The effect of price, advertising, and income on consumer demand: an almost ideal demand system investigation

Abstract

Theoretically, an equiproportionate change in prices and income should not affect the sales of products. This is known as the homogeneity of demand property on which the economic consumer demand theory is built. Rejection of this assumption is indicative of a state of mind called ‘money illusion’. Evidence from applied economics literature suggests that consumers respond asymmetrically to equal changes in prices and income. Such an asymmetry could be, among other things, due to the exclusion of marketing mix variables in their demand functions or inappropriate grouping of products.

The main focus of the dissertation is to provide a theoretically consistent approach to include marketing variables in a sales response function. Specifically, advertising is hypothesized to act as a moderator in eliminating the asymmetry.

A related issue investigated in this research is the existence and empirical testing of mental expenditure accounts. Grouping of products into mental expenditure accounts is thought to improve the homogeneity of demand.

A system of equations is developed since the model involves prices and advertising of all products. The systems approach offers a consistent means to analyze sales when advertising programs interact; for example, orange juice advertising may affect the demand for milk and vice versa. The expenditure share system of equations is estimated using the Seemingly Unrelated Regression (SUR) estimation procedure to allow for dependence among error terms and cross-equation coefficients.

Theoretically, this research tests the validity of the well established consumer demand theory. It provides an approach, consistent with neoclassical economic theory, to include marketing mix variables in sales response modeling.

Managerially, this study helps in determining the level of advertising necessary to reduce the asymmetry in consumer response due to price and income changes. Substitution patterns obtained from the proposed analysis will aid managers to decide upon prices of closely related products within a category in the wake of income changes. The proposed model provides a methodology to explore and test market structure.