budget constraint x + 2y 100. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
28 Consumer Consumption Problem How a consumer decides which market basket to purchase? Objective: Want to maximize its utility subject to the budget constraint. Geometrically, the consumer s optimal choice is the highest indifference curve that touches the budget constraint. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
29 Consumer Consumption Problem Illustration of Consumer s Optimal Choice U 1 < U 2 < U 3 are three indifference curves; Budget constraint is x c + 2y c 100; Minutes of Playing Games 50 y c a b c U3 U2 U 1 x c 100Minutes of Watching Movie Figure: Consumer s optimal market basket choice is basket c. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
30 Consumer Consumption Problem Consumer s Optimal Choice in the previous figure The derivative of the indifference curve with utility U3 at basket c equals to the slope of the budget constraint at basket c, i.e., the budget constraint is the tangent line to the indifference curve at basket c, y = P x x P y U(x,y)=U3,(x,y)=(x c,y c ) Recall that the budget constraint is P x x + P y y I The lefthand side is called marginal rate of substitution (MRS), representing how much the consumer is willing to tradeoff one product with the other product. In general MRS is not a constant on a particular indifference curve. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
31 Consumer Demand Function Consumer Demand Function: Characterizes how a consumer s demand of a product changes with the price of that product. Market demand function: simply the summation of all consumers demand functions in the same market. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
32 Consumer Demand Function Example: Assume that there are three games on ipad. The consumer can choose one game to play and watching movie. The energy prices of these three games are 1/min, 2/min, and 4/min, respectively. The energy price of watching movie is 1/min. Minutes of Playing Games 100 y A 50 y B 25 y C A B C P y = 1/min P y = 2/min P y = 4/min 100 Minutes of Watching Movie Figure: Consumer s optimal choices: A for 1/min, B for 2/min, C for 4/min. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
33 Consumer Demand Function Connecting the consumer s optimal choices under different energy prices will lead to the demand function. Energy Price of Playing Games y C y B y A Minutes of Playing Games Figure: Consumer s demand function (for playing games) as a function of the energy price. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
34 Price Elasticity Price Elasticity: Characterize the sensitivity of demand in term of price, i.e., how fast the demand changes with the price. Example: Cellular Wireless Data Usage. A college student might be very price sensitive, and will dramatically decrease the monthly data usage if the price increases; A business consumer might be much less sensitive and not even notice the change of price until several months later. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
35 Price Elasticity Definition (Price Elasticity) The price elasticity of demand measures the ratio between the percentage change of demand and the percentage change of price, i.e., E d = % change in demand % change in price = Q d/q d P/P Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
36 Price Elasticity Illustration of Price Elasticity E d E d < 0 due to the downward slopping of the demand curve. Price (P) P Q d = D(P) Q d Quantity (Q d ) Figure: The change of demand Q d due to the change of price P. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
37 Price Elasticity When the demand function Q d is differentiable, then E d = P Q d Q d P Three Demand Types: Elastic demand: the demand changes significantly with the price and E d < 1. Inelastic demand: the demand is not sensitive to price and 1 < E d < 0. Unitary elastic demand: Ed = 1. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
38 Section 3.3: Firm Behavior Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
39 Firm Behavior Focus on the behavior of a particular firm, and understand how the market supply function Q s = S(P) is derived from the firm s cost minimization behavior. Basic Concepts Marginal Cost Competitive Firm Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
40 Firm Cost Total Cost of A firm: Fixed cost: the cost independent of the quantity produced. Variable cost: the cost depending on the production quantity. Definition (Firm Cost) The total production cost of a firm includes both the fixed cost F and variable cost V (q), i.e., C(q) = F + V (q) where q is the production quantity. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
41 Marginal Cost Marginal Cost: Characterize how the total cost C(q) changes when the firm changes the production quantity q. Definition (Marginal Cost) The marginal cost measures how the total cost changes with the production quantity, i.e., MC(q) = change in total production cost change in production quantity = C(q) V (q) = q q The fixed cost F does not affect the computation of marginal cost. If the variable cost function V (q) is differentiable, then MC(q) = C(q) q = V (q) q Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
42 Competitive Firm Definition (Competitive Firm) A competitive firm is price-taking and acts as if the market price is independent of the quantity produced and sold by the firm. The above definition reflects the reality when the firm faces many competitors in the same market. Each firm s production decision is unlikely to significantly change the total quantity available in the market, and thus will not significantly affect the market price. Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
43 Competitive Firm Profit Total Profit of a Competitive Firm q: the firm s production quantity; P: the market price independent of the quantity q; F : the firm s fixed cost independent of the quantity q; V (q): the firm s variable cost depending on the quantity q; Definition (Profit of Competitive Firm) A competitive firm s total profit is the difference between the total revenue and total cost, i.e., π(q) = P q V (q) F Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
44 Competitive Firm Optimal Decision A Competitive Firm s Decision Problem: Decide the optimal production quantity q that maximize its total profit: π(q) = P q V (q) F The Firm s Optimal Quantity Choice q is given by: P = V (q) q = MC(q) Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
45 Section 3.4: Chapter Summary Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
46 Key Concepts Supply and Demand Consumer Behavior Model Firm Behavior Model Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
47 Extended Reading Huang & Gao ( c NCEL) Wireless Network Pricing: Chapter 3 September 9, / 45
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