Marketing Model (BA ZC 421) Sidharth Mishra 13/01/2021: BITS Pilani BITS Pilani

BITS Pilani
Pilani Campus
Marketing Model (BA ZC 421)

Sidharth Mishra
13/01/2021
Course Instructor
• Sidharth Mishra
• B. E. from NIT, Rourkela (Mechanical Engineering), PGDM from IIM, Ahmedabad
(Marketing and Finance)
• 25 years experience in the corporate sector, Consumer Durable and Ed Tech
space.
Contents
• Modelling – Definition and Scope

• Types of Models
• Purpose
• Methodology
• Marketing Model – a case study.
• Course Outline
• Course Objective
• Frequency Distributions
• Bernoulli’s, binomial, Negative binomial, Poisson, Normal Distribution
COURSE INTRODUCTION
• Most students would have gone through basic and more advanced courses on
marketing. They would be familiar with concepts like Segmentation, Targeting and
positioning, product management and pricing among other things. They would
have looked at marketing problems using the case approach.
• In this course we shall see how marketing decisions can be fine tuned using
quantitative modelling methods to predict consumer behaviour, decide on product
features, analyse pricing issues and improve the overall quality of marketing in an
increasingly cluttered and complex world of business.
• The pedagogy would combine exposition of concepts with the solving of
problems/cases to obtain a better grasp.
Model definition
A system or thing used as an example to follow or imitate.
Example: Rutherford’s Model of the Atom (Physics)
In the above model the positively charged protons were considered to be residing at
the center while the negatively charged electrons revolved around them.
The model, with certain assumptions was used to predict the behaviour of atom.
Similar models are created in marketing to understand/predict buyer-intermediary-

supplier behaviour based on certain assumptions.
Types of Models
• Measurement Model
• Measuring Demand, Impact of an ad campaign etc.
• Decision Support Model
• McDonald’s gets differing reception in different parts of the world. It needs
decision support models to improve its chances of success.
• Theoretical Model
• Used to understand marketing phenomena
• Ex: The demand of certain essential goods (Griffin Goods in Economics)
increases as their prices increase. This is obviously counterintuitive and
needs theoretical modelling for understanding.
Examples
• Pricing of a product line to avoid cannibalization (Dobson-Kalish Model)

• Product attribute / Price Management in a competitive set up. (Hotelling Model)
• Perceptual Models to identify gaps in the market.
Riding Comfort
I
Economy
L H
Perceptual Map
Marketing Model Caselet
A Model to solve a marketing case.

• Rajnish Mishra has just been appointed as the Area Sales Manager in charge of
the city of Indore in Madhya Pradesh in April, 1997. He had been hired by a well
known consumer electronics firm (CE) which had been a late entrant in the Indian
market and was fighting to gain market share against a slew of well established
brands. His company had given him a target of achieving a 10% market share in
the city.
• A quick trip to the market gave him a picture of the consumer electronics trade in
the city. The business was dominated by 5 big counters. There were a number of
small counters who were trying to establish their footholds in the city.
Unfortunately for them the dynamics of the trade did not make it an easy task. The
electronics good customer was fairly counter-loyal. People had a tendency to flock
to the same show room to purchase their TVs from where they or their parents
had once purchased the first family radio.
• From discussions with various people from the trade Rajnish gathered the
following picture from the trade.
Marketing Model Caselet
• The market was dominated by 5 brands viz. BPL,Videocon,Onida and the Korean
chaebols LG and Samsung.
• There were 5 major counters in the city which have been represented by the
letters A,B,C,D and E in the case. There were a number of smaller counters which
were upgrading from selling black and white televisions to color televisions. The
top counters (A,B,C,D and E) were also working as distributors of various brands
of color televisions and the smaller stores were actually buying from them.
• The number of brands and televisions sold by each counter are given on the next
slide.
• Consumer electronics items like CTVs, Refs and Washing Machines were sold to
dealers and retailers on 45 days’ credit.
• His company CE Electronics was also reporting a collection problem.
Marketing Model A sample
counter total
Brand A B C D E size < 10* sales market share • Rajnish concluded that in order to improve
BPL 50 0 30 40 0 30 150 0.24 his market share he needs to improve his
Videocon 70 40 110 0.18
Onida 30 30 60 30 150 0.24 addressal.
LG 30 20 50 0.08 • Most of the bigger dealers were not stocking
Samsung 20 40 20 80 0.13 his product because of the large number of
CE 0 10 0 0 0 20 30 0.05
Others 20 10 10 10 50 0.08 Smaller players who were cutting price and
Total 100 120 80 100 90 130 620 hence reducing margins.
Addressal % 16 19 13 16 15 21 100 • His predecessor was billing directly to the smaller
Extraction% 0 0.083 0 0 0 0.15 0.05
Total Market 620
players which had alienated the bigger dealers who
Total were also into distribution.
Addressal 250 40.32% Example • He appointed a big dealer D as his distributor for
Total Sales 30
Total the smaller dealers. This gave him access to D’s
Extraction 12% Retail business also which improved his addressability.
Addres • With reduced price competition it was easier to
Marker sal*Ext
Share raction 5% Motivate the bigger retailers to focus on his brand.
He added to it with better in-shop promotion to
Improve extraction and consequently achieve his
market share target.
Addressal = Total sale (all brands) from counters where the brands is present / market Size
Extraction = Total sale of brand in question / Total sale of all brands from counters where the brand is present.
The Complexity of Marketing
1. Marketing Mix interaction
1. 4Ps influence each other.
2. Competitive Effects
1. Effects of competitor action.
3. Delayed Response
1. market response to a stimulus is not immediate.
4. Multiple territories.
1.Different territories giving different responses.
5. Multiple Products
1. multiple products affecting each other’s sales (cannibalization)
6. Functional Interactions
1. Marketing interacts with other departments.
7. Multiple Goals
1. The company follows multiple goals like sales and profit maximisation.
Marketing Model What it can do?
• We can use the modelling process to improve our marketing insights. Here are a
few examples.
• The efficacy of schemes
• A company launched a scheme and had its sales numbers increase. Was it
purely because of the scheme or were there other factors?
• The probability of purchase of a brand given a customer’s past buying
behaviour.
• Finding the probability of purchase of a particular product by a buyer given
his/her stated utility of competing options.
• Formulating a pricing decision in a way as to minimize product cannibalization
especially for a company with a product line comprising a large number of
products.
• Optimizing the features of a product.
• Predicting demand
Course Overview
• Introduction to marketing model

• Model Consumer Behaviour
• Business to Business Market
• Pricing Models
• Product Modelling
• New Product Introduction Models
• Modelling for Promotion (Advertising)
• Distribution
Course Objective
1. The course will assist students to acquire the quantitative skills needed to explore
and undertake such analyses and decision making
2. The course will help to develop the quantitative foundations for marketing decisions
in terms of both theoretical models to help analyze marketing issues and also decision-
support models
3. Provide students with an understanding of how to create theoretical marketing
models and to use mathematical logic and computer models to extract linkages among
several decision variables
4. Improve students' skill in viewing marketing processes and relationships
systematically and analytically.
Background
• Frequency Distributions
• Calculus
• Elementary Differentiation and Integration
• Probability and Statistics
Frequency Distribution
• Frequency Distributions are important to understand consumer behaviour.

• A tea stall owner is located inside an apartment complex that houses 10,000
people. A typical person in the complex makes three visits to the shop on a day
and consumes a cup of tea on each visit. How many cups of tea can the vendor
expect to sell on a standard day?
• The answer to the above question can be modelled by assuming a distribution of
the above behaviour across the population of 10000 that inhabits the complex.
You may note that everyone in the complex may not consume 3 cups of tea like
the person mentioned in the question.
• There are many distributions available in statistics to model problems of the above
kind. Some of the distributions we would encounter would include, Bernoulli
distribution, binomial distribution, negative binomial distribution, Poisson
Distribution, Normal distribution, Logistic, Beta and Gamma distribution.
Distribution of marks in a class
Roll Nos Marks Roll No Marks Score Interval frequency* probability

1 40 11 19 0-10 2 0.1
2 38 12 45 11-20 3 0.15
21-30 4 0.2
3 25 13 36
31-40 7 0.35
4 12 14 41 41-50 4 0.2
5 17 15 39 total 20 1
6 42 16 8
7 36 17 27
• Frequency = number of students
8 33 18 3 in the specified marks band.
9 22 19 40
10 21 20 42
Question: If a student is taken randomly from the class, what is

the probability that he/she would have a score between 31 and
The table represents the marks scored by 40?
20 students of a class in a particular subject Answer: 35%
from a maximum of 50.
Distribution
• In a class the student roll numbers have been arranged as per their academic
proficiency. It has been stated that you can approximate a particular student’s
score in a subject by using the following formula.
• Score of a student = Xe-k(Rollnumber)
Where X is the full marks associated with the subject and k is a constant which
varies from subject to subject and has been determined through experimentation.
As you can see, one can use that formula to predict scores of students ins
different subjects. For example, in the subject of Mathematics, if the full marks is
100, the value of k is 0.02 the score of the student with roll number 10 can be
estimated to be 100*e-0.02(10) = 81.
e is Euler number which is extensively used in mathematics and has a value equal to 2.72.
Important Terms
• Random Experiment
• Sample Space
• Elementary Event
• Random Variable
• Discrete Variable
• Continuous Variable
• Distribution
• Discrete
• Continuous
Important Terms
• Experiment
• An experiment in probability is a trial which has a well defined set of outcomes and can be
infinitely repeated.
• Tossing of coin, Rolling of a die
• An experiment is considered to be deterministic if it has only one outcome. It is called a random
experiment if it has more than one outcomes. A Bernoulli experiment is one with exactly two
outcomes (head/tail, pass/fail, sale/no sale
• Trial
• Each performance of an experiment is called a trial e.g. one toss of a coin, one roll of a die.
• Outcome
• The result of a trial is called an outcome or an elementary event.
• Sample Space
• A sample space relates to the outcomes of an experiment. The set of all possible outcomes of a
given experiment is called the sample space associated with that experiment. {H,T} in case of
one toss of a coin, {1,2,3,4,5,6} in case of a roll of a die. {HH, HT, TH, TT} in case of one toss of
two coins.
• Event is a subset of a sample space. For example in the experiment of tossing two coins the
outcomes involving one head are covered by the subset {HT, TH} constitutes an event.
Bernoulli Distribution
• Bernoulli distribution deals with one random experiment with exactly two
outcomes.
• Examples
• The toss of a coin which yields only two outcomes (Head, Tail)
• The purchase possibility of a customer (buy or not buy)
• The probability of a manufactured unit passing the quality test. (Pass, Not pass)
• Expression
• P(X=x) = =for x = 0 or 1
= 0 for all other values of x.
• Example:
Based on his past behaviour, a customer buys Lux soap 4 out of every 5 times he
visits the supermarket. What is his probability of buying Lux on his next visit there?
Solution
If you labeled the customer’s purchase of Lux a success and non-purchase a failure,
p = 4/5 = 0.8. His probability of being a “success” on the next visit = ( 0.8 )1 ( 1− 0.8 )1 −1
= 0.8.
Binomial Distribution
• Binomial distribution is the extension of Bernoulli’s distribution to include multiple

random experiments.
• Example:
A die is rolled 10 times. What is the probability of getting ‘6’ exactly 4 times?
The probability of getting a “6” in a single roll of dice = 1/6
One can get 4 sixes in 10 rolls in 10C4 ways. The remaining 6 rolls have to necessarily
be without sixes so as to get exactly four favourable outcomes (sixes).
10 4 10 − 4
The probability is given by the expression 4 ❑ 𝐶 ( 1/6 ) ( 5/6 )
and is equal to 0.0542.
A random variable X is said to follow binomial distribution if it assumes only non-
negative values and its probability is given by the following expression.
P(X=r) = where r = 0,1,2,3….n
0 otherwise = n!/ (r!)(n-r)! where n! = n(n-1)(n-2)…3.2.1

Conditions for a binomial distribution:
1. Binomial distribution involves a finite number (n) of trials.
2. Each trial has only two mutually exclusive and collectively exhaustive outcomes.
3. The trials are independent of each other.
4. The probability of success p is constant for each trial.
Applications
Some of the applications are illustrated in the example section.
Binomial is a discrete distribution where the random variable takes only specific
integral values. In the dice example given in the previous slide is illustrative. The
number of sixes can only be whole numbers and can never be fractions.
However, we shall see later how binomial distribution gives rise to a number of
continuous probability distributions including the famous Normal (Gauss) distribution.
Binomial Distribution Example
• Question
The probability of a customer buying something from a coffee outlet is 0.8 each time
he visits the same. On a particular day he has visited the outlet 5 times. What is the
probability he made exactly 3 purchases? What is the probability he made at least 2
purchases?
Solution
The above case represents a finite number of trials (5). The probability of success
(purchase made on part of the customer) is constant. The other probability is not
making a purchase which is mutually exclusive to the original outcome of purchase
and both put together constitute a collectively exhaustive list of outcomes of the
random experiment (the customer’s visit). The number of purchases cannot be
negative.
The above mentioned situation fits the conditions of a binomial distribution.
Probability of exactly 3 purchases = P(X=3) = 𝐶 53 ( 0.8 )3 ( 0.2 )5 − 3 = 0.205
Probability of at least 2 purchases = P(2)+P(3)+P(4)+P(5) = 1-P(0)-P(1)
5 0 5−0 5 1 5 −1
• Please note that P(0)+P(1)+P(2)+P(3)+P(4)+P(5) = 1. They cover the whole

spectrum of outcomes over 5 trials. The customer can choose not to buy even on
one occasion to buying during all 5 visits. Hence the probabilities would add up to
a certainty of 1.
Negative Binomial Distribution
• As we saw before, the probability of occurrence of a desired outcome over a large

number of trials is expressed by using a binomial distribution provided the
experiment satisfies other conditions associated with the distribution.
• The probability of obtaining a desired number of successes after a stated number
of failures is obtained using negative binomial distribution. Please see the example
given below.
• Example
• An ice cream vendor has entered a colony with 5 sticks of ice cream in his push
cart. From prior experience he knows that the probability of making his sell at each
house is 0.1. What is the probability that he would be able to exhaust his stock
exactly at the 11th house?
• Solution on next slide.
Example
An ice cream vendor has entered a colony with 5 sticks of ice cream in his push cart. From prior experience he
knows that the probability of making his sell at each house is 0.1. What is the probability that he would be able to
exhaust his stock exactly at the 11th house?
• Solution
• The vendor would sell the last piece of ice cream at the 11th house. This implies he
would have sold 4 ice creams in the 10 houses he had covered earlier. This is a
case of binomial distribution we had studied earlier.
• Pr( 4 sales (successes) in 10 preceding houses (trials)) = -1
• Pr (last sale in the 11th house) = 0.1 -2
• probability of the vendor exhausting his stock at the 11th house= 1X2 10− 4
10 5 ❑
= x = exact number of failures = 6 𝐶 4 ( 0.1 ) ( 0.9 )
𝑥 +𝑟 −1 𝑟 𝑥
P(X=r) = 𝐶 𝑟 − 1 𝑝 ( 1− 𝑝 )
= 0.0011
r = exact number of successes=5
No of trials = x+r = 11
Definition
A random variable is said to follow negative binomial distribution with parameters r
and p if its probability is given by
𝑥 +𝑟 −1 𝑟 𝑥
P(X=r) = 𝐶 𝑟−1 𝑝 ( 1− 𝑝 ) , x = 0,1,2,3…..
0 otherwise. Here x is the exact number of failures before r successes.
In the example, the vendor would encounter exactly 6 failures before exhausting his
stock by selling the last stick at the 11th house.
Poisson Distribution
• Poisson Distribution is applicable to illustrate events which affect a large body of
people but have a relatively low probability of occurrence.
• Applications
• Incidence of heart disease (or cancer etc.) in a city.
• Number of faulty items in a batch
 of production
• Number of phone calls received by a call centre during a given time period on a
day.
• Number of purchased made by the inhabitants of a colony from a local grocery.
𝑒− 𝜆 𝜆 𝑥
• Expression 𝑃 ( 𝑋=𝑥)=
𝑥!
• where 𝜆 is the parameter of the distribution and is equal to ‘np’ where n is the
population and p the probability of occurrence of the event. 𝜆 is a measure of the
average occurrence of an event. A consumer electronics company has 100,000 𝜆
customers in a city. Probability of a customer calling on a particular day =
1/10,000. The probability of calling is Poisson distributed with the parameter𝜆
= 100,000*(1/10000) = 10
• Poisson Distribution is a special case of a binomial distribution.
Poisson Distribution Examples
Question1:
On a city of 10,000 people the probability of a person suffering from a heart attack on
any random day is 1/1000. Find the probability that on a particular day the hospitals
of the city would get exactly 8 heart patients.
Solution:
Here n = 10,000, p= 1/1000
As n is high and p small, the above distribution can be described in Poisson manner
with parameter = 10,000 * 1/1000 = 10
𝑥 −𝜆
P( X=x) = 𝜆 𝑒 = 𝑒−10
10 𝑥
Probability distribution of patients Note: You may calculate the probabilities on your own
and check for practice from the table shown here.
𝑥! 𝑥! Exact no of The distribution can be used in various ways.
patients Probability- calculated
For example the probability that the hospital
𝑒−10 108
0 0.000045
would have less than four patients on a
P(X=8) = = 0.112 1
2
0.00045
0.00225 particular day = P(0)+P(1)+P(2)+P(3) etc.
8! 3 0.075
4 0.079
Poisson Distribution
• Question2
A car hire firm has two cars, which it hires out day by day. The number of demands
for a car on each day is distributed as a Poisson distribution with mean 1.5. Calculate
the proportion of days on which (i) neither car is used and (ii) the proportion of days
on which some demand is refused.
Solution
(i) This is a 0case− 1,5
of 0 demand.
1.5 𝑒
P(X=0) = 0! = 0,2231
(ii) This is a case of demand exceeding 2 cars.
1.5 0 𝑒− 1,5 1.5 1 𝑒 −1,5 1.5 2 𝑒 −1.5
P(X>2) = 1-P(X=0)-P(X=1)-P(X=2)= 1 – 0!
– 1!
– 2! = 0.19126
Poisson Distribution Example
• Question-3
A grocery store inside a colony on an average gets 10 customers on a day. What is
the probability that on a particular day it would get less than 3 customers.
Solution:
P(< 3 customers) = P(0)+P(1)+P(2) P(1) = Probability of getting 1 customer
10 0 − 10
𝑒 10 1 𝑒 −10 10 2 𝑒 −10
= + +
0! 1! 2!
= 0.00276
Normal Distribution Introduction
• All distributions we studied this far were ‘discrete’ in nature. The random variables
involved could only take specific values. For example, the event of getting a six in
multiple throws of a die can only take integral values like 1, 2 or 3. It cannot take
fractional values.
• But then there are variables like age, income, purchased quantity etc. used in
marketing which can take fractional values. In fact the items mentioned above can
take values of all real positive numbers. They are examples of continuous
variables. Their variations are described using continuous distributions.
• The Normal distribution (or Gauss distribution) is the most well known example of
a continuous random distribution.
Normal Distribution
Definition
A random variable is said to have a normal distribution with parameters 𝜇 (mean)
and 𝜎 (standard deviation) if its probability is distributed as per the following
expression. The expression is called the probability distribution function.
2
− ( 𝑥 −𝜇 )
1 2𝜎
2
𝑓 ( 𝑥 , 𝜇, 𝜎 )= 𝑒
𝜎 √ 2 𝜋 where 𝜇 all values from
x and can take to − ∞and ∞is 𝜎
positive. The above expression is simplified to by
( 𝑥 − 𝜇)
substituting with z.
𝜎
Probability as area under curve

Probability of the random variable taking values
between P1 and P2 is given by the area under the P1 P2
normal distribution curve. In the adjoining figure the area
Normal Distribution
• A normal distribution is specified by two parameters𝜇 and 𝜎, is sometimes

represented as N( , 𝜎).


• The normal distribution of a random variable X is a bell shaped curve which is
symmetrical about X = 𝜇
• The values taken by X stretch from - ∞ to ∞ . This limits the usage of Normal
distribution in marketing where situations concerning negative numbers usually do
not arise. It is a little abnormal to think it terms of negative sales and market
shares.
• A binomial distribution would tend to be “normal” as the population n approaches
infinity. This can be mathematically proven. If the parameters of a binomial
distribution are n and p, the parameters of the corresponding normal distribution
would be 𝜇 = np, 𝜎= [np(1-p)]1/2
Normal Distribution Example
• Question
• The random variable X is normally distributed with a mean of X is 12 and standard
deviation is 4. Find the probability of the following.
(a) X >= 20 (b) X < 20 (c) 0<=X<=12
Solution
The problem aims to familiarise the student with the usage of a normal distribution
table to calculate probabilities. A sample normal distribution table is given in the next
slide.
Step:1
The normal distribution has mean 𝜇 = 12 and standard deviation 𝜎 .= 4
( 𝑥 − 𝜇)
Convert X into its z version using the formula z = 𝜎
20− 12
For X = 20, z = 4
=2
• Step 3
• The probability is represented by the hatched area shown from z=2 to infinity as
shown in the figure below.
• This area is equal to the area under the normal distribution curve spreading from
AB to infinity – (minus) the area under the enclosed space ABPC.
The area represented by the normal distribution curve spreading from –(infinity) to +
(infinity) is 1 and by symmetry the area from AB to infinity is equal to A
0.5.
C
The area under the enclosed space is obtained from the
normal distribution table shown on the next slide and is B P
Z=2
Equal to 0.4772. Hence the said probability = 0.5-0.4772 = 0.0228
b. P(X<20) = 1- P(X>=20) = 1- 0,0228 = 0.9772

c. Follow the same steps as sub question a.
The z values would turn out to be -3 and 0. It has been worked out in the box below.
P(-3<=z<=0) is shown by the area of the curve as given in the adjoining diagram.
By symmetry this is equal to the area covered under 0<=z<=3.
The area is equal to 0. 4987 as obtained from the normal distribution table given
overleaf.
0 −12
When X = 0, z = 4 = -3
X = 12, z = 12 −12 = 0 -3 0 3
4
Normal Distribution Table
Note:
1. Almost all normal distribution tables are one sided in the positive
direction probabilities from the negative side are calculated using the
principle of symmetry.
2. The left most column denotes the value of z up to first decimal. The
top row denotes the second decimal value of z. If you want to find the
Probability for z = 2.38, you should look up 2.3 on the left most colum
and follow the top row to the right up to the digit 8. The answer is
0.4913.
Normal Distribution Applications
• A town has a population of 100,000. As per market research, the mean age of the
population is 30 and the standard deviation is 5. A manufacturer of premium jeans
wants to find the size of the population which is in the age group of 26 to 40
assuming age to be normally distributed. How many people in the city fall under
this age group?
Solution
The normal distribution has a mean 𝜇 = 30 and a standard deviation 𝜎 = 5.
At x = 26 and 40, the values of z would be -0.8 and 2.
The probability of a person lying in this age group is given
by the area hatched.
P(-0.8 <z<2.0) = P(-0.8<z<0) + P(0<z<2.0) = P(0<z<0.8)+P(0<z<2)
26 30 40
= 0.2881+0.4772 = 0.7653
The number of people in the age bracket = 0.7653*100,000 = 76530
A fairly young city, isn’t it?
Normal Distribution Application
• A coffee shop is located inside a colony of 600 people. The probability of a

resident turning up at the shop on any day is 0.05. How many chairs should the
shop place so as to ensure that the probability of a potential customer not finding a
seat and leaving disappointed is less than 10% ?
Solution
This is strictly a binomial distribution problem where n is 600, p is 0.05 and we are
being asked to find the unknown variable “x” (the number of chairs) so that the
binomial probability of the number of people at the coffee shop exceeding x is less
than 10%.
This would be a unwieldy problem though if solved the binomial way as we have to
find “x” which solves the equation
<10%
The problem can be handled with greater ease if the binomial distribution is
approximated to a normal one.
Normal Distribution
• The mean and s.d of a binomial distribution with parameters n and p equal np and
√¿¿ respectively. We shall now approximate the distribution to normal
distribution with the same parameters.
np = 600*0.05 = 30
√ ¿¿ =[600*0.05*(1-0.05)]1/2 = (28.5)1/2 = 5.34
It is the normal distribution N(30,5.34) and we have to find the number of chairs
x such that the area of the curve to its right (shown hatched) is equal to 0.1.
This means the area under ABDEC in the normal curve A
shown in the figure is equal to 0.5 -0.1 = 0.4 C

This corresponds to the value of z = 1.28 in the normal x
B D
distribution table. (see corresponding slide).
𝑥 − 30
Hence 5.34 = 1.28
On solving x = 30+ 1.28*5.34 = 37
• Question
A manufacturer of vests (banyans) wanted to understand the distribution of vest
sizes of men in a particular state in order to arrive at their production plan. In a
sample study conducted with the help of a market research firm they obtained the
following data. Fit the data into a normal distribution and obtain how many vests they
should produce in the 82 to 87 size group if their total production plan for the state is
100,000 for a particular month.
Size 60-65 65-70 70-75 75-80 80-85 85-90 90-95 95-100
Frequency 3 21 150 335 326 135 26 4
Normal Distribution Solution
(i) We have a normal distribution with
class interval mid point(x) frequency (f) fx mean deviation(d) f.d^2
Parameters 79.945 and 5.445 as obtained
60-65 62.5 3 187.5 79.945 -17.445 913.0 from the adjoining table.
65-70 67.5 21 1417.5 79.945 -12.445 3252.4 (ii) The proportion of people in the 82-87
70-75 72.5 150 10875 79.945 -7.445 8314.2 range is determined as below.
The values of z for the extreme cases are
75-80 77.5 335 25962.5 79.945 -2.445 2002.6
= 0.377
80-85 82.5 326 26895 79.945 2.555 2128.1
= 1.30
85-90 87.5 135 11812.5 79.945 7.555 7705.5
90-95 92.5 26 2405 79.945 12.555 4098.3 The area under the curve = 0.4032 – 0.1480
95-100 97.5 4 390 79.945 17.555 1232.7
= 0.2552 from normal table.
The company should produce 25520 vests
total 1000 79945 29646.98
of this size.
Mean 79.945 variance 29.647
std. dev. 5.445
0.377 1.30
BITS Pilani
Pilani Campus

Sidharth Mishra
Lecture-2
Contents
• Gamma Distribution
• Five Stages of Consumer Behaviour
• Stochastic Model of Purchase Incidence
• Death Rate Models
Gamma Distribution
• The usage of normal distribution in marketing gets constrained by the fact that is
has a spread from - ∞ to +∞.
• We usually don’t deal with situations of negative purchases. While studying
purchases, especially when purchase behaviour needs be aggregated over a
population, Gamma distribution is preferred.
• The probability density function for Gamma Distribution is described as follows.
wh
• The cumulative density function is also given.
• F(x/ r, α) = ʃ dx where the integration is done from 0 to x.
• The above gives probability of x staying in the range 0 to x.

• Г(r) = (r-1).(r-2)…3.2.1 (for example Г(4) = 3.2.1 = 6)
Normal and Gamma Distribution
Normal Distribution g(x/μ,σ) = Gamma Distribution g(x/α,r)=
x1 x2
x1 x2
• Normal Distribution spreads on both negative and • Gamma Distribution spreads only on the Positive side of
Positive sides of the number line. the number line.
• The area under the curve (shown hatched) represents • It can be proven that for higher values of r the gamma Distribution approaches
the probability that the variable would lie between x1 and x2. normal distribution. The area under the
Curve represents the probability that the variable would lie between X 1 and x2 .
Gamma distribution is used to describe the sizes of insurance claims, amounts of rainfall,
For a normal distribution with parameters as given, the values of mean
number of cancer occurrences across age groups
and variance are μ and σ respectively.
In a particular area etc. We shall use it to study the phenomenon of Purchase incidence.
For a gamma distribution with parameters , the mean and variance are r/α and r/α2
Respectively.
Gamma Distribution Problem -1
A Coffee outlet inside a college campus did a market study and found that the average daily consumption of coffee amongst
Students and staff of the college followed a gamma distribution pattern with r =2 and α =1. The company was interested in finding
the size of the high consumption segment, defined as people whose daily consumption of coffee exceeded 4 cups. Find
the answer if the number of people inside the campus is 5000. = 0.91
Solution:
As is evident, the heavy coffee-users would fall on the right side of the hatched
Area.
The expression for the gamma distribution g(x/r=2, α =1) =
The total area under the curve = 1.

Hence the hatched area = 1 – Area under the gamma curve between 0
X =4
and 4 = 1 – = 1 -0.91 = 0.09
This implies 9% of the total population would fall under the heavy user category.
No of customers = 9% *5000 = 450 (Answer)
Gamma Distribution Problem 2
• In the above problem, the market study found that the average daily consumption
of the students and staff on the campus was 2 cups of coffee. The standard
deviation was also 2. Find the gamma distribution and the number of heavy users
as mentioned in the previous question ?
The mean and standard deviation of a gamma distribution with parameters r and α is and respectivel
=2 = 2.
Dividing them , we get α = 1 and r = 2. The remaining part is similar to the previous problem.
.
Gamma Distribution
• The Poisson distribution is described with one parameter. The Gamma distribution
employs two parameters to describe the behavior of a variable. Important points
concerning the gamma distribution have beenr given r 1 
below.
• Probability density function = g ( / r ,  )    e
( r )
r 1
( )i 
• Cumulative density function = F ( / r ,  )  1   e
i 0 i!
if r is an integer. The non integer case is out of the scope of our discussion.
The cumulative density function gives the actual probability illustrated
in the next slide using an example.
In the market model under discussion the Poisson distribution tracks an individual
consumer’s behavior in terms of her mean purchases in unit time ( a day in the
given case). Her behavior is then aggregated over the population where the
same mean is assumed to be gamma distributed.
Gamma Distribution
• Let us illustrate gamma distribution with an example of a grocer in a housing

society. The population of the housing society is vary large. The mean rate of
purchase from the grocer per day by the residents of the housing society can be
described by the following gamma distribution.
0.53  31 2 e0.5

f ( X   / r, )    0.5, r  3
(3)  3!
(0.5*3)i 0.5*3
P(  3 /   0.5, r  3)  1   i  0
i 31 2
e
i!
1 2
1.5 1.5
 1  e 1.5 (1   )  0.191
1! 2!
Contents
• Discrete Distributions
• Bernoulli’s Distribution
• Binomial Distribution
• Negative Binomial Distribution
• Poisson Distribution
• Continuous Distribution
• Normal Distribution
Important Terms
• Random Experiment
• Sample Space
• Elementary Event
• Random Variable
• Discrete Variable
• Continuous Variable
• Distribution
• Discrete
• Continuous
BITS Pilani
Pilani Campus

Sidharth Mishra
Lecture-3
Contents
• Gamma Distribution
• Stochastic Processes
• Consumer Behaviour Stages
• NBD (Negative Binomial Distribution) model of purchase incidence
• Death Rate models
• Joint and conditional probability
Five Stage Consumer Behavior Model
Sl No. Stage Description Models

Stochastic Models of Purchase Incidence
– NBD Model
1 Need Arousal Discrete Binary Choice Models
Individual Awareness models
Consideration Models
2 Information Search Information Integration Models
Perception Perceptual mapping
Attitude Models
Non-compensatory
3 Evaluation Preference Compensatory
Multinomial Discrete Choice Models
4 Purchase Markov Models
Variety Seeking Models
Satisfaction Model
5 Post-Purchase Communication and Network Models
Gamma Distribution
• The usage of normal distribution in marketing gets constrained by the fact that is
has a spread from - ∞ to +∞.
• We usually don’t deal with situations of negative purchases. While studying
purchases, especially when purchase behaviour needs be aggregated over a
population, Gamma distribution is preferred.
• The probability density function for Gamma Distribution is described as follows.
wh
• The cumulative density function is also given.
• F(x/ r, α) = ʃ dx where the integration is done from 0 to x.
• The above gives probability of x staying in the range 0 to x.

• Г(r) = (r-1).(r-2)…3.2.1 (for example Г(4) = 3.2.1 = 6)
Normal and Gamma Distribution
Normal Distribution g(x/μ,σ) = Gamma Distribution g(x/α,r)=
x1 x2
x1 x2
• Normal Distribution spreads on both negative and • Gamma Distribution spreads only on the Positive side of
Positive sides of the number line. the number line.
• The area under the curve (shown hatched) represents • It can be proven that for higher values of r the gamma Distribution approaches
the probability that the variable would lie between x1 and x2. normal distribution. The area under the
Curve represents the probability that the variable would lie between X 1 and x2 .
Gamma distribution is used to describe the sizes of insurance claims, amounts of rainfall,
For a normal distribution with parameters as given, the values of mean
number of cancer occurrences across age groups
and variance are μ and σ respectively.
In a particular area etc. We shall use it to study the phenomenon of Purchase incidence.
For a gamma distribution with parameters , the mean and variance are r/α and r/α2
Respectively.
Gamma Distribution Problem -1
A Coffee outlet inside a college campus did a market study and found that the average daily consumption of coffee amongst
Students and staff of the college followed a gamma distribution pattern with r =2 and α =1. The company was interested in finding
the size of the high consumption segment, defined as people whose daily consumption of coffee exceeded 4 cups. Find
the answer if the number of people inside the campus is 5000. = 0.91
Solution:
As is evident, the heavy coffee-users would fall on the right side of the hatched
Area.
The expression for the gamma distribution g(x/r=2, α =1) =
The total area under the curve = 1.

Hence the hatched area = 1 – Area under the gamma curve between 0
X =4
and 4 = 1 – = 1 -0.91 = 0.09
This implies 9% of the total population would fall under the heavy user category.
No of customers = 9% *5000 = 450 (Answer)
Gamma Distribution Problem 2
• In the above problem, the market study found that the average daily consumption
of the students and staff on the campus was 2 cups of coffee. The standard
deviation was also 2. Find the gamma distribution and the number of heavy users
as mentioned in the previous question ?
The mean and standard deviation of a gamma distribution with parameters r and α is and respectivel
=2 = 2.
Dividing them , we get α = 1 and r = 2. The remaining part is similar to the previous problem.
.
Gamma Distribution
• The Poisson distribution is described with one parameter. The Gamma distribution
employs two parameters to describe the behavior of a variable. Important points
concerning the gamma distribution have beenr given r 1 
below.
• Probability density function = g ( / r ,  )    e
( r )
r 1
( )i 
• Cumulative density function = F ( / r ,  )  1   e
i 0 i!
if r is an integer. The non integer case is out of the scope of our discussion.
The cumulative density function gives the actual probability illustrated
in the next slide using an example.
In the market model under discussion the Poisson distribution tracks an individual
consumer’s behavior in terms of her mean purchases in unit time ( a day in the
given case). Her behavior is then aggregated over the population where the
same mean is assumed to be gamma distributed.
Gamma Distribution
• Let us illustrate gamma distribution with an example of a grocer in a housing

society. The population of the housing society is vary large. The mean rate of
purchase from the grocer per day by the residents of the housing society can be
described by the following gamma distribution.
0.53  31 2 e0.5

f ( X   / r, )    0.5, r  3
(3)  3!
(0.5*3)i 0.5*3
P(  3 /   0.5, r  3)  1   i  0
i 31 2
e
i!
1 2
1.5 1.5
 1  e 1.5 (1   )  0.191
1! 2!
Stochastic Process
• A stochastic process involves one or more random variables. A stochastic process

is one where the evolution (the way things shape up) is partially or fully random in
nature and if the process is run over several times, it will NOT give identical
results.
• Stochastic processes may be contrasted with deterministic processes where the
system evolves in an exact predictable manner over a period of time. A
deterministic process will always give identical conclusions with the same starting
conditions.
Stochastic Process Example
• Given the choice between Coke, Pepsi, Limca and Sprite, Shyam chooses Coke
60% of the time, Pepsi 20% of the time, Limca and Sprite each 10% of the time.
• Stochastic models are appropriate in studying consumer behaviour for low
involvement purchases which are often impulse driven and are not classified by a
clear cause and effect relationship.
• In the above example, Shyam may not always be able to explain his preference on
any particular occasion to any clear factor. He may say “I don’t know.” and shrug
the question off.
• A large number of small value, frequently purchased consumer items fall under
this category.
• Most stochastic models use a mixing approach to study customer behaviour. They
pick up a characteristic represented by a model parameter(see next slide). This
characteristic is then aggregated over the population using a probabilistic
distribution (gamma distribution in the NBD model discussed later) to capture the
market behaviour.
Stochastic Model - Advantages
• Determination of efficacy on marketing inputs

• A marketing scheme has resulted in a spurt in sales. But has it
come from new buyers? Or it has come from existing buyers who
have only stocked the goods for future usage?
• Identifying “alive” customers from a data base.
• An alive customer is one still interested in the product despite
limited usage in the immediate past.
• Evaluating the probability of a new product’s success based on trial
and repeat purchase data.
Assumptions NBD model for purchase incidence
•Poisson Purchasing Behavior: The individual’s purchase behavior is assumed to follow a Poisson distribution.
•P(X=x/ ) =
Thus an individual who has a mean number of 2 purchases per day would have her purchase pattern given by the expression
Probability of this individual making 3 purchases in a day = P(X=3/2) =

r and α (alpha) are the parameters of the gamma distribution.
 x e 
•Gamma distribution of purchase behavior of households. The mean purchase of individuals ( ) as mentioned above is considered distributed among the population as per the expression given below. Gamma distribution has been covered in detail in the following slide.
•Stationarity
x!
•The purchase parameters DO NOT significantly change over time.
2 x e 2
P ( X  x / 2) 
x!
23 e 2
 0.18
3!
 r  r 1e 
g ( / r ,  ) 
(r ) 𝛤 𝑖𝑠𝑝𝑟𝑜𝑛𝑜𝑢𝑛𝑐𝑒𝑑 𝑔𝑎𝑚𝑚𝑎 . 𝛤 (𝑟 )=(𝑟 −1)!
Aggregate of a population

P ( X  x / r ,  )   P ( X  x /  ) g ( )d 
0
x  r 1  r 1 x This is identical to the expression

C x ( ) ( )
  1   1 for negative binomial distribution.
r Hence the name.
E( X ) 
 Expectation
When I throw a dice what is the expected score
r 1 1 (1/6). 2(1/6), 3((1/6), 4(1/6). 5(1/6). 6(1/6)
E ( X 2 / X 1  x)  ( )x 1*1/6+2*1/6+3*1/6+4*1/6+5*1/6+6*1/6
 1  1
Illustration
redit card company runs a promotion scheme to induce usage among low users. The company
gmented its user behavior based on information from its database. Based on prior research, the com
s found its customer base to be gamma distributed with r=0.07, α=0.19
Actual Purchase
pected number of usages by a customer No of History of during promotion NBD
customers Purchase period Projection Difference
uring the scheme period / his usage 880 0 185 53 132
the previous period =0) 53 1 57 48 9
0.07 1 24 2 45 41 4
E ( X 2 / X 1  0)  ( ) *0 14 3 31 35 -4
0.19  1 0.19  1 29 4 165 166 -1
0.06 1000 483 343 140
ojected purchase by the 880 zero base customers in the normal course of events would have been
06*880 = 53.
u can similarly find out the NBD model projection for other usage classes.
Illustration Analysis
• The scheme has been significantly successful in inducing usage among non-
users.
• It has not been as successful with low volume users (1 or 2 usages in the past
period).
• It has had a negative effect on frequent users. Given that the deviations are low, it
is likely to be statistically insignificant though the card company would be well
placed to check if the scheme had not been received well by heavy users or if the
competition has launched a parallel scheme to lure away this segment of
customers etc.
NBD Model -II
• This is a modified model applicable to instances where the customer has a

“lifetime.” Examples would include credit cards, social media sites etc. where the
customer joins and either chooses to stay or exits after a period of his choice. His
departure is referred to as “death”.
• The customer’s lifetime is described with an exponential function.
• P(customer’s lifetime <= T) = 1 – e-μT μ is the parameter of the distribution.
NBD Model with a customer death rate
1
P(  T /  ,  , X  x, t , T ) 

1 * e(    )(T t )
 
  Purchase rate
  Customer Death rate T  Present Time
  Customer Life Time t  Time of last purchase
Illustration
credit card company’s data revels that a particular customer on an average makes a transaction onc
n 10 days. A typical customer use the credit card for a period of one year (365 days). The customer h
ast used the card 30 days ago. Calculate the probability of the customer being alive today.
olution :
Application
1. Helps track the health of the business. A
large number of active customers is a
1 1 1 positive indictor.
  day ,   day 1
10 365 2. Helps focus promotional campaigns.
“Inactive customers may be lured with
attractive discounts while active
1
P (  30days )   0.045 customers may be
1/ 10
1 e(1/101/365)*30 delighted relation benefits.
1/10  1/ 365
Models of Brand choice
• The previous model dealt with purchase incidence. It did not involve customer’s
brand preference. In this section we shall study models which track brand choices.
Models of Brand Choice
• Brand choice models have to deal with the following factors.
• Population Heterogeneity
• Heterogeneity covers diversity of population in terms of their brand choices.
• As in the previous case, heterogeneity is handled by using a mixing distribution. In the previous
case we had used the gamma distribution.
• Purchase Event Feedback
• Brand choice is influenced by past purchase behaviours.
• Zero Order model : The past behaviour has no bearing on brand choice.
• Markov Model (first order) : Only immediate past purchase event influences brand choice.
• Learning Model
• Entire purchase history of the customer affects brand choice.
• Exogenous Factors
• Advertising
• Price cuts etc.
Population heterogeneity
Brand preference has been researched in three different population groups over 2 brands A and B
% population 1
0 Probability of purchase of brand A 1
• Curve 1 represents a homogenous population with most people having equal preference for either brand.
• Curve 2 is a moderately heterogeneous population with a spread of purchase preferences.
• Curve 3 is a highly heterogeneous population which is divided into two camps with the spike on the right representing
people who have a high probability of buying A and the one on the left representing those with a high probability of opting for B.
Conditional probability
• Purchase event feedback needs understanding of conditional probability.
The table represents purchase of three brands A, B and C on two different occasions. Please note that all 513
purchases on the second occasion have a precedent in first purchase.
Brand purchased on occasion 2

Brands A B C Total
Brand
A 137 47 19 203
purchased Table-1
B 41 179 12 232
On occasion 1
C 22 10 46 78
Total 200 236 77 513
Conditional Probability of the second purchase being B when the first purchase was A: P(B/A)
= No of purchases of B on Occasion2 with A chosen in Occasion 1
Total No of Purchases of A on Occasion 1
= 47/203 = 0.232. (You may calculate the same for other combinations.)
Conditional and joint probability
Conditional Probability Matrix:
Second purchase brand
Brands A B C Total
First
A 0.674 0.232 0.094 1
Purchase
Brand B 0.177 0.772 0.051 1
Table 2
C 0.283 0.125 0.592 1

The decimal numbers represent probabilities of brand choice in second purchase given the choice in first purchase. Sometimes
this is referred to as the brand switching matrix.
Joint Probability
Refer to table-1.
Joint probability of A (first purchase) and B (second purchase): P(B and A)
No of purchases of B on Occasion2 with A chosen in Occasion 1
=
Total No of Purchases
= 47/513 = 0.092. The Joint Matrix table is in the next slide. Please note
that P(B and A) is different from P(A and B).
Joint Probability Matrix for Table:1

Brands A B C Total
A 0.267 0.092 0.037 0.396
B 0.08 0.349 0.023 0.452 Table 3
C 0.043 0.019 0.09 0.152
Total 0.39 0.46 0.15 1
Relation between conditional and joint probability

P(B and A) = Total No of Purchases
No of purchases of B on Occasion2 with A chosen in Occasion 1 X Total No of Purchases of A on Occasion 1

= Total No of Purchases of A on Occasion 1 Total No of Purchases
= P(B/A)*P(A)
Bayes Theorem

Brands A B C Total
A 0.267 0.092 0.037 0.396
B 0.08 0.349 0.023 0.452 Table 3
C 0.043 0.019 0.09 0.152
Total 0.39 0.46 0.15 1


= P(B/A)*P(A)
BITS Pilani
Pilani Campus

Sidharth Mishra
Lecture 4
Contents
• Zero Order model
• Markov Model of first order
• Linear learning model
Models of Brand choice
• The previous model dealt with purchase incidence. It did not involve customer’s
brand preference. In this section we shall study models which track brand choices.
Models of Brand Choice
• Brand choice models have to deal with the following factors.
• Population Heterogeneity
• Heterogeneity covers diversity of population in terms of their brand choices.
• As in the previous case, heterogeneity is handled by using a mixing distribution. In the previous
case we had used the gamma distribution.
• Purchase Event Feedback
• Brand choice is influenced by past purchase behaviours.
• Zero Order model : The past behaviour has no bearing on brand choice.
• Markov Model (first order) : Only immediate past purchase event influences brand choice.
• Learning Model
• Entire purchase history of the customer affects brand choice.
• Exogenous Factors
• Advertising
• Price cuts etc.
• Condition of Stationarity
• Customer behavior does not change significantly with time.
Population heterogeneity
Brand preference has been researched in three different population groups over 2 brands A and B
% population 1
2
3
0 Probability of purchase of brand A 1
• Curve 1 represents a homogenous population with most people having equal preference for either brand.
• Curve 2 is a moderately heterogeneous population with a spread of purchase preferences.
• Curve 3 is a highly heterogeneous population which is divided into two camps with the spike on the right representing
people who have a high probability of buying A and the one on the left representing those with a high probability of opting for B.
• Purchase event feedback needs understanding of conditional probability.
The table represents purchase of three brands A, B and C on two different occasions. Please note that all 513
purchases on the second occasion have a precedent in first purchase.
Brand purchased on occasion 2

Brands A B C Total
Brand
A 137 47 19 203
purchased Table-1
B 41 179 12 232
On occasion 1
C 22 10 46 78
Total 200 236 77 513
Conditional Probability of the second purchase being B when the first purchase was A: P(B/A)
= No of purchases of B on Occasion2 with A chosen in Occasion 1
Total No of Purchases of A on Occasion 1
= 47/203 = 0.232. (You may calculate the same for other combinations.)
Conditional Probability Matrix:
Second purchase brand
Brands A B C Total
First
A 0.674 0.232 0.094 1
Purchase
Brand B 0.177 0.772 0.051 1
Table 2
C 0.283 0.125 0.592 1

The decimal numbers represent probabilities of brand choice in second purchase given the choice in first purchase. Sometimes
this is referred to as the brand switching matrix.
Joint Probability
Refer to table-1.
Joint probability of A (first purchase) and B (second purchase): P(B and A)
=
Total No of Purchases
= 47/513 = 0.092. The Joint Matrix table is in the next slide. Please note
that P(B and A) is different from P(A and B).

Brands A B C Total
A 0.267 0.092 0.037 0.396 Bayes Theorem of Probability
B 0.08 0.349 0.023 0.452 Table 3
C 0.043 0.019 0.09 0.152
Total 0.39 0.46 0.15 1


= P(B/A)*P(A)
Generalized model of brand choice
• Let us extend the model to include ‘n’ brands. Please give careful attention to the
notations involved.
• p(i/j) = conditional probability of choosing the brand i on second occasion when
the jth brand has been the first choice.
• p(i,j) = joint probability of the ith brand on the second occasion and jth brand on
first occasion.
• p(j) = probability of purchasing brand j on first occasion.

General formulae marketing probability
1. Probability of a random customer buying a brand i at any point of time is equal to the extant market share o
the brand = pi = mi
n
2.  p(i, j )  m
j
i
Explanation: Sum of joint probabilities of all second occasion purchases of brand i

with an exhaustive sequence of all available brands on first purchase = market share
of brand I
Illustration:
Refer Table 1. There are three brands (A,B and C). Hence n =3. If we choose the second
brand (i=2) B to obtain the above sum; the equation can now be rewritten in the following
manner.
3
 p(2, j )  p(2,1)  p(2, 2)  p(2,3)  p( B, A)  p( B, B)  p( B, C )

j 1 = Market Share of B
= Total Purchase of B on second occasion
Total Purchase of all brands on second occasion
3. Sum of conditional probabilities of the purchase of Brand i, given that brand j

was purchased under the first occasion = 1
General Formulae
3.  p(i / j )  1
i
Explanation: Sum of conditional probabilities of the purchase of Brand i, given
that brand j was purchased under the first occasion = 1
Illustration: Refer Table 1. Taking j =2 (brand B), the left hand side of the above equation
can be written as P(A/B)+P(B/B)+P(C/B)
= 2nd Purchase of A given B as the first purchase + 2nd Purchase of B given B as first purchase+ 2 nd purchase of C given B as first purchase
Total Purchase of B
= Total purchase of B =1
Total Purchase of B
Brands A B C Total
Conditional
A 0.674 0.232 0.094 1
p(i, j ) probability
4. p (i / j )  B 0.177 0.772 0.051 1
p( j )
This has been already proved. C 0.283 0.125 0.592 1
Zero order model Ehrenberg postulate
Ehrenberg postulated that the joint probability of a consumer purchasing brands i and j on successive occasions is given by the
following formula.
p(i, j )  kmi m j mj and mi are mkt shares of brands j and i; where i is not equal to j. k is a constant which can be
evaluated using a formula given below.
n
p (i, i )   p (i, j )  p(i )  mi Application
j i Ehrenberg’s postulate can be used
n n to predict the brand switching
p (i, i )  mi   p (i, j )  mi  kmi ( m j )  mi  kmi (1  mi ) probability of an individual
customer or a homogenous set of
j i j i
n customers if we know the
k can be determined by the following

1   p (i , i ) following.
1. Current market shares of all
formula. k  i
n available brands. (mi )
1   mi 2 2. Customer loyalty to brand.
For proof see Appendix - 1 P(i,i)
i
Zero order model Illustration
Joint Probability Table
Brands A B C Total
A 0.267 0.092 0.037 0.396
B 0.08 0.349 0.023 0.452
C 0.043 0.019 0.09 0.152
Total 0.39 0.46 0.15 1
Table - 3
n
p (i, i )   p (i, j )  p(i )  mi
j i
P(i, i) = mi – Ʃp(i.j) = mi – Ʃkmi mj = mi – kmi Ʃmj = mi – kmi (1-mi)
If i = 1 ( Brand A)
P(A,A) + p(A,B)+ p(A,C) = 0.267+0.092+0.037 = 0.396 = market share of brand A
Zero Order Model Ehrenberg postulate
Illustration
For the example given in Table -1, find the value of k assuming a zero order model of brand
choice. Use the value to calculate the joint probabilities from Table -1.
Solution:
In this case, n=3.
Brands A B C Total
3
 p(i, i)  p(1,1)  p(2, 2)  p(3,3)  0, 267  0.349  0.09  0.706

i 1
A 0.267 0.092 0.037 0.396
B 0.08 0.349 0.023 0.452
3 C 0.043 0.019 0.09 0.152
m
i 1
i
2 2
1
2
2
2
3
2 2
 m  m  m  0.39  0.46  0.15  0.386 2
Total 0.39 0.46 0.15 1
n n
1   p (i , i ) 1   p (i , i )
k  i 1  0.706
n =  0.48 k  i
1   mi 2 1  0.386 n
i 1   mi 2
i
Zero order model example
A comparison table between the probabilities computed using zero order Model and actual observations sourced from
table -3.
A B C
%Mkt.
Brands computed actual computed actual computed actual Total Share-I
A 0.275 0.267 0.087 0.092 0.029 0.037 203 0.40

Points with significant discrepancies have been
B 0.085 0.080 0.339 0.349 0.033 0.023 232 0.45 highlighted in red.
C 0.028 0.043 0.034 0.019 0.089 0.090 78 0.15
Total 200 236 77 513
Brands A B C Total
Mkt Share-II 0.39 0.46 0.15 K=0.48
A 0.267 0.092 0.037 0.396
Sample Computation B 0.08 0.349 0.023 0.452
P(B,A) = Joint probability of purchasing B on C 0.043 0.019 0.09 0.152
the second occasion and A on the first
Total 0.39 0.46 0.15 1
= kmB*mA = 0.48*0.46*0.39 = 0.087 n n
p(i, i )  mi   p(i, j )  mi  kmi ( m j )  mi  km
P(A,A) = mA – kmA (1-mA )= 0.39-0.48*0.39(1-0.39)
j i j i
= 0.275
p (i / j )  kmi When j 
i
 1  k (1  mi ) When j = i
The above result can be derived by using the relation of conditional probability p(i/j)*p(j) = p(i,j)
which has been mentioned earlier.
Markov’s model (of first order)
Markov’s model of first order assumes customer’s brand preference is influenced by his brand
choice in the immediately preceding purchase event only. It assumes other purchase events
before that would have no bearing on the customer’s brand preference
In mathematical terms it is written as given below.
P(Yt  k / Yt 1 , Yt  2 ....Y0 )  P (Yt  k / Yt 1 )
Yt  Choice of brand on the tth occasion
For a continuous Markov Model with stationary conditions (i.e, where the conditions for the
buyer to opt for brands do not change)
P(Yt  k / Yt 1 )  P (Yt  k / Y0 )
Markov’s model probabilities
The probabilities of brand choice are computed as given below.
pij  Probability of choosing brand j given that the previous choice was brand i. This is sometimes referred to as
switching probability.
mit  Market share of brand i at time t
i n
mit 1   pij mit j = 1,2,3…..n
i 1
Markov’s model Problem
2 occasion
Question:
A B
The switching matrix between two brands A and B is given here. Assume that the 0.5 A
1 occasion
two brands possess market shares of 0.5 each to start with. What would be their 0.7 0.3
market shares after two purchase cycles? 0.5 B 0.5 0.5
Solution
Note that as per the given switching matrix 0.7 times A’s customers would stick with the brand while 0.3 times would switch to B.
The corresponding numbers for B are 0,3 and 0,5 respectively. Obviously A commands greater loyalty in the market place.
Market Share of Brand A after the first purchase cycle = 0.5*0.7+0.5*0.5 = 0.6
Market Share of Brand B after first purchase cycle = 0.5*0.3+0.5*0.5 = 0.4
For the second purchase cycle the initial marker shares are 0.6 and 0.4 respectively.
Market Share of Brand A after second purchase cycle = 0.6*0.7+0.4*0.5 = 0.62.
Market Share of Brand B after second purchase cycle = 0.6*0.3+0.4*0.5 = 0.38
As you may note A would start increasing its market share owing to its more loyal customers.
Markov’s model example
• The market for branded salt in a country is estimated to be worth U$ 1 billion in

annual revenues. There are two players in the market A and B with equal market
share and indifferent brand preference. Brand A decided to launch a customer
retention scheme with a budget of U$ 10 million. The company’s test marketing
revealed that the scheme had a likelihood of improving customer retention to 0.7.
Discuss the financial implications of the scheme. Please restrict your calculations
to three iterations. Assume the gross margin on branded salt to be 20% of
revenue.
A B
A 0.7 0.3
B 0.5 0.5
Solution
The current market share of A is 0.5 and is not expected to grow as the customers have no distinct preference
for it in the absence of the customer retention program. The program can be considered successful in and only
if it is able to pull in sufficient revenues where the additional margin exceeds the cost of the retention program.
The new switching matrix is given below.
1st Iteration: purchase t+1

mAt+1 = 0.5*0.7+0.5*0.5 = 0.6 Initial
A B mkt. shares
mBt+1 = 0.5*0.3+0.5*0.5 = 0.4 0,5 A
purchase t
0.5
0.7 0.3
2nd
Iteration
mAt+2 = 0.6*0.7+0.4*0.5 = 0.62 0,5 B 0.5
mBt+2 = 0.6*0.3+0.4*0.5 = 0.38 0.5 0.5
3rd Iteration: The scheme is expected to increase market share from 0.5 to 0.624, an
mAt+3 = 0.62*0.7+0.38*0.5= 0.624 improvement of 124 basis points. This is an additional revenue of 0.124* U$ 1
mBt+3 = 0.62*0.3+0.38*0.5= 0.376 billion = U$ 124 million which fetches a gross margin of U$ 124 million*20% =
U$ 24.8M.
Hence the expense of U$ 10 M is justified.
Long Term Markov model a + a.r + a.r2+ ar3+ ….. Infinity = a/(1-r)
2,4,8,16….. Common ratio of 2. 4/2=2; 8/4=2, 16/8=2

1+1/2+1/4+1/8……..infinity first number (a) =1
Common ratio = ½ , a/(1-r)
t+1
Buy No Buy
Buy 0 kp Kp.p+(1-kp)kp = kp+ kp(p-kp)+…

p 1-p
t
No Buy
1 kp 1-kp 1-kp
A buying probability model with Markov properties of first order is given here. as you
may note the probabilities in the second row are expressed as a multiple of the first.
For a customer who enters the system as a non buyer the long term probability of
becoming a buyer or remaining a non buyer is obtained with infinite iterations and is
given by the following expressions.
kp
1  1  Probability of customer becoming a buyer
1  p  kp
1 p
0 
1  p  kp
0 Probability of customer remaining a non-buyer
The proof is given in appendix.
Long Term Markov Model Application
The Problem
Merril Lynch, the well known financial company conducted a study of the transaction habits
of their customers. The customers were classified as prime and non prime based on their
transactional values. Naturally higher value customers fetched higher returns for the
company which wanted to track their transaction patterns. The company wanted to create a
mathematical model to predict how many of their customers would remain in the “prime”
category based on their past behavior.
The Solution
The company used the long term Markov model to estimate individual behavior
which was then aggregated over the customer universe using a mixing beta
distribution. The parameters of the distribution and the values of p and k were
estimated from the Company data base and were modified with managerial judgment.
The result is displayed in the following slide.
Merril Lynch outcome
1980
1978 1979 prediction actual
Prime Prime 0.626 0.632
not Prime Prime 0.432 0.456
Prime not Prime 0.177 0.138
not Prime not Prime 0.066 0.063
The company used this model to provide benchmarks for their marketing
and promotional program.
Learning Model Linear Learning Model
The Markov model of first order assumes the purchase decision to be dependent
only on the buyer’s immediately preceding purchase experience. The linear model
seeks to incorporate the influence of other purchase experiences into the analysis.
Acceptance Operator
The Acceptance Operator gives the probability of a customer purchasing a brand on occasion t
when he had purchased the brand on the immediately preceding occasion where his buying
probability was pt-1.
For a random customer this probability typically is indicated by the brand’s
prevailing market share. So if on the previous occasion the brand had a market share = pt-1 and
the customer had indeed purchased the same his probability of purchase on the following
occasion pt is given by the following equation.
pt  1  1 pt 1
1
Linear learning Model Acceptance/Rejection Operator
The second term denotes Markov’s influence of the immediately preceding purchase while
the first constant represents the effects of other purchase experiences and extraneous
factors.
Rejection Operator
The rejection operator becomes applicable when the customer had not purchased
i.e. rejected the brand on the previous occasion.
pt   2  2 pt 1
Linear learning Model Example
Question : The market share of brand A is 0.2. The acceptance operator and the
rejection operators are given by the following equations.
Acceptance Operator: pt+1 = 0.3+0.6pt , Rejection Operator: pt+1 = 0.1+0.3pt

Find the probability of a customer of buying the brand on the second occasion
when he has purchased it on the first occasion. Find the probability of a customer
buying the same brand which she had rejected on the previous occasion.
Solution:
Pt+1 = 0.3+0.6*0.2 = 0.42 for the first customer
Pt+1 = 0.1+ 0.3*0.2 = 0.16 for the second customer.
Probability of the first customer rejecting the brand = 1-0.42 = 0.58.

Similarly one can find the probability of rejection by the second customer.
LLM Example
Customer First Occasion Second Occasion Third Occasion
1 Buy (Accept) Not Buy(Reject) Decision Buy (Accept) Not Buy(Reject) Decision Buy (Accept) Not Buy(Reject) Decision
1 0.2 0.8 Buy (Accept) 0.42 0.58 Not Buy(Reject) 0.1+0.3*0.42=0.226 0.774
2 0.2 0.8 Not Buy(Reject) 0.16 0.84 Buy (Accept) 0.3+0.6*0.16=0.396 0.604
Lower and upper limits Linear learning Models
Proof of Upper Limit
pt  1  1 pt 1 Eq:1
pt 1  1  1 pt 2
pt  1  1 pt 1  1  1 (1  1 pt  2 )
1
 1 (1  1  12  .....) 
1  1
Putting the value in Equation 1 and solving would yield the same value for pt 1 That is an
interesting conclusion which states that there is an upper limit to the level of customer
conversion. The probability of a customer choosing a brand would not exceed the above
limit pointing to the phenomenon of incomplete habit formation where the customer
despite numerous prior purchases would still retain some “affection” for the competing
brand. 2
Solving the equation for the rejection operator would yield the lower limit 1  2
Linear Model
Upper limit =
1 1,2  1
1  1 Acceptance Operator
0.78 pt  1   pt 1
B
pt = pt-1
Rejection Operator
Pt
0.31 A
2
Lower limit =
1  2
0.6
Pt-1
Linear learning models(LLM)
• The following slide illustrates the manner in which LLMs can be used.
• Imagine a situation where the random probability* ofbrand purchase in a market is 0.6. The probability of
a customer who had bought the brand of buying it on his/her next purchase occasion is 0.78.
• The probability of a customer who had rejected the brand in this occasion of buying it in his/her next
purchase is 0.31.
• LLM can be extended to prove that there are lower and upper limits of brand adoptions.
1
• The upper limit = 1   1

• The lower limit = 1  
2
• It has been observed that LLMs work better in two brand situations.
• and  can be estimated from past customer data.
* Unless there are specific factors this probability can be taken as equal to market share of the brand.
Appendix
On separation of variables,
n
1   p (i, i )
k  i
n
1   mi 2
i
BITS Pilani
Pilani Campus

Sidharth Mishra
15.02.2019
Contents
• Models of Need Arousal

• Maslow’s Hierarchy of Needs Model
• Binary choice model
• Binary Probit Model
• Binary Logit model
• Model of Information Search
• Model of brand awareness
Five Stage Consumer Behavior Model
Sl No. Stage Description Models

Stochastic Models of Purchase Incidence
– NBD Model, Brand Choice Model
1 Need Arousal Discrete Binary Choice Models
Individual Awareness models
Consideration Models
2 Information Search Information Integration Models
Perception Perceptual mapping
Attitude Models
Non-compensatory
3 Evaluation Preference Compensatory
Multinomial Discrete Choice Models
4 Purchase Markov Models
Variety Seeking Models
Satisfaction Model
5 Post-Purchase Communication and Network Models
Consumer model Need Arousal
• Maslow’s Need hierarchy
A typical human being moves from lower order to higher order needs.
Need arousal Binary Choice Model
Need arousal generally concerns the need for a product category and not a specific brand. For example
need is aroused for an air conditioner, a product category. The choice of brand follows and shall be
studied later using different modelling techniques.
The binary choice model deals with two choices before the customer. To Buy a category
of products ( an air conditioner, washing machine, car etc.) or Not To Buy.
The purchase preference of the buyer is decided by the utility he/she seeks to derive from the product.
Customer i has two different utility functions.
U Bi  VBi   Bi UBi is the utility derived from buying the product which is again
represented as the sum of a systematic component VBi which can be

U Ni  VNi   Ni assessed and a random component Bi which is the outcome of all
unobserved factors.
UNi is the utility derived from NOT buying the product which can be similarly described.
Probability of purchase
The consumer buys when the utility of buying exceeds the utility of not buying.
Probability of Buying = Pr(UBi > UNi) = Pr( VBi+ Bi >VNi+ Ni )
= Pr(Vbi>VNi+ ( - )  Ni  Bi
Binary Probit Model
As can be seen from the above equation the probability of purchase is dependent
on the systematic component of the utility function as well as the randomly occurring
Error element .
Assuming that Ni and Bi are individual normal distributions with means =0 and
Standard deviations , N, B their sum can be assumed to be normally distributed
2 2 2
with mean and standard deviation equal to 0 and σ . Where   B   N
As the variations in originate from the attribution vector set of V Ni and VBi. Hence
it has been argued that N and  B are equal to the corresponding standard
deviations of VNi and VBi and can be estimated as such.
Binary probit model Probability of Buying = Pr(UBi > UNi) = Pr( VBi+ >VNi+ )
= Pr(Vbi>VNi+ ( - ) eNi - eBi
eNi – eBi
Pr(buying )  Pr(VBi  VNi   Bi   Ni )
 Pr( Bi   Ni  VBi  VNi )
eNi - eBi
x
VBi VNi ( )2
1 

 2  e 2
.dx
0
 VBi - VNi
The above probability can be estimated from a normal distribution table.
Correction to the above equation

Pr (Buying) = Pr (VBi – VNi > ϵNi - ϵBi) = Pr(ϵNi - ϵBi < VBi – VNi)
Binary logit model
The binary logit model does away with the requirement of referring to a distribution table.
The error functions are assumed to be following the logistic distribution. Here the probability of
purchase is given as below.
e VB e = 2.718
PBi  VB
e  e VN
Where is a distribution parameter which can be estimated in a manner similar to standard deviation in case
of normal distribution.
Example.
A customer is putting the utility of a car he wants to purchase at Rs. 460,000. What is the probability of purchase for
him. Assume the error function is logistically distributed with μ equal to 10-6 and the value of his non-purchase is 0.
What is the probability of his purchase?
6
e10 *460,000  0.46
PB  0.46
 0.61
e 1
Utility
A young newly married couple setting up their home are considering the
Purchase of a new washing machine costing Rs. 20,000. They expect the
Machine to last for five years. We shall calculate VBi and VNi purely on the basis
of Financial considerations.
VBi
Net Savings generated = Maid Servant’s wages – Cost of Electricity – Cost of
Maintenance* = 800*12*5 – 100*12*5 – 1000*4 = Rs. 38000
VNi
Expenditure saved = Rs. 20,000

Interst accrued over 5 years @ 10% per annum = Rs. 10000
Total Saving = Rs. 30,000
Utility
• Utility as a function of attributes

• VBi = f(attribute1 , attribute2, …..attributen)
• VB(WM)=f(quality of washing, silent operation, low maintenance, aesthetics)
• Utility of a category
• Often a customer decides on the utility of a category by checking up on all
options he would consider within a category
VBi  E (max(U j )  log e ( e j )
V
E (max(U j )) =Expected maximum utility of the category
jC
where C is the consideration set of brands
Illustration
A man considering the purchase of a car has three models in his
Consideration set. He is willing to pay (which can be ascertained through
a regular survey) Rs. 250,000 for a Renault Kwid, Rs. 350,000 for a Maruti
Alto and Rs. 400,000 for a Honda Brio.
2.5 3.5 4
log
His expected category utility of car (V) = e ( e  e  e )  4.6 (Rs. 4.6 lakh)
Need arousal linear programming problem (LPP)
A customer seeks to maximize his/her overall utility within the constraints of

a budget. The following Linear programming problem has been formulated to
illustrate the customer’s decision problem. It pertains to a consumer’s decision
to buy a set of consumer items (TV, Refrigerator, Washing Machine, Car etc.)
Linear Programming Problem (LPP)

Maximize u 1g 1 + u 2g 2 + ……+ u ng n + u(y)
Subject to p1g 1 + p 2g 2 + …….+p ng n+ y <= B
and g j>= 0
Where p = expected price of the durable

u = expected utility of the durable
g = 1, if the durable is purchased
=0, if durable is not purchased
B = budget of the consumer
y = part of the budget spent of non durable items.
uy utility derived from non durable objects
Need arousal LPP outcomes
• There are two ways in which consumers set their priorities of consumption.
• Value per unit cost
• Net Value (Utility) –( cost)
• The LPP model after being applied empirically revealed that the Value for Unit cost
premise works for 60% of the population with a correlation of greater than 0.5).
The same figure for the Net Value premise is 84%.
Information search models
• The second aspect of consumer behavior deals with information search. Information search of a
customer is greatly influenced by advertising, one of the variables of any firm’s marketing mix. The
study of information search has three aspects.
• Brand Awareness
• This will be modeled considering the consumer’s exposure to advertisements placed by the
firm.
• Formation of considered set
• Based on his information the customer would ultimately form a shortlist (considered set) of
brands
• Integration of Information
• Perception management
• Multi dimensional scaling
• Factor Analysis
• Compensatory Model
• Non compensatory Models
Brand Awareness
e=Euler’s Number
We shall study brand awareness as a consequence of exposure to ads only and

the subsequent effect on sales.
Let us assume the reach of a company’s media plan extends to a fraction “q” of q= (no of people reading T
Its intended consumers. This means a random consumer has a probability of “q” = 10 lakh/ 2 crore = 0.05 =
of seeing the ad.
We human beings are also forgetful in nature. We shall assume that the probability
of an ad being remembered is exponentially distributed and is given by the following
relationship.
Pt is the probability of the ad being remembered by the customer at time t after exposure.
Pt  e  t You may note that α is a negative measure of the memorability (forgettability coefficient)
of the ad. The higher its value the lower is the memorability of the ad.
Let us consider a firm which has launched a series of ads at times t 1, t2 ….tn probability that the ad is
remembered at time t is given by the expression given below. Please note that we have ignored the
possibility of repeat viewership.
n
f (t )  qe  ( t t1 )
 q (1  q )e   ( t  t2 ) 2
 q (1  q ) e  ( t  t3 )
 ....   q r (1  q ) r 1 e (t tr )
r
Consume Behaviour Brand Awareness Model
• Consider two ads one of which has an alpha value of 1 per day while the other has
a value 2 per day.
• After one day of viewing the probability of a viewer remembering the ads are e-1
(0.37) and e-2 (0,14) respectively. As you can see, the probability of the first ad
being remembered is higher.
• We have ignored the possibility of repeat viewership to ensure simplicity of
calculation. This condition stays valid for media plans with relatively lower reach.
For a media plan with a target reach of 0.1, the probability or repeat viewership is
0,1*0.1 = 0.001 which is small.
Consumer Behavior Brand Awareness Model
We shall link brand awareness to sales with the following equation.
s (k )  c1  c2  f (t )dt
k
sk= sales during period k
c1 and c2 are constants ,c1 is the sale that
would be generated even when brand awareness was zero.
Substituting f(t) with the equation given on the previous slide and integrating
we get

nk
c2 q (1  e )
sk  c1  ( ). .{nk  k (1  knk ) / (1  k )  (1  knk ). k 1} 1
c1 (1  k )
where 
k  (1  q )e nk
 k 1  knk 1  1.k  2  k 1 (1  knk 1  1) / (1  k 1 )
Brand Awareness Model Interpretation
• The equation gives a mathematical relationship between sales during a period k

and the reach (q) and frequency (nk) of ads. Obviously, the higher the reach and
frequency the more is sales.
• The carry over effects of ads done on previous occasions is dependent of the
reach and frequency of current ads. The higher they are, the more is the impact of
current as well as previous ads.
• The lower the value of α, higher is the memorability of ads which would translate
to better sales.
Brand Awareness Model Example
• During the festival period of Navratri, Dussehra and Deepavali spread over 30
days a consumer goods company decided to increase its sales by giving two ads
in leading newspapers of a state reaching 4 million people in the top socio
economic category (SEC-A) which was the segment targeted by the company.
This segment comprised 20 million people in all. The ad agency which designed
the ad creative assured that the ad would have a forgettability (α) of 0.5. The ads
were taken out on the first day and the 15th day. The company knows from its
previous experience that the constants c1 and c2 have values 10000 and 20000
respectively.
• What would be the expected sales?
• The actual sale 16000 units. What was the actual forgettabiliy factor (α) assuming
that the remaining information was correct.
Brand Awareness Model Solution
• Solution:
• Probability of viewership in the target segment = Media Reach /target segment population
= 4 million / 20 million = 0.2 (q)
Probability of first ad being seen and remembered on tth day = 0.2e-0.5(t-0)
( taking α = 0.5 as suggested by ad agency)
• Probability of 2nd ad being seen and remembered = 0.8*0.2e-0.5(t-15) Remember that
the second ad was released on 15th day.
• Expected Sales s ( k )  c1  c2 f (t ) dt = 
k
In the calculation we have ignored the powers

of e, like e-15 and e-7,5 whose values are very less.
Integration of e to the power “at” = e to the power “at”/a

Brand Awareness Model contd..
• Actual sale = 16000 

s (k )  c1  c2 f (t )dt
• 16000 = 10000 + 20000 ( integration f(t)dt) k
• Integrand = (16000-10000) / 20000 = 6000/20000 = 0.3
A = 0.36/0.3 =1.2, 0.5

Definite Integration
Formation of considered set
The considered set is the customer’s shortlist of brands he/she is finally

Going to consider before purchase. Naturally a brand would like to be a part
Of the consumer’s considered set.
Often there is a cost of consideration (cn). It could include the direct expenditure
Incurred by the consumer in experiencing the product as well as the indirect
Cost of time and efforts invested in the process. A consumer would consider a
Brand only if delivers it a minimum value against a particular cost of consideration
(cn)
The expected utility of a considered set C is given as below. Assume that the set
contains k brands.
EB / C  log( e j )  log(eU1  eU 2  ....eU k )
U
The Logit choice model / Ben Akiva Model
jC
The inclusion of the new brand N changes the expected utility. The new expected
Utility is given by the following expression.

U
EB / C  N  log( e j )  log(eU1  eU 2  ....eU k  eU n )
jC  N
Considered Set Illustrative Example
• Find the maximum expected utility for a customer from the category of small cars
if his consideration set involves Maruti Alto and Renault Kwid. He has assessed
his utility for these two models as Rs.2.0 lakh and Rs. 2.6 lakh respectively.
• Maximum Expected Utility = loge (e2 +e2.6 ) = 3.0 lakh
• Find the maximum expected utility if the customer expands his consideration set to
include Honda Brio whose utility he has assessed at Rs. 3.0 lakh.
• Maximum Expected Utility = loge (e2 + e2.6 + e3) = 3.71 lakh
• Find maximum expected utility if the customer expands his consideration set to
include Tata Nano in place of Honda Brio whose utility as assessed by the buyer is
Rs. 1 lakh.
Maximum Expected Utility = loge(e2 + e2.6+ e1) = 3.16 lakh
Consideration set EB / C  log( e j )  log(eU1  eU 2  ....eU k )
U
jC
EB/CUN – EB/C =log (eU1 + eU2+…..+eUi + eUn) - log (eU1 +eU2+…..+eUi ) > cn
log [e 1+ e 2+ ….. e i + e n ]/ e 1 + e 2 +….e ] > cn
U U U U U U Ui
For a rational customer the cost of search should be less than the additional
expected utility generated by it.
Additional Expected Utility = EB / C  N  EB / C  cn
 e  log  e Log X – log Y = log (X/Y)

Uj Uj
log  cn
jC  N jC
Log X = a
 Un
 X = ea definition of log
Log (Ʃ eUj / Ʃ eUj )  e 
cn  log 1  j  Log Y = b
 
e
jC
 Y = eb
(E1+e2+e3+eN)/(e1+e2+e3) = 1+ eN/(e1+e2+e3)
X/Y = ea / eb = ea-b
Log (X/Y) = log(ea-b ) = a-b = log X – l

Application
Kia Motors, a South Koran manufacturer of passenger cars is the latest entrant
in the crowded automobile market in India. The company estimated that at the
Entry level a typical Indian consumer considers the following brands and associates
The utility mentioned alongside the brand in Rs. Lakh. What is the minimum utility
They should be able to impress on the customer’s U mind to be included in his consideration
Set. Assume that an average customer spends a full working day in evaluating a car and
estimates its total cost (including the cost of travel etc.) at Rs. 10,000. His utilities from
the considered set of brands are as follows.
Ukwid = Rs. 2.0 lakh UBrio = Rs. 3.0 lakh UAlto = Rs. 2.6 lakh
Solution: The cost of search = cN = Rs. 10000 = Rs. 0.1 lakh
 Un
 eU n eU n
 e  0.1
e  1  2 3 2.6 
cn  log 1 
 ej  e e e 40.94
 jC 
eU n  40.94(e0.1  1)  4.305
eU n
0.1  log[1  2 3 2,6 ]
e e e U n  log(4.305)  1.46
Ukia should be at least equal to Rs. 1.46 lakh for the Kia car to be included in the consumer
consideration set.
Application contd..
• With a view to increasing the probability of including their brands in the customer’s
consideration set, firms are known to take aggressive steps to cut down on the
cost of search.
• Auto firms are known to offer test drives at door step.
• Firms incentivize customer trials. Restaurants are known to offer innovative
cuisine for trial to familiar customers free or at discounted prices. Websites and
software companies offer trial packs for limited period. For example, I am making
these slides using a month long free trial pack of the Mathtype software.
BITS Pilani
Pilani Campus

Sidharth Mishra
15.02.2020
Contents

• Model of Information Evaluation
• Models of Perceptual Evaluation
• Multidimensional Scaling
• Factor Analysis
Information Evaluation
• Non-compensatory Models
• Compensatory Models
Non-compensatory Models Salary: 100000, 150,000
Designation:
Location:
• Conjunctive Model
• There is a minimum requirement of all attributes.
• Disjunctive Model
• Either … Or i.e. the brand needs to qualify on any one of the attributes.
• Lexicographic Model
• The attributes are listed in terms of their priorities. The evaluation is based on
the fulfilment of the higher priority attributes followed by lower ones.
Lexicon = A dictionary
Non-compensatory Models
Car Brand Mileage Space Pick-up Price
Honda 10 8 6 8
Maruti 8 9 8 7
Hyundai 6 8 10 5
Toyota 4 3 7 8
Minimum
Requirements(Conjunctive) 7 6 7 2
Minimum
Requirements(Disjunctive) 9 NA 9 NA
Attribute Order
1+0 = 1
(Lexicographic) 3rd 4th 2nd 1st
Min (1,1) = 1
Conjunctive Choice: All attributes must be satisfied. Only MAruti qualifies.

Disjunctive Choice : It is either mileage of pick up. A and C qualify.
Lexicographic: First we compare all brands on price. Thus B and C would get eliminated. We compare A and D on the next
Important attribute i.e. pick up. As D with a score of 7 is better than A with 6, D is selected. We don’t have to move further.
Maruti (1), Hyundai (2), Honda(3) Need Arousal, inform
Evaluation, purchase
• Conjunctive Models
Where yjk is the score of the brand on the kth

attribute and Tk is the corresponding target value of
the kth attribute. Pric
Car Brand Mileage Space Pick-up e
y23
Honda 10 8 6 8
Maruti 8 9 8 7
Hyundai 6 8 10 5
• Disjunctive Model Toyota 4 3 7 8
Minimum
Requirements(Co
Compensatory model
• As discussed earlier this model allows for the deficiency of the object in one attribute or more to be
compensated by higher score on other attributes. The consumer’s attitude is dependent on the
sum total of his evaluation of the attribute (good or bad) and his belief about the degree to which
the product possesses that attribute.
• The Fishbein Model
• Ao = ∑ibi ai Ao = attitude towards object, bi= belief that the object possessed the necessary
attribute i, ai= evaluation (goodness of badness) of attribute i
• Criticism
• Measurement of ai and bi was difficult for real life marketing situations
Fishbein model
Evaluation
Attribute (ai) Suzuki Dzire (bi) Honda jazz(bi)
Mileage 8 8 7
Room 6 6 8
Safety 5 6 6
Pick-up 4 5 7
Looks 4 6 8
Price -5 6 7
Attitude Score 144 159
Criticism
Measurement of ai and bi was difficult for real life
marketing situations
Extended fishbein model
This model extends the original Fishbein model to include the influence of
Society on customer behavior.
BI = ∑ibi ai + ∑j(SNBj)*(MCj)
BI = Behavioral Intent
SNBj = Social Normative Belief (Social Approval) from the jth social group
MCj = Motivation to comply with the SNB of jth group.
bj and aj have the same meaning as earlier.
Suzuki Honda
Attribute Evaluation Dzire jazz Remarks
Mileage 8 8 7
Room 6 6 8
Safety 5 6 6
Pick-up 4 5 7
Looks 4 6 8
Price -5 6 7
Attitude
Score 144 159
Motivation Suzuki Honda
Social Group to comply Dzire Jazz
Family 10 6 7 Honda has a slight brand premium
Office 6 6 6 No one really cares.
every one in my neighborhood has a
Neighbor 2 7 6 Suzuki
City 7 5 7 Honda has a slight brand premium
Social
Normative
Score 145 167
Behavour
intent 289 326
Criticism
Measurements of ai and bi other variables and are difficult
for real life marketing situations
Integration of information
• Based on the information collected the consumer forms a perception of the brand /
product. We shall study this phenomenon here using tools like multidimensional
scaling (MDS) and factor analysis. In these models competing brands get
evaluated against each other.
• Compensatory/Non-compensatory Model which is applicable for evaluating stand
alone brands.
Perception Evaluation
• Two approaches are primarily used.

• Multidimensional scaling (MDS)
• Evaluates using brand relationships
• Non-metric MDS
• Metric MDS
• Factor Analysis
• Based on consumer’s evaluation of various attribute data which are then
filtered to determine underlying factors. See later slides for details.
Multidimensional Scaling
• Non metric multidimensional Scaling
• Uses ordinal data (ranks) to describe similarity between two products
• Example: pair the following brands of soap from the most similar to the most
dissimilar. Lux, Pears, Lifebuoy. The responses can be placed in a box as
shown below. The respondent has ranked (Lux,Pears) to be most similar and
(Pears, Lifebuoy) to be most distant in the group.
Lux Pears Lifebuoy
Lux 1 2
Pears 3
Lifebuoy
• Metric Multidimensional scaling

• Uses an interval or ratio scale data to describe similarity
• On a scale of 1-9, rank the level of similarity and dissimilarity among the three
soapLuxbrands
Pears mentioned
Lifebuoy above.
Lux 3 7
Pears 9
Lifebuoy
Multidimensional scaling
• The simplest form of MDS is Single mode Non metric scaling which involves a
single respondent and where the data is collected in the ordinal format discussed
in the previous slide.
The algorithm ensures that the points representing the different brands are placed
in a plane in a manner that offers the closest fit to the distances specified by the
customers. The algorithm minimizes stress as given below which is the discrepancy
between the distances given by the respondent and the actual distances between the
points on the plane.
dij = inter product distance between the ith and jth products specified by the
respondent
[ ]
dij ‘ = inter product distance on the plane 2 1/ 2
∑ ( 𝑑𝑖𝑗 ❑ − 𝑑 𝑖𝑗 )
′
𝑖≠ 𝑗
𝑆𝑡𝑟𝑒𝑠𝑠= ❑
∑ 𝑑 𝑖𝑗 ❑2
𝑖
MDS illustration
The comparison data for 9 brands done by a respondent have

been shown below.
Product1 Product2 Product3 Product4 Product5 Product6 Product7 Product8 Product9

Product1 16 17 2 19 10 13 21 22
Product2 16 1 11 15 14 25 31 30
Product3 8 7 9 27 32 34
Product4 12 3 20 24 26
Product5 4 29 35 36
Product6 23 28 33
Product7 5 18
Product8 6
Product9
Brands 2 and 3 are closest to each other (rank 1) while brands 5 and
9 are furthest apart. (rank 36; the last rank available)
MDS
TATA
Maruti
Hyndai
Economy Honda
Corolla
Jaguar
Audi
Mercedes
BMW
Luxury
Factor analysis
• If you ask a group of consumers (during a focus group (study for example), you may come across
a rather wide variety of answers. Factor Analysis is a tool that allows to analyze those answers and
reduce them into a smaller number of factors which are easier to handle for managers.
• Consider a focus group discussion happening on the choice of a particular brand of motor cars.
The focus group comprising 25 potential consumers have finally spoken about the factors
mentioned in the table given on next slide and has evaluated the available brand options on a
scale of 1 to 5. The evaluation done by one of the focus group participants (kth) is given in the
table.
Factor analysis
Sl. No Attribute Maruti Hyundai Honda Toyota Audi

1 Luxury 1 1 2 3 5
2 Style 1 1 3 3 5
3 Relaibility 5 4 4 5 5
4 Mileage 5 4 5 5 1
5 Safety 2 2 3 4 5
6 Maintenance 1 2 4 3 2
7 Quality 4 3 4 5 5
8 Durability 3 3 4 5 4
Riding
9 Performance 2 2 3 3 5
xijk refers to the ith person’s rating of the jth brand on the kth attribute.
For example xi23 would refer to the i person’s rating of the 2 brand (Hyundai) on the
3 attribute (Reliability) which as per the given table is 4.
Factor analysis
We believe that we can improve our insight into the customer’s selection of
Attributes (here they are 9 in number) and fine tune it into a smaller number
of factors.
If we choose to reduce it to R number of factors (R < 9) we can write individual

ratings using the following mathematical formula,
xijk = ak1 Fij1 +……+ akR FijR+ dk yijk + error
Here F is the score that the ith individual would have given to Factor 1 or Factor 2
etc. had he been asked to evaluate. The last but one term (d kyijk ) represents a unique
factor that takes into account the individuality of the respondent where d k is the load of and yijk
is the unique factor.
ak1, ak2 etc. are factor loadings associated with each factor which are statistically
determined.
Factor analysis
The underlying factors are intuitively determined after looking at their

respective contributions ( as determined from factor loadings) to individual
consumer ratings. This is illustrated below.
Sl. No Attribute Factor1 Factor2 This is a two factor analysis.

1 Luxury 0.91 -0.03 The factors have to be separately
2 Style 0.64 0.19 identified based on their factor loadings
3 Relaibility 0.39 0.65 Specific to each attribute.
4 Mileage -0.1 0.62
5 Safety 0.61 0.2 For example Factor1 has maximum
6 Maintenance 0.18 0.65 Contributions to attributes like
7 Quality 0.48 0.64 Luxury, style, safety and riding performance.
8 Durability 0.37 0.63
We may assume this refers to “CLASS”.
9 Riding Performance 0.62 0.4
Similarly Factor2 is about ECONOMICS.
Factor score coefficients
Ride
Sl. No Attribute CLASS ECONOMY Maruti Hyundai Honda Toyota Audi
1 Luxury 0.2 0.01 1 1 2 3 5
2 Style 0.18 0.05 1 1 3 3 5
3 Relaibility 0.03 0.15 5 4 4 5 5
4 Mileage 0.05 0.3 5 4 5 5 1
5 Safety 0.15 0.03 2 2 3 4 5
6 Maintenance 0.08 0.23 4 4 4 3 2

7 Quality 0.1 0.1 4 3 4 5 5
8 Durability 0.01 0.08 3 3 4 5 4
Riding
9 Performance 0.2 0.05 2 2 3 3 5
CLASS 2.23 2.05 3.12 3.53 4.55
Ride
ECONOMY 4.03 3.48 4.15 4.29 3.03
Fijr = br1 xij1 +……+ brk xijk+ error

Perceptual map
Audi
Toyota
Class
Honda
Ride Economy
Maruti
Hyundai
General Expression
xijk = ak1 Fij1 +……+ akR FijR+ dk yijk +εijk

Practice problems
5. A customer’s visit to a coffee outlet follows a Poisson distribution with a mean purchase of 1 per
week. The customer’s life time for the coffee outlet follows an exponential distribution with a
parameter of 1/2. The customer had last visited the outlet 10 days ago. Find the probability
that the customer is still “alive” (i.e. still interested in the coffee outlet.)
Solution:
λ = 1/7 = 0.14
μ = 1/2 = 0.5
Probability of the customer being “alive” =1÷[1+(μ/(λ+μ))e(λ+μ)t
=
1÷ [1+(0.5/0.64)e0.64]
=0.4
Practice problem solution
Total No of Expected No of Total no of

No of purchases No of Purchases during puchases per family Expected Actual no of
during 1st Quarter Families Q1 as per NBD Purchases Purchases Difference % Difference
0 1000 0 0.33 330 1000 670 203
1 500 500 1.16 580 650 70 12
2 300 600 2 600 700 100 17
3 200 600 2.83 566 500 -66 -12
4 200 800 3.66 732 800 68 9
Total 2200 2500 2808 3650 842 30
The above results need be analyzed for marketing insights.

As you may note the scheme has been very successful in attracting first
Time customers while the response from existing customers has not been
as enthusiastic. One possibility could be existing users were already
Familiar with the super market practice of discounting and 10%
Discount failed to excite them.
Distributions practice problems
Q.1) The probability of a consumer buying from a retail store in 0.2 on a visit. Find
the probability of
(i) Exactly 3 purchases. (ii) at most 3 purchases(iii) at least 3 purchases
(iv) At least one purchase.
Practice Problems Distributions
Q.2) An ice cream vendor is left with a stock of 5 sticks of ice cream. He decides
to enter a colony where he hoped to liquidate the stock. He parks his push cart
In front of each house and rings the bell to attract attention and hopes to sell his
ice cream. From his experience he knows that if he approaches 4 houses in this
manner he is able to make one sale.
a. What is the probability exhausting his stock exactly at the 10th house.
b. What is the probability exhausting his stock BY the 10th house.
Practice problem
Q.3)A family makes on an average 4 purchases per week from a local grocery.
Assuming that there purchase behavior follows Poisson distribution, find the
Probability of the family making 6 purchases during a particular week. What is the
Probability of making at lease one purchase?
Solution:
Probability of x purchases = (e-λ λx)/ x!
= (e-4 46 )/ 6!
= 0.1
Probability of at least one purchase = 1 – probability of zero purchase
= 1- e-4
= 0.98
Please note that 0! = 1

Brand Purchase models
The following models detail the probability of a consumer choosing a brand.
Luce’s Axiom
Pij(Ci ) = Vij / (∑Vik )

k beongs to Ci
Pij = probability of the ith customer choosing the jth brand.

Ci = the consideration set of the ith customer
Vij = individual i’s ratio scaled preference of brand j (explained in the next slide)
Luce’s Axiom Example
A customer is asked to evaluate three brands A, B and C using 20 chips. He

has to evaluate the brands in pairs and allocate chips in a manner as to
reflect his preference for each brand. The following result was obtained. Find
his probability of purchase of each brand.
A 16 A 16 B 10
PAIR B 4C 4C 10
Total 20 20 20
Solution
pA / pB = 16 / 4 = 4 / 1 , pA / pC = 16 / 4 = 4/1, pB / pC = 10 / 10 = 1/1
From the first equation , if pB = k, pA = 4k. From equation 3, pC = pB = k

As the choice of the consumer is restricted to the three brands A, B and C
pA + pB+ pC = 1
k + k + 4k = 6k = 1
k = 1/6
pA = 4/6 = 2/3 , pB = 1/6, pC = 1/6
Multinomial logit model
Luce’s Axiom is a constant utility model which assumes that the brand preference
mentioned by the consumer at the time of survey remains unchanged at the time
of purchase. Empirical evidence does not agree with this assumption. Consumer’s
utility has a random character which is represented by an error term.
Uij = Vij + e ij where eij is the error term associated with utility.
The distribution of error is assumed to be double exponential.

Pr( eij <= x) = exp[e-bx]
Pr ( ith consumer preferring brand 1 over brand 2) = Pr (Ui1 > Ui2 )
= Pr (Vi1 + ei1 >= Vi2 + ei2 ) = Pr ( ei2 <= Vi1 – Vi2 + ei1 ) = e-b(Vi1-Vi2+ei1)
Pr (customer choosing brand 1 in a set of j brands) = Pr (customer choosing

Brand 1 over Brand 2 AND Brand 1 over Brand 3 ….AND Brand 1 over Brand j)
= e-b(Vi1-Vi2+ei1) * e-b(Vi1-Vi2+ei1) ……..
The above expression can be simplified to yield
Pi1 = e(bVi1 ) /( ∑ebVij )
Probability of the customer i opting for brand k in a considered set

of j brands = (ebVik ) / (∑ebVij )
Note that the above expression comprises Vij which is the constant utility
Figure obtained from surveys. The randomness has been accounted for in the
derivation through the error term which has been ultimately eliminated.
Utility can be expressed as the sum product of the customer’s evaluation of the
Brand in terms of its attributes and the weight assigned to each attribute.
Vij = The utility of jth brand for the ith customer
= ∑k wk bijk
Where wk = weightage associated by the customer for the kth attribute

bijk = the ith customer’s evaluation of the jth brand on kth attribute

= ∑k wk bijk

Solved Example
A homogeneous group of customers rate four stores in his neighborhood in terms

of four parameters
a) Variety of items available, b) Quality of goods c) Parking d) Value for money.
The weights associated by the customer to each attribute is given below. The fourth
Store is a new store. Estimate the market share of each store and the share attracted
By the new store from each of the old stores. b=1
Value for
Store Variety Quality Parking Money
1 0.7 0.5 0.7 0.7
2 0.3 0.4 0.2 0.8
3 0.6 0.8 0.7 0.4
4 0.6 0.4 0.8 0.5
Weight 2 1.7 1.3 2.2
Solved Example contd..
Share
Share Estimate Estimate
Value for without new with new
Store Variety Quality Parking Money Utility (Vj) store store Draw
1 0.7 0.5 0.7 0.7 4.7 0.512 0.407 0.105
2 0.3 0.4 0.2 0.8 3.3 0.126 0.1 0.026
3 0.6 0.8 0.7 0.4 4.35 0.362 0.287 0.075
4 0.6 0.4 0.8 0.5 4.02 0.206
Weight 2 1.7 1.3 2.2 1 1 0.206
Pr (purchase from store 1) = (e4.7 ) / (e4.7 + e3.3 + e4.35 +e4.02 )

= 0.407
0.7*2+0.5*1.7+0.7*1.3+0.7*2.2 = 4.7
Criticisms
• The error distribution has been assumed to be exponential. Opinions are divided on the suitability of this assumption with some arguing the normal distribution to be more
representative.
• Independence of Irrelevant Alternatives (IIA)
The inclusion of irrelevant alternatives skews the probability calculations. For example, the inclusion of a luxury car like Audi in the consideration set of a consumer whose ultimate
purchase would be a mid price car can give a distorted picture of probabilities.
The problem is addressed by formulating a hierarchical choice of decision making.
Hierarchical model of consumer choice (hmcc)
Passenger
Four wheeler
Product Category
hatchback sedan S UV Choice
Mahindr
Maruti Hyundai Honda Maruti Hyundai Honda Renault Toyota
a
Brand Choice
Nissan Renault Kia
Skoda Toyota NIssan
The diagram illustrates the three tier choice process of a consumer

deciding on a passenger four wheeler.
You may note that a brand choice model where all the categories are mixed
up would yield distorted results.
Nested logit model
The nested logic model allows the application of multinomial logit analysis to
the hierarchical model of consumer choice.
Pij = Pj/i *Pi Eqn:1

We would deal with the Ben Akiva Model.
where
Pij is the choice of brand j in the product category i

Pj/i is the probability of choice of brand i given the consumer has chosen product
category i.
Pi is the probability of choosing the product category i
For example:
the probability of the consumer choosing an SUV of Honda make is given
in the following manner.
PSUV,HONDA = PHONDA/SUV * PSUV

Nested logit model
U
jC
Pj/i can be estimated from the multinomial logit model. Note that as we are
determining the probability of a brand within a product category we have
reduced the incidence of irrelevant choice error.
If
Uij = Utility of brand j in product category i
Ui = Utility of product category I
Uj/i = Unique Utility of brand j within product category i
Pj/i = (e bUj/i ) / [∑e bUk/i ] - Eqn 2 b is the parameter of the Multinomial Logit model
Pi (probability of choosing a product category) can be obtained by a utility

analysis as given below.
Pi = Probability [Expected Utility of category i > Expected Utility of remaining
Categories) = Pr[ E(Uij ) > E(Ui’j ) ] = Pr[ Ui + maxj Uj/i > Ui’ +maxj Uj/i’ ]
Note: Expected utility of a category = Utility of the category as a whole + maximum

Unique Utility of a brand within the category.
Nested logit model continued
We have segregated the utilities of product categ
Pij = probability of joining Mechanical at IIT, Roork
Assuming a logit distribution of probabilities Pij = Pi* Pj/I
Pi = Institute Reputation and the different branch
Pi = eμ[Ui +ln(∑jexp(Uj/i)] / ∑ eμ[Ui’ +ln(∑exp(Uj/i’ ) Eqn :3
Pij can now be determined using Eqns 1, 2 and 3 given in the current
and previous slides.
The equation indicates the important point that the customer’s buying
Probability is dependent on the probabilities of all categories involved
As well as the unique utilities of individual brands within each category
It is possible to further simplify the nested logit model to replace individual

Utilities with market shares in order to estimate the consumer’s probability
of opting for a particular category / brand. However that is out of scope of the
current discussion.
Nested logit model discussion
• The hierarchical model considered before did not evaluate the brands at each level. For example it considered his choice of a category (hatchback, sedan, SUV) independent
of the brands involved. A customer can, however consider the brands at each level and modify their consideration set accordingly. He may choose not to consider Maruti while
looking at the consideration set for SUVs. There are models which account for such buyer behavior where the brands are evaluated at each level of decision making.
• Corrections are often incorporated to the model especially to account for IIA (independence of irrelevant alternatives) issues.
• For example, let us say the ratio of purchase probability of Colgate and Pepsodent is revealed to be 2:3 in a study. In the same study if the ratio for Colgate, Pepsodent and
Patanjali turns out to be 1:2:3, the model needs a first order correction to account for the fact that the presence of the third brand alters the consumer’s buying preference.
Multinomial probit model
• This model automatically corrects IIA.

• Here the error is considered to be normally distributed. In the logit model we had
assumed them to be distributed in the double exponential manner.
• The errors are also not considered independent. They can have non zero
covariance with each other.
• However the math involved is cumbersome and the results lack the elegance of
logit model. However this is gaining popularity with increasing availability of
software.
Factor Analysis
• Factor analysis helps reduce a large number of variables to a few underlying

factors.
• A large variety of variables are obtained during focus group discussions. None
of these variables is discarded outright. Instead all of them are fed into the FA
algorithm which classifies them on the basis of their respective relevance. The
more relevant items are studied further to identify underlying factors.
• Factor analysis helps evaluate an item in terms of the factors so generated thus
helping create a perception map of all competing products in a certain product
space. The map helps marketers identify “empty areas” for the launch new
products or models.
• The value of factors thus identified can be calculated based on the way the
focus group respondents had evaluated the original variables. The factor scores
so obtained are averaged out to obtain the factor score coefficients (FSE) of
each product.
Factor Analysis Toy Example
• The table below represents the variables that each of the three respondents found
important in their estimation of cars and they evaluated four makes bases on
them. For example the first respondent though mileage and brakes to constitute
important considerations and evaluated the four makes 2,3, 1 and 4 respectively.
Respondent Variable Honda Maruti Hyundai Renault

Mileage 2 3 1 4
1 Good Brakes 3 2 4 1
Low maintenance 4 3 2 1
2 Airbags 1 2 3 4
Affordable 2 3 4 4
3 Look Good 4 3 2 1
Factor Analysis
• A 2-factor analysis could reveal a table like this.

Factor Analysis Example
Factor loading Factor Score Coefficients

Sl. No Attribute Factor1 Factor2 Factor1 Factor2
1Effective Information Exchange -0.77 -0.17 -0.1 -0.04
2Find and Reach Right Person 0.25 0.43 -0.08 0.11

3Save Time 0.17 0.47 -0.05 0.26
4Not need visual aids 0.39 -0.16 0.06 0.04
5Get Trapped -0.33 -0.2 0.07 0.06
6Eliminate paperwork 0.31 0.43 0.02 0.18
7Persuade -0.7 -0.2 0.13 0.01
8Focus on issues -0.04 -0.07 0.01 0
9All forms of information 0.65 -0.18 -0.02 -0.05
10Real Hassle -0.11 -0.83 0.07 -0.29
11Control Impression 0.56 0.07 0.03 -0.04
12Security 0.18 0.11 0 -0.02
13Plan in Advance 0.23 -0.44 0.04 0
14Eliminate red tape 0 -0.21 0 0.01
15Monitor People,operations 0.65 0.15 0.05 0.01
16Interaction 0.78 0.05 0.25 -0.07
17Solve Problems -0.55 -0.27 -0.02 -0.09
18Express Feelings 0.66 0.17 0.13 -0.05
19Misinterpret -0.49 0 0 0.05
20Group discussion 0.75 0.05 0.2 -0.08
21Inexpensive -0.27 0.52 -0.04 0.09
22Quick Response 0.07 0.71 -0.04 0.2
23Enhance Idea Development 0.77 0.09 0.22 -0.05
24Commitment 0.44 0.32 0.06 0.05
25Maintain Contact 0.5 0.52 0.07 0.18
BITS Pilani
Pilani Campus

Sidharth Mishra
15.02.2020
Contents

• Model of Information Evaluation
• Models of Perceptual Evaluation
• Multidimensional Scaling
• Factor Analysis
Information Evaluation
• Non-compensatory Models
• Compensatory Models
Non-compensatory Models Salary: 100000, 150,000
Designation:
Location:
• Conjunctive Model
• There is a minimum requirement of all attributes.
• Either … Or i.e. the brand needs to qualify on any one of the attributes.
• Lexicographic Model
• The attributes are listed in terms of their priorities. The evaluation is based on
the fulfilment of the higher priority attributes followed by lower ones.
Lexicon = A dictionary
Car Brand Mileage Space Pick-up Price
Honda 10 8 6 8
Maruti 8 9 8 7
Hyundai 6 8 10 5
Toyota 4 3 7 8
Minimum
Requirements(Conjunctive) 7 6 7 2
Minimum
Requirements(Disjunctive) 9 NA 9 NA
Attribute Order
1+0 = 1
(Lexicographic) 3rd 4th 2nd 1st
Min (1,1) = 1
Conjunctive Choice: All attributes must be satisfied. Only MAruti qualifies.

Disjunctive Choice : It is either mileage of pick up. A and C qualify.
Lexicographic: First we compare all brands on price. Thus B and C would get eliminated. We compare A and D on the next
Important attribute i.e. pick up. As D with a score of 7 is better than A with 6, D is selected. We don’t have to move further.
• Conjunctive Models
Where yjk is the score of the brand on the kth

attribute and Tk is the corresponding target value of
the kth attribute.
Compensatory model
• As discussed earlier this model allows for the deficiency of the object in one attribute or more to be
compensated by higher score on other attributes. The consumer’s attitude is dependent on the
sum total of his evaluation of the attribute (good or bad) and his belief about the degree to which
the product possesses that attribute.
• The Fishbein Model
• Ao = ∑ibi ai Ao = attitude towards object, bi= belief that the object possessed the necessary
attribute i, ai= evaluation (goodness of badness) of attribute i
• Criticism
• Measurement of ai and bi was difficult for real life marketing situations
Fishbein model
Evaluation
Attribute (ai) Suzuki Dzire (bi) Honda jazz(bi)
Mileage 8 8 7
Room 6 6 8
Safety 5 6 6
Pick-up 4 5 7
Looks 4 6 8
Price -5 6 7
Attitude Score 144 159
Criticism
Measurement of ai and bi was difficult for real life
marketing situations
This model extends the original Fishbein model to include the influence of
Society on customer behavior.
BI = ∑ibi ai + ∑j(SNBj)*(MCj)
BI = Behavioral Intent
SNBj = Social Normative Belief (Social Approval) from the jth social group
MCj = Motivation to comply with the SNB of jth group.
bj and aj have the same meaning as earlier.
Suzuki Honda
Attribute Evaluation Dzire jazz Remarks
Mileage 8 8 7
Room 6 6 8
Safety 5 6 6
Pick-up 4 5 7
Looks 4 6 8
Price -5 6 7
Attitude
Score 144 159
Motivation Suzuki Honda
Social Group to comply Dzire Jazz
Family 10 6 7 Honda has a slight brand premium
Office 6 6 6 No one really cares.
every one in my neighborhood has a
Neighbor 2 7 6 Suzuki
City 7 5 7 Honda has a slight brand premium
Social
Normative
Score 145 167
Behavour
intent 289 326
Criticism
Measurements of ai and bi other variables and are difficult
for real life marketing situations
Integration of information
• Based on the information collected the consumer forms a perception of the brand /
product. We shall study this phenomenon here using tools like multidimensional
scaling (MDS) and factor analysis. In these models competing brands get
evaluated against each other.
• Compensatory/Non-compensatory Model which is applicable for evaluating stand
alone brands.
Perception Evaluation
• Two approaches are primarily used.

• Multidimensional scaling (MDS)
• Evaluates using brand relationships
• Non-metric MDS
• Metric MDS
• Factor Analysis
• Based on consumer’s evaluation of various attribute data which are then
filtered to determine underlying factors. See later slides for details.
Multidimensional Scaling
• Non metric multidimensional Scaling
• Uses ordinal data (ranks) to describe similarity between two products
• Example: pair the following brands of soap from the most similar to the most
dissimilar. Lux, Pears, Lifebuoy. The responses can be placed in a box as
shown below. The respondent has ranked (Lux,Pears) to be most similar and
(Pears, Lifebuoy) to be most distant in the group.
Lux Pears Lifebuoy
Lux 1 2
Pears 3
Lifebuoy
• Metric Multidimensional scaling

• Uses an interval or ratio scale data to describe similarity
• On a scale of 1-9, rank the level of similarity and dissimilarity among the three
soapLuxbrands
Pears mentioned
Lifebuoy above.
Lux 3 7
Pears 9
Lifebuoy
Multidimensional scaling
• The simplest form of MDS is Single mode Non metric scaling which involves a
single respondent and where the data is collected in the ordinal format discussed
in the previous slide.
The algorithm ensures that the points representing the different brands are placed
in a plane in a manner that offers the closest fit to the distances specified by the
customers. The algorithm minimizes stress as given below which is the discrepancy
between the distances given by the respondent and the actual distances between the
points on the plane.
dij = inter product distance between the ith and jth products specified by the
respondent
[ ]
dij ‘ = inter product distance on the plane 2 1/ 2
∑ ( 𝑑𝑖𝑗 ❑ − 𝑑 𝑖𝑗 )
′
𝑖≠ 𝑗
𝑆𝑡𝑟𝑒𝑠𝑠= ❑
∑ 𝑑 𝑖𝑗 ❑2
𝑖
MDS illustration
The comparison data for 9 brands done by a respondent have

been shown below.
Product1 Product2 Product3 Product4 Product5 Product6 Product7 Product8 Product9

Product1 16 17 2 19 10 13 21 22
Product2 16 1 11 15 14 25 31 30
Product3 8 7 9 27 32 34
Product4 12 3 20 24 26
Product5 4 29 35 36
Product6 23 28 33
Product7 5 18
Product8 6
Product9
Brands 2 and 3 are closest to each other (rank 1) while brands 5 and
9 are furthest apart. (rank 36; the last rank available)
MDS
TATA
Maruti
Hyndai
Economy Honda
Corolla
Jaguar
Audi
Mercedes
BMW
Luxury
Factor analysis
• If you ask a group of consumers (during a focus group (study for example), you may come across
a rather wide variety of answers. Factor Analysis is a tool that allows to analyze those answers and
reduce them into a smaller number of factors which are easier to handle for managers.
• Consider a focus group discussion happening on the choice of a particular brand of motor cars.
The focus group comprising 25 potential consumers have finally spoken about the factors
mentioned in the table given on next slide and has evaluated the available brand options on a
scale of 1 to 5. The evaluation done by one of the focus group participants (kth) is given in the
table.
Factor analysis
Sl. No Attribute Maruti Hyundai Honda Toyota Audi

1 Luxury 1 1 2 3 5
2 Style 1 1 3 3 5
3 Relaibility 5 4 4 5 5
4 Mileage 5 4 5 5 1
5 Safety 2 2 3 4 5
6 Maintenance 1 2 4 3 2
7 Quality 4 3 4 5 5
8 Durability 3 3 4 5 4
Riding
9 Performance 2 2 3 3 5
xijk refers to the ith person’s rating of the jth brand on the kth attribute.
For example xi23 would refer to the i person’s rating of the 2 brand (Hyundai) on the
3 attribute (Reliability) which as per the given table is 4.
Factor analysis
We believe that we can improve our insight into the customer’s selection of
Attributes (here they are 9 in number) and fine tune it into a smaller number
of factors.
If we choose to reduce it to R number of factors (R < 9) we can write individual

ratings using the following mathematical formula,
xijk = ak1 Fij1 +……+ akR FijR+ dk yijk + error
Here F is the score that the ith individual would have given to Factor 1 or Factor 2
etc. had he been asked to evaluate. The last but one term (d kyijk ) represents a unique
factor that takes into account the individuality of the respondent where d k is the load of and yijk
is the unique factor.
ak1, ak2 etc. are factor loadings associated with each factor which are statistically
determined.
Factor analysis
The underlying factors are intuitively determined after looking at their

respective contributions ( as determined from factor loadings) to individual
consumer ratings. This is illustrated below.
Sl. No Attribute Factor1 Factor2 This is a two factor analysis.

1 Luxury 0.91 -0.03 The factors have to be separately
2 Style 0.64 0.19 identified based on their factor loadings
3 Relaibility 0.39 0.65 Specific to each attribute.
4 Mileage -0.1 0.62
5 Safety 0.61 0.2 For example Factor1 has maximum
6 Maintenance 0.18 0.65 Contributions to attributes like
7 Quality 0.48 0.64 Luxury, style, safety and riding performance.
8 Durability 0.37 0.63
We may assume this refers to “CLASS”.
9 Riding Performance 0.62 0.4
Similarly Factor2 is about ECONOMICS.
Factor score coefficients
Ride
Sl. No Attribute CLASS ECONOMY Maruti Hyundai Honda Toyota Audi
1 Luxury 0.2 0.01 1 1 2 3 5
2 Style 0.18 0.05 1 1 3 3 5
3 Relaibility 0.03 0.15 5 4 4 5 5
4 Mileage 0.05 0.3 5 4 5 5 1
5 Safety 0.15 0.03 2 2 3 4 5
6 Maintenance 0.08 0.23 4 4 4 3 2

7 Quality 0.1 0.1 4 3 4 5 5
8 Durability 0.01 0.08 3 3 4 5 4
Riding
9 Performance 0.2 0.05 2 2 3 3 5
CLASS 2.23 2.05 3.12 3.53 4.55
Ride
ECONOMY 4.03 3.48 4.15 4.29 3.03

Perceptual map
Audi
Toyota
Class
Honda
Ride Economy
Maruti
Hyundai
General Expression
xijk = ak1 Fij1 +……+ akR FijR+ dk yijk +εijk

Practice problems
5. A customer’s visit to a coffee outlet follows a Poisson distribution with a mean purchase of 1 per
week. The customer’s life time for the coffee outlet follows an exponential distribution with a
parameter of 1/2. The customer had last visited the outlet 10 days ago. Find the probability
that the customer is still “alive” (i.e. still interested in the coffee outlet.)
Solution:
λ = 1/7 = 0.14
μ = 1/2 = 0.5
Probability of the customer being “alive” =1÷[1+(μ/(λ+μ))e(λ+μ)t
=
1÷ [1+(0.5/0.64)e0.64]
=0.4
Practice problem solution
Total No of Expected No of Total no of

No of purchases No of Purchases during puchases per family Expected Actual no of
during 1st Quarter Families Q1 as per NBD Purchases Purchases Difference % Difference
0 1000 0 0.33 330 1000 670 203
1 500 500 1.16 580 650 70 12
2 300 600 2 600 700 100 17
3 200 600 2.83 566 500 -66 -12
4 200 800 3.66 732 800 68 9
Total 2200 2500 2808 3650 842 30
The above results need be analyzed for marketing insights.

As you may note the scheme has been very successful in attracting first
Time customers while the response from existing customers has not been
as enthusiastic. One possibility could be existing users were already
Familiar with the super market practice of discounting and 10%
Discount failed to excite them.
Distributions practice problems
Q.1) The probability of a consumer buying from a retail store in 0.2 on a visit. Find
the probability of
(i) Exactly 3 purchases. (ii) at most 3 purchases(iii) at least 3 purchases
(iv) At least one purchase.
Practice Problems Distributions
Q.2) An ice cream vendor is left with a stock of 5 sticks of ice cream. He decides
to enter a colony where he hoped to liquidate the stock. He parks his push cart
In front of each house and rings the bell to attract attention and hopes to sell his
ice cream. From his experience he knows that if he approaches 4 houses in this
manner he is able to make one sale.
a. What is the probability exhausting his stock exactly at the 10th house.
b. What is the probability exhausting his stock BY the 10th house.
Practice problem
Q.3)A family makes on an average 4 purchases per week from a local grocery.
Assuming that there purchase behavior follows Poisson distribution, find the
Probability of the family making 6 purchases during a particular week. What is the
Probability of making at lease one purchase?
Solution:
Probability of x purchases = (e-λ λx)/ x!
= (e-4 46 )/ 6!
= 0.1
Probability of at least one purchase = 1 – probability of zero purchase
= 1- e-4
= 0.98
Please note that 0! = 1

Brand Purchase models
The following models detail the probability of a consumer choosing a brand.
Luce’s Axiom
Pij(Ci ) = Vij / (∑Vik )

k beongs to Ci
Pij = probability of the ith customer choosing the jth brand.

Ci = the consideration set of the ith customer
Vij = individual i’s ratio scaled preference of brand j (explained in the next slide)
Luce’s Axiom Example
A customer is asked to evaluate three brands A, B and C using 20 chips. He

has to evaluate the brands in pairs and allocate chips in a manner as to
reflect his preference for each brand. The following result was obtained. Find
his probability of purchase of each brand.
A 16 A 16 B 10
PAIR B 4C 4C 10
Total 20 20 20
Solution
pA / pB = 16 / 4 = 4 / 1 , pA / pC = 16 / 4 = 4/1, pB / pC = 10 / 10 = 1/1
From the first equation , if pB = k, pA = 4k. From equation 3, pC = pB = k

As the choice of the consumer is restricted to the three brands A, B and C
pA + pB+ pC = 1
k + k + 4k = 6k = 1
k = 1/6
pA = 4/6 = 2/3 , pB = 1/6, pC = 1/6
Luce’s Axiom is a constant utility model which assumes that the brand preference
mentioned by the consumer at the time of survey remains unchanged at the time
of purchase. Empirical evidence does not agree with this assumption. Consumer’s
utility has a random character which is represented by an error term.
Uij = Vij + e ij where eij is the error term associated with utility.
The distribution of error is assumed to be double exponential.

Pr( eij <= x) = exp[e-bx]
Pr ( ith consumer preferring brand 1 over brand 2) = Pr (Ui1 > Ui2 )
= Pr (Vi1 + ei1 >= Vi2 + ei2 ) = Pr ( ei2 <= Vi1 – Vi2 + ei1 ) = e-b(Vi1-Vi2+ei1)
Pr (customer choosing brand 1 in a set of j brands) = Pr (customer choosing

Brand 1 over Brand 2 AND Brand 1 over Brand 3 ….AND Brand 1 over Brand j)
= e-b(Vi1-Vi2+ei1) * e-b(Vi1-Vi2+ei1) ……..
The above expression can be simplified to yield
Pi1 = e(bVi1 ) /( ∑ebVij )

= ∑k wk bijk


= ∑k wk bijk

Solved Example
A homogeneous group of customers rate four stores in his neighborhood in terms

of four parameters
a) Variety of items available, b) Quality of goods c) Parking d) Value for money.
The weights associated by the customer to each attribute is given below. The fourth
Store is a new store. Estimate the market share of each store and the share attracted
By the new store from each of the old stores. b=1
Value for
Store Variety Quality Parking Money
1 0.7 0.5 0.7 0.7
2 0.3 0.4 0.2 0.8
3 0.6 0.8 0.7 0.4
4 0.6 0.4 0.8 0.5
Weight 2 1.7 1.3 2.2
Solved Example contd..
Share
Share Estimate Estimate
Value for without new with new
Store Variety Quality Parking Money Utility (Vj) store store Draw
1 0.7 0.5 0.7 0.7 4.7 0.512 0.407 0.105
2 0.3 0.4 0.2 0.8 3.3 0.126 0.1 0.026
3 0.6 0.8 0.7 0.4 4.35 0.362 0.287 0.075
4 0.6 0.4 0.8 0.5 4.02 0.206
Weight 2 1.7 1.3 2.2 1 1 0.206
Pr (purchase from store 1) = (e4.7 ) / (e4.7 + e3.3 + e4.35 +e4.02 )

= 0.407
0.7*2+0.5*1.7+0.7*1.3+0.7*2.2 = 4.7
Criticisms
• The error distribution has been assumed to be exponential. Opinions are divided on the suitability of this assumption with some arguing the normal distribution to be more
representative.
• Independence of Irrelevant Alternatives (IIA)
The inclusion of irrelevant alternatives skews the probability calculations. For example, the inclusion of a luxury car like Audi in the consideration set of a consumer whose ultimate
purchase would be a mid price car can give a distorted picture of probabilities.
The problem is addressed by formulating a hierarchical choice of decision making.
Hierarchical model of consumer choice (hmcc)
Passenger
Four wheeler
Product Category
hatchback sedan S UV Choice
Mahindr
Maruti Hyundai Honda Maruti Hyundai Honda Renault Toyota
a
Brand Choice
Nissan Renault Kia
Skoda Toyota NIssan
The diagram illustrates the three tier choice process of a consumer

deciding on a passenger four wheeler.
You may note that a brand choice model where all the categories are mixed
up would yield distorted results.
Nested logit model
The nested logic model allows the application of multinomial logit analysis to
the hierarchical model of consumer choice.
Pij = Pj/i *Pi Eqn:1

We would deal with the Ben Akiva Model.
where
Pij is the choice of brand j in the product category i

Pj/i is the probability of choice of brand i given the consumer has chosen product
category i.
Pi is the probability of choosing the product category i
For example:
the probability of the consumer choosing an SUV of Honda make is given
in the following manner.
PSUV,HONDA = PHONDA/SUV * PSUV

Nested logit model
U
jC
Pj/i can be estimated from the multinomial logit model. Note that as we are
determining the probability of a brand within a product category we have
reduced the incidence of irrelevant choice error.
If
Uij = Utility of brand j in product category i
Ui = Utility of product category I
Uj/i = Unique Utility of brand j within product category i
Pj/i = (e bUj/i ) / [∑e bUk/i ] - Eqn 2 b is the parameter of the Multinomial Logit model
Pi (probability of choosing a product category) can be obtained by a utility

analysis as given below.
Pi = Probability [Expected Utility of category i > Expected Utility of remaining
Categories) = Pr[ E(Uij ) > E(Ui’j ) ] = Pr[ Ui + maxj Uj/i > Ui’ +maxj Uj/i’ ]
Note: Expected utility of a category = Utility of the category as a whole + maximum

Unique Utility of a brand within the category.
Nested logit model continued
We have segregated the utilities of product categ
Pij = probability of joining Mechanical at IIT, Roork
Assuming a logit distribution of probabilities Pij = Pi* Pj/I
Pi = Institute Reputation and the different branch
Pi = eμ[Ui +ln(∑jexp(Uj/i)] / ∑ eμ[Ui’ +ln(∑exp(Uj/i’ ) Eqn :3
Pij can now be determined using Eqns 1, 2 and 3 given in the current
and previous slides.
The equation indicates the important point that the customer’s buying
Probability is dependent on the probabilities of all categories involved
As well as the unique utilities of individual brands within each category
It is possible to further simplify the nested logit model to replace individual

Utilities with market shares in order to estimate the consumer’s probability
of opting for a particular category / brand. However that is out of scope of the
current discussion.
Nested logit model discussion
• The hierarchical model considered before did not evaluate the brands at each level. For example it considered his choice of a category (hatchback, sedan, SUV) independent
of the brands involved. A customer can, however consider the brands at each level and modify their consideration set accordingly. He may choose not to consider Maruti while
looking at the consideration set for SUVs. There are models which account for such buyer behavior where the brands are evaluated at each level of decision making.
• Corrections are often incorporated to the model especially to account for IIA (independence of irrelevant alternatives) issues.
• For example, let us say the ratio of purchase probability of Colgate and Pepsodent is revealed to be 2:3 in a study. In the same study if the ratio for Colgate, Pepsodent and
Patanjali turns out to be 1:2:3, the model needs a first order correction to account for the fact that the presence of the third brand alters the consumer’s buying preference.
Multinomial probit model
• This model automatically corrects IIA.

• Here the error is considered to be normally distributed. In the logit model we had
assumed them to be distributed in the double exponential manner.
• The errors are also not considered independent. They can have non zero
covariance with each other.
• However the math involved is cumbersome and the results lack the elegance of
logit model. However this is gaining popularity with increasing availability of
software.
Factor Analysis
• Factor analysis helps reduce a large number of variables to a few underlying

factors.
• A large variety of variables are obtained during focus group discussions. None
of these variables is discarded outright. Instead all of them are fed into the FA
algorithm which classifies them on the basis of their respective relevance. The
more relevant items are studied further to identify underlying factors.
• Factor analysis helps evaluate an item in terms of the factors so generated thus
helping create a perception map of all competing products in a certain product
space. The map helps marketers identify “empty areas” for the launch new
products or models.
• The value of factors thus identified can be calculated based on the way the
focus group respondents had evaluated the original variables. The factor scores
so obtained are averaged out to obtain the factor score coefficients (FSE) of
each product.
Factor Analysis Toy Example
• The table below represents the variables that each of the three respondents found
important in their estimation of cars and they evaluated four makes bases on
them. For example the first respondent though mileage and brakes to constitute
important considerations and evaluated the four makes 2,3, 1 and 4 respectively.
Respondent Variable Honda Maruti Hyundai Renault

Mileage 2 3 1 4
1 Good Brakes 3 2 4 1
Low maintenance 4 3 2 1
2 Airbags 1 2 3 4
Affordable 2 3 4 4
3 Look Good 4 3 2 1
Factor Analysis
• A 2-factor analysis could reveal a table like this.

Factor Analysis Example
Factor loading Factor Score Coefficients

Sl. No Attribute Factor1 Factor2 Factor1 Factor2
1Effective Information Exchange -0.77 -0.17 -0.1 -0.04
2Find and Reach Right Person 0.25 0.43 -0.08 0.11

3Save Time 0.17 0.47 -0.05 0.26
4Not need visual aids 0.39 -0.16 0.06 0.04
5Get Trapped -0.33 -0.2 0.07 0.06
6Eliminate paperwork 0.31 0.43 0.02 0.18
7Persuade -0.7 -0.2 0.13 0.01
8Focus on issues -0.04 -0.07 0.01 0
9All forms of information 0.65 -0.18 -0.02 -0.05
10Real Hassle -0.11 -0.83 0.07 -0.29
11Control Impression 0.56 0.07 0.03 -0.04
12Security 0.18 0.11 0 -0.02
13Plan in Advance 0.23 -0.44 0.04 0
14Eliminate red tape 0 -0.21 0 0.01
15Monitor People,operations 0.65 0.15 0.05 0.01
16Interaction 0.78 0.05 0.25 -0.07
17Solve Problems -0.55 -0.27 -0.02 -0.09
18Express Feelings 0.66 0.17 0.13 -0.05
19Misinterpret -0.49 0 0 0.05
20Group discussion 0.75 0.05 0.2 -0.08
21Inexpensive -0.27 0.52 -0.04 0.09
22Quick Response 0.07 0.71 -0.04 0.2
23Enhance Idea Development 0.77 0.09 0.22 -0.05
24Commitment 0.44 0.32 0.06 0.05
25Maintain Contact 0.5 0.52 0.07 0.18
Managerial Economics
MBA ZC 416
BITS Pilani Sidharth Mishra

Pilani Campus Associate Professor, Management
Email: sidharth.mishra@pilani.bits-pilani.ac.in
BITS Pilani
Pilani Campus
Production Analysis - Part 1
AGENDA
• Production Function
• Key relationships: Total, Average and marginal products
• The law of diminishing returns
• The three stages of production function
• Isoquants and Isocosts
• Economic Region of Production
• Returns to Scale
• Empirical production function
Production Process
• The organization of production

• Inputs
• Fixed inputs
• Variable inputs
• Transformation of inputs into output
The Three Decisions That All Firms Must Make
Firm: An organization that comes into being when a person

or a group of people decides to produce a good or service to
meet a perceived demand.
All firms must make several basic decisions to achieve
what we assume to be their primary objective—
maximum profits.
The Behavior of Profit-Maximizing Firms
Optimal method of production - The production method that

minimizes cost.
Short-run vs. Long-run decisions
Short run: The period of time for which two conditions
hold:
At least one of the inputs (labor or capital) is fixed.
 The firm is operating under a fixed scale (fixed factor)
of production, and
 Firms can neither enter nor exit an industry.
The firm has fixed and variable costs.
Example: A hospital with a fixed number of beds with
lease contracts (with the land lord) and employment
contracts (doctors, paramedics, technicians and support
staff) for a period of 1 year.
Long run: That period of time for which there are no
fixed factors of production:
 Firms can increase or decrease the scale of
operation, and
 New firms can enter and existing firms can exit the
industry.
There is no fixed cost.
Production function
• Production function with two inputs:

• Q = f (K, L)
• Output = Number of the units of commodity
• Labour = Number of workers employed
• Capital = Amount of equipment used in the
production
• Assumption: both L and K are homogeneous
• This principle can apply to firms using more than
two inputs and delivering more than one output
The Production Process
Production technology The quantitative

relationship between inputs and outputs.
Labor-intensive technology that relies heavily
on human labor instead of capital.
Capital-intensive technology: Technology that

relies heavily on capital instead of human labor.
While choosing the most appropriate technology,

Firms choose the one that minimizes the cost of
production.
Total, average and marginal product
• Total product- The total amount of output produced

• Marginal output (MP) of labour is the change in total product or extra output per unit changes in
labour used
TP
MPL 
L
• Average product (AP) of labour:
TP total product divided by the quantity of labour used
APL 
L
• Output elasticity of labour: percentage change in output divided by the percentage change in the
quantity of labour used
% Q
EL 
• % L =
• This can also be written as:

MPL
EL 
APL
Production function with one variable
input
Labour Total Product Marginal Average Output

(Number of (TP) Product (MP) Product (AP) elasticity of
workers) labour
0 0 - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1
TP, MP, AP of labour curves
Three Stages of Production
• Graphical relationship between TP, MP, and AP vs. units of labour

• It helps firms set production schedules and make staffing decisions
• The slope of TP curve rises up to some point, and then becomes zero at some point, and is
negative thereafter 2
• Three stages of production

• In the first stage – increasing marginal return
• AP of labour is maximum
• TP is increasing
• In the second stage – law of diminishing returns sets in
• AP of labour declines
• MP of labour is zero
• TP is maximum
• In the third stage – marginal returns become negative
• Adding more resources becomes counter productive
Three Stages of Production
Law of diminishing
returns
• As we use more and more units of the variable
input with a given amount of the fixed input, after
a point we get diminishing returns from the
variable input
Thank You
246
MBA ZC 416
BITS Pilani Sidharth Mishra

Pilani Campus Associate Professor, Management
Email: sidharth.mishra@pilani.bits-pilani.ac.in
BITS Pilani
Pilani Campus
Production Analysis - Part 2
Optimal use of labour
• Marginal revenue product of labour (MRP)-the extra revenue generated by
the use of an additional unit of labour. This equals
MRPL  ( MPL )( MR )
• Marginal resource cost of labour (MRC of labour)-the extra cost of hiring an
additional unit of labour, which equals to
TC/ L
• Condition: (Labour will be hired until) The extra revenue generated from the
sale of output by employing additional unit of labour equals the extra cost of
hiring the labour
• Example: additional revenue Rs. 30 and extra cost is Rs. 20
Optimal use of labour-Graphical
representation
MRCL=w
MRPL
Units of labour
used
Isoquants and Isocosts
Isoquant: shows all the combinations of capital and labor that

can be used to produce a given amount of output.
Isocost: shows all the combinations of capital and

labor available for a given total cost
Production function with two inputs
Alternative Combinations of Capital (K)

and Labor (L) Required
to Produce 50, 100, and
150 Units of Output
QX = 50 QX = 100 QX = 150
K L K L K L
A 1 8 2 10 3 10
B 2 5 3 6 4 7
C 3 3 4 4 5 5
D 5 2 6 3 7 4
E 8 1 10 2 10 3
Isoquant that shows all the combinations of capital

and labor that can be used to produce a given
amount of output.
MRTS
Slope of isoquant:
K MPL

L MPK
B Marginal rate of
A
technical substitution
The rate at which a firm
can substitute capital for
labor and hold output
constant.
The Slope of an Isoquant Is Equal
to the Ratio of MPL to MPK
Isocosts
Isocost line A graph

that shows all the
combinations of PL * L + PK*K = Constant
capital and labor
available for a given Slope = -PL / PK
total cost.
FIGURE Isocost Lines Showing the Combinations

of Capital and Labor Available for $5, $6,
and $7
Isocosts
FIGURE Isocost Line Showing All

Combinations of Capital and
Labor Available for $25
Slope of isocost line:
K TC / PK P
  L
L TC / PL PK
Finding the Least-Cost Technology with Isoquants and Isocosts
Finding the Least-Cost

Combination of Capital and
Labor to Produce 50 Units of Profit-maximizing firms will
Output minimize costs by producing
their chosen level of output with
the technology represented by
the point at which the isoquant
is tangent to an isocost line.
Here the cost-minimizing

technology—3 units of capital
and 3 units of labor—is
represented by point C.
The Cost-Minimizing Equilibrium Condition
At the point where a line is just tangent to a curve,

the two have the same slope. At each point of
tangency, the following must be true:
MPL P
slope of isoquant    slope of isocost   L
MPK PK
MPL PL
Thus, 
MPK PK
Dividing both sides by PL and multiplying

both sides by MPK, we get
MPL MPK Cost-minimizing

PL PK equilibrium condition
Economic Region of Production
• Economic region of production is given by the negatively sloped segment of

isoquants between ridge lines
Ridge lines
• Ridge lines separate the relevant from
irrelevant portions of the isoquants
• Isoquants have zero slope where ridge line
joins on the various isoquants
• Ridge line OV-the isoquants are negatively
sloped to the left and positively sloped to the
right
• The isoquants are negatively sloped to the right
of the ridge line (OZ) positively sloped to the left
Return to Scale
• Return to scale is the change in output achieved when the input factors are
changed by the same proportions.
• Constant Return to scale
• The output changes by the same proportion as input factors.
• Increasing return to scale
• The output change is more than the proportionate change in input factors.
• Decreasing return to scale
• The output change is less than the proportionate change in input factors.
• Example (capital and labour are considered the input factors)
• If the output doubles when capital and labour are doubled, it is a case of
constant return to scale.
• If the output MORE than doubles when capital and labour are doubled, it is a
case of increasing return to scale.
• If the output is LESS than double in the above case, it is decreasing return to
Empirical Production
function
• Cobb-Douglas empirical function
Q refers to the qty of outputQ  AK L

a b
K-capital
L-Labour
a and b are parameters to be estimated empirically, a and b would lie between 0
and 1.
Cobb-Douglas Production function-Properties
 The MP of capital and MP of labour depend on the quantity of capital and quantity of
labour used in the production which diminish with increasing input of the corresponding
factor of production (capital or labor).
 The exponents of K and L (a and b) represent the output elasticity of labour and capital
and sum of the exponents measures the returns to scale.
a b
 a+b =1; constant return to scale.
 a+b >1; increasing return to scale.
Q  AK L
 a+b <1, decreasing return to scale.
 Cobb-Douglas production function can be estimated by regression analysis by
transforming into ln Q  ln A  a ln K  b ln L
 Cobb-Douglas production function can be extended to deal with more than two inputs
Logarithm base 10.
Ln = loge Logarithm base e.
Euler’s number e = 2.7

Cobb Douglas Function - Properties
• Marginal Productivity (MP)

• MPL (Marginal productivity of Labour) = dQ/dL = d(Aka Lb)/dL = bAka Lb-1
(Differentiation at constant K)
• b-1 is negative as b<1 and hence as L increases, dQ/dL would decrease.
a b
• You can do the same analysis for MPk (Marginal productivity ofQCapital).
 AK L
• Output Elasticity
• Labour Output Elasticity = (% change in production)/% change in labour
input = (dQ/Q)/(dL/L) = (L/Q)(dQ/dL) = (L/Aka Lb)(bAka Lb-1 ) = b(Aka Lb / Aka
Lb) = b
• Capital output of elasticity = a
• Returns to Scale
• For constant return to scale, the output should double if the input factors
(capital and labour) are doubled.
• 2Q = A(2k)a (2L)b = 2a+b (Aka Lb) = 2a+bQ; 2=2a+b ; a+b =1
Solved Example-1
• The production function for a firm is Q=8K0.6 L0.4. Calculate the firm’s outputs if it
employs 30,40,50 and 60 hands for labour if 25 units of capital is used. What is
the firm’s return to scale?
Q  AK a Lb
• Solution:
Q = 8(25)0.6 (30)0.4 = 215 units. Outputs at other levels can be calculated
accordingly.
As a+b =0.6+0.4 =1, the firm would display constant return to scale.
change in Marginal
Capital Labour Output output Productivity
25 30 215
25 40 241 26 2.6
25 50 264 23 2.3
25 60 284 20 2
Solved Example-2
• A young doctor started a clinic in a new town. After experimenting for sometime could estimate
that at an investment of Rs. 1 lakh and with one attendant she is able to handle 10 patients per
day. The corresponding numbers (patients handled per day) with (Rs. 2 lakh,2 employees) and
(Rs. 5 lakh, 4 employees) are 18 and 35 respectively. How much capital does she need to
invest if she does not want to increase the number of employees but wants to increase the
capacity of her clinic to handle 50 patients per day? Assume the Cobb Douglas production
function and the unit of capital as Rs. Lakh.
• Solution is on the next slide.
Solution
lnQ = lnA+ alnK+ blnL - Eqn 1 Cobb Douglas Function in log format.
The three production situations mentioned in the question have been represented in the accompanying table.
Output(Q) Capital (K) Labour(L)
10 1 1
18 2 2
35 5 4
Putting the figures for the three production situation into the equation we obtain
ln10 = lnA+ aln1 + bln1 –Eqn 2
ln18 = lnA+ aln2+bln2 - Eqn 3
ln35 = lnA+aln5+bln4 - Eqn 4
Substituting the log values in the equations (ln1 =0, ln2 = 0.7, ln4 = 1.4 and ln5 = 1.6, ln10 =2.3,ln18=2.9,ln35=3.6)
2.3 = lnA
2.9 = lnA+0.7a+0.7b
3.6 = lnA+1.6a+1.4b
The above equations can be solved to give A =10, a=0.5, b=0.357
The Cobb Douglas function can now be written as lnQ = ln10+0.5lnK+0.357lnL
Solution (continued)
We need to find out the capital required when Q=50 and L=4
Using the Cobb-Douglas equation
lnQ = ln10+0.5lnK+0.357lnL
Ln50 = ln10+0.5lnK+0.357ln4
Substituting the logarithm values,

3.9= 2.3+0.5lnK+0,357*1.4 ln50 = 3.9. ln10=2.3, ln4=1.4
lnK = 2.21
K = e2.21 = Rs. 9.1 lakh.
The doctor has to employ a capital of Rs. 9.1 Lakh to get the output of 50 patients per day with four labour hands.
13/02/2016 MBA ZC416 Session 07

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BITS Pilani

Marketing Model (BA ZC 421)

• Modelling – Definition and Scope

A system or thing used as an example to follow or imitate.

Example: Rutherford’s Model of the Atom (Physics)

Similar models are created in marketing to understand/predict buyer-intermediary-

• Pricing of a product line to avoid cannibalization (Dobson-Kalish Model)

A Model to solve a marketing case.

• Introduction to marketing model

• Frequency Distributions are important to understand consumer behaviour.

Roll Nos Marks Roll No Marks Score Interval frequency* probability

Question: If a student is taken randomly from the class, what is

• Binomial distribution is the extension of Bernoulli’s distribution to include multiple

0 otherwise = n!/ (r!)(n-r)! where n! = n(n-1)(n-2)…3.2.1

• Please note that P(0)+P(1)+P(2)+P(3)+P(4)+P(5) = 1. They cover the whole

• As we saw before, the probability of occurrence of a desired outcome over a large

Probability as area under curve

• A normal distribution is specified by two parameters𝜇 and 𝜎, is sometimes

b. P(X<20) = 1- P(X>=20) = 1- 0,0228 = 0.9772

• A coffee shop is located inside a colony of 600 people. The probability of a

shown in the figure is equal to 0.5 -0.1 = 0.4 C

Marketing Model (BA ZC 421)

• The above gives probability of x staying in the range 0 to x.

The expression for the gamma distribution g(x/r=2, α =1) =

The total area under the curve = 1.

• Let us illustrate gamma distribution with an example of a grocer in a housing

0.53  31 2 e0.5

Marketing Model (BA ZC 421)

Sl No. Stage Description Models

• The above gives probability of x staying in the range 0 to x.

The expression for the gamma distribution g(x/r=2, α =1) =

The total area under the curve = 1.

• Let us illustrate gamma distribution with an example of a grocer in a housing

0.53  31 2 e0.5

• A stochastic process involves one or more random variables. A stochastic process

• Determination of efficacy on marketing inputs

Probability of this individual making 3 purchases in a day = P(X=3/2) =

x  r 1  r 1 x This is identical to the expression

• This is a modified model applicable to instances where the customer has a

0 Probability of purchase of brand A 1

• Purchase event feedback needs understanding of conditional probability.

Brand purchased on occasion 2

Second purchase brand

C 0.283 0.125 0.592 1

Joint Probability Matrix for Table:1

Relation between conditional and joint probability

No of purchases of B on Occasion2 with A chosen in Occasion 1

No of purchases of B on Occasion2 with A chosen in Occasion 1 X Total No of Purchases of A on Occasion 1

Joint Probability Matrix for Table:1

Relation between conditional and joint probability

No of purchases of B on Occasion2 with A chosen in Occasion 1

No of purchases of B on Occasion2 with A chosen in Occasion 1 X Total No of Purchases of A on Occasion 1

Marketing Model (BA ZC 421)

0 Probability of purchase of brand A 1

• Purchase event feedback needs understanding of conditional probability.

Brand purchased on occasion 2

Second purchase brand

mBt+1 = 0.50.3+0.50.5 = 0.4 0,5 A