Chapter 5 Consumers and Incentives

Chapter 5 Outline Why does the demand curve have a negative slope? 5 Consumers and Incentives Chapter 5 Outline 5.1 The Buyer’s Problem 5.2 Putting It All Together 5.3 From the Buyer’s Problem to the Demand Curve 5.4 Consumer Surplus 5.5 Demand Elasticities Key Ideas The buyer’s problem has three parts: what you like, prices, and your budget. An optimizing buyer makes decisions at the margin. An individual’s demand curve reflects an ability and willingness to pay for a good or service. Consumer surplus is the difference between what a buyer is willing to pay for a good and what the buyer actually pays. Elasticity measures a variable’s responsiveness to changes in another variable. Why does the demand curve have a negative slope?

5.1 The Buyer’s Problem What You Like: Tastes and Preferences What do you like? How much does it cost? How much money do you have? 5.1 The Buyer’s Problem What You Like: Tastes and Preferences What do you like? Everyone has different likes and dislikes, but we assume everyone has two things in common: We all want the “biggest bang for our buck” What we actually buy reflects our tastes and preferences

How much money do you have? 5.1 The Buyer’s Problem Prices of Goods and Services How much does it cost? We also assume two characteristics of prices: Prices are fixed—no negotiation We can buy as much as we want of something without driving the price up (because of an increase in demand) – i.e. , as individual consumers, is too small an influence on the overall market for our actions to have any effect on the market price. 5.1 The Buyer’s Problem How Much Money You Have to Spend: The Budget Set How much money do you have? There are lots of things to do with your money, but we assume: There is no saving or borrowing, only buying That even though we use a straight line to represent purchase choices, we only purchase whole units Explain that #2 means that each of us, as individual consumers, is too small an influence on the overall market for our actions to have any effect on the market price.

Why does the budget line have a negative slope? 5.1 The Buyer’s Problem How Much Money You Have to Spend: The Budget Set Exhibit 5.1 The Budget Set and the Budget Constraint for Your Shopping Spree If you have $300 to spend and all you buy are jeans, which cost $50 a pair, how many jeans can you buy? If all you buy are sweaters at $25 each, how many sweaters can you buy? Then connect the dots. Explore the three areas defined by this budget constraint: Bundles on the line—combinations of jeans and sweaters that exactly spend $300. Bundles inside the line (including buying no jeans and no sweaters)—bundles you can afford, but that don’t spend your income. Remind students that there is no saving, so if the $300 is not spent, it is lost—there is no other use for it than buying jeans and/or sweaters. Bundles outside the constraint—these are bundles that you can’t afford (that would cost more than $300). Remember there is no borrowing, so these bundles are unattainable. Why does the budget line have a negative slope? -- The negative slope represents trade-offs: if you want more of one thing, you have to give up something else, as long as prices and income stay constant.

5.1 The Buyer’s Problem How Much Money You Have to Spend: The Budget Set What does the slope represent? The slope is = to the Pjeans/Psweaters.

Exhibit 5.2 Your Buyer’s Problem ($300 available) 5.2 Putting It All Together Exhibit 5.2 Your Buyer’s Problem ($300 available) The first sweater = 4; 1 jeans = 3.2; therefore, you should buy a sweater since it has greater marginal benefit per dollar than the first pair of jeans. The second sweater = 3.4; first pair of jeans = 3.2; therefore, you should buy the second sweater for the same reason. You now own 2 sweaters and 0 jeans. The third sweater = 3; first pair of jeans = 3.2; therefore, you should buy the first pair of jeans. You now own 2 sweaters and one pair of jeans. We now look at the third sweater and the second pair of jeans: third sweater = 3; second pair of jeans = 3. You should buy both, but should you stop there? No, because you still have money left (remember the only choice of what to do with your money is to spend it on these two goods). You now own 3 sweaters and 2 pairs of jeans. The fourth sweater = 2.6, and the third pair of jeans = 2. You should buy the sweater. Continue in this way until you get to 6 sweaters and 3 pairs of jeans. Once again, the marginal benefit per dollar for each at that point is 2 and equal. At this point, you have spent $300.

Consumer Equilibrium Condition: 5.2 Putting It All Together Consumer Equilibrium Condition: MBs = MBj Ps Pj What if MBs = $75 and MBj = $100? Remind yourself that equilibrium just means there is no incentive to change your behavior. What would happen if the marginal benefit of another sweater were $75 and the marginal benefit of another pair of jeans was $100. The ratio would be 3 for sweaters and 2 for jeans. Suppose you get more bang for your buck with sweaters, is there an incentive to change your behavior? Yes, you would buy more sweaters. The incentive to change your behavior goes away when the two ratios are equal. If the ratio is 3 to 2 and they have an incentive to buy another sweater, what happens to the ratio? When you buy another sweater, the marginal benefit of that sweater is less than that of the previous sweater (because of diminishing marginal benefit), so it is less than $75, bringing it back to equilibrium.

5.2 Putting It All Together Price Changes Suppose the price of sweaters doubles, to $50. Before, the price of sweaters was $25 and the price of jeans was $50. You asked how many sweaters they could buy with their $300 if they didn’t buy any jeans and their answer was 12. If they only bought jeans, they could buy 6. Looking at the original line, ask them what would happen if the price of sweaters doubles, to $50. If they only buy sweaters, how many can they buy? The answer is 6. Ask what that looks like on the original graph—the budget constraint pivots on the jeans axis (horizontal). Now ask what would happen if instead, the price of jeans decreases to $25. If they buy only jeans (no sweaters), they can buy 12 pairs. Ask how the graph would change (the budget constraint would pivot on the vertical axis—the sweater axis).

5.2 Putting It All Together Price Changes The new budget constraint reflects the increase in the price of sweaters—and the line pivots on the other good. At the new price of sweaters, ask how many jeans must be given up if you want another sweater.. Exhibit 5.3 An Inward Pivot in the Budget Constraint from a Price Increase

5.2 Putting It All Together Price Changes Notice how the graph changes when the price of jeans decreased. Again, the budget constraint pivots on the axis with the other good and again, the opportunity cost changes. Exhibit 5.4 A Rightward Pivot in the Budget Constraint from a Price Decrease

5.2 Putting It All Together Income Changes Return to the original condition of the price of a sweater = $25 and the price of jeans = $50. What would happen if they had $600 instead of $300. Again, if all they buy is sweaters, they could now afford 24; jeans, 12. The slope of the line does not change because the ratio of the prices hasn’t changed (and that means opportunity cost doesn’t change), so the budget constraint shifts out in parallel fashion. Exhibit 5.5 An Outward Shift in the Budget Constraint from an Increase in Income

Marginal Benefits per Dollar Spent = 5.3 From the Buyer’s Problem to the Demand Curve   Sweaters $25 Jeans $50 Quantity Total Benefits (A) Marginal Benefits (B) Marginal Benefits per Dollar Spent = (B) / $25 (C) (D) (D) / $50 (D) / $75 1 100 4 160 3.2 2.13 2 185 85 3.4 310 150 3 260 75 410 1.33 325 65 2.6 490 80 1.6 1.07 5 385 60 2.4 520 30 0.6 0.4 6 435 50 530 10 0.2 0.13 7 480 45 1.8 533 0.06 0.04 8 40 535 0.03 9 555 35 1.4 536 0.02 0.01 589 34 1.36 537 11 622 33 1.32 538 -0.02 12 654.5 32.5 1.3 539 -0.07 Go back to the table with marginal benefits (Exhibit 5.2). when the price of jeans is $50, the optimal quantity of jeans is 3. what happens to the optimal number of jeans if the price of jeans increases to $75. look carefully at the table on this slide and notice that the last column has changed (the values have decreased) because the price of jeans has increased. Perform the same kind of analysis as before, with the result that when the price is $75, the optimum quantity of jeans is 2. If you want, you can change this column a few more times with different prices of jeans, getting various optimal quantities. These results are summarized in the next slide.

5.3 From the Buyer’s Problem to the Demand Curve Why does a soda machine only dispense one bottle or can at a time, but a newspaper vending machine opens up so that you can take as many as you want? Idea: marginal benefit: the marginal benefit of an additional newspaper is zero—there’s no incentive to take another one. But the marginal benefit of another bottle of pop is (probably) positive.

Exhibit 5.8 Market-Wide Consumer Surplus Consumer Surplus -The difference between what you are willing to pay and what you have to pay (the market price) Summing across all the individual demand curves gives us a market curve, along with a market consumer surplus. We can get an exact measure by using the formula for the area of a triangle. Exhibit 5.8 Market-Wide Consumer Surplus

Exhibit 5.9 Market-Wide Consumer Surplus When Prices Change 5.4 Consumer Surplus An Empty Feeling: Loss in Consumer Surplus When Price Increases When the price of a good increases, there are fewer people who are willing to pay more than the market price. Therefore, consumer surplus falls. So when the price of a good increases, for whatever reason, the added benefit to consumers (overall) falls. Likewise, when the price decreases, consumer surplus increases, increasing the overall welfare of consumers. Exhibit 5.9 Market-Wide Consumer Surplus When Prices Change

Your Buyer’s Problem with an Extra $100 ($300 → $400) 5 Consumers and Incentives Your Buyer’s Problem with an Extra $100 ($300 → $400) Compare this table to the original—the marginal benefits and the marginal benefits per dollar are the same. What’s different is that now you have $400 to spend instead of $300. So the optimal bundle of sweaters and jeans has changed. One can now buy 8 sweaters (before it was 6) and 4 pairs of jeans (before it was 3 pairs). Accepting the $100 per month to quit smoking means that you can consume 2 more sweaters and 1 more pair of jeans.

5.4 Demand Elasticities Suppose you play in a band. Your band has a steady gig with a bar that gives you the cover charge without taking a cut. You and your band are interested in increasing the money you make from this gig and are talking about changing the cover charge. Should you increase it or decrease it? The Issue we know from the law of demand that if price increases, quantity demanded decreases and vice-versa. So one option is to increase the cover charge, making more from each person who comes in but knowing that fewer people will attend. The other option is to decrease the price, knowing that more people will attend but that you will be making less from each person. Both options make sense and are reasoned correctly. But only one can be correct.

5.4 Demand Elasticities Elasticity- A measure of how sensitive one variable is to changes in another Three measures of elasticity: 1. Price elasticity of demand 2. Cross-price elasticity of demand 3. Income elasticity of demand 1. Price elasticity of demand answers the question: How much does quantity demanded change when the good’s price changes? Mathematically: the percentage change in quantity demanded due to a percentage change in price: 5.4 Demand Elasticities -The Price Elasticity of Demand

5.4 Demand Elasticities Price Elasticity of Demand Jeans example from Exhibit 5.6: The lowest price was $25, and the optimal quantity was 4 pairs. The second price was $50, and the optimal quantity was 3 pairs. Quantity decreased by 25% ((4-3)/4) when price increased by 100% ((25-50)/25), so ED = -25%/100% = -0.25 Ask students why the sign is negative. Lead them to understand that if price and quantity have an inverse relationship, as is the case because of the law of demand, this result must be negative. Because it is always negative, we ignore the sign and focus on the magnitude of the number.

5.4 Demand Elasticities Elasticity Measures ED > 1 = Elastic ED < 1 = Inelastic ED = 1 = Unit Elastic ED = ∞ = Perfectly Elastic ED = 0 = Perfectly Inelastic The jeans example returned an elasticity of 0.25 (remind them to ignore the negative sign), so that makes the price elasticity of demand for jeans inelastic. What does that mean? Remember how that number was computed: price increased by 100%, but the effect on the quantity was not nearly that much—only 25%. So people don’t respond very much (in terms of their demand for jeans) when the price changes. If demand is elastic, people are pretty responsive to price changes and will change their quantity demanded quite a bit. With perfectly elastic demand, any change in price means that consumers stop purchasing completely. And perfectly inelastic means that no matter what the price is, consumers will buy the same amount. These two extremes are more theoretical than practical, although they will be seeing perfectly elastic demand functions in an upcoming chapter.

Exhibit 5.13 Examples of Various Price Elasticities 5.4 Demand Elasticities Elasticity Measures Exhibit 5.13 Examples of Various Price Elasticities

Should you increase it or decrease it? 5.4 Demand Elasticities Suppose you play in a band. Your band has a steady gig with a bar that gives you the cover charge without taking a cut. You and your band are interested in increasing the money you make from this gig and are talking about changing the cover charge. Should you increase it or decrease it?

TR = P x Q = TR 5.4 Demand Elasticities TR = P x Q If demand is inelastic, when price increases, quantity decreases—a little: TR = P x Q = TR The price increase pushes total revenue up, the quantity decrease pushes total revenue down, but the price increase is more than the quantity decrease, so the final result is that total revenue increases. If price decreases, total revenue also decreases. As a result of the lower price, quantity increases, but because demand is inelastic, quantity increases only slightly. The net result on total revenue is that it decreases. TR = P x Q = TR

Number and closeness of substitutes Budget share spent on the good 5.4 Demand Elasticities Determinants of the Price Elasticity of Demand Determinants: Number and closeness of substitutes Budget share spent on the good Time horizon available to adjust to price changes

5.4 Demand Elasticities Determinants of the Price Elasticity of Demand (a). Why are last-minute airplane tickets so expensive? (b). Why are last-minute Broadway show tickets so cheap? Key: Think of the determinants of elasticity, particularly substitutes. If someone needs to get somewhere quickly, there are no substitutes for flying there. But there are many substitutes for Broadway show tickets—there are a lot of other things to do in New York City, so people will be more responsive to the price.

5.4 Demand Elasticities The Cross-Price Elasticity of Demand Cross-price elasticity of demand answers the question: How much does the quantity demanded of one good change when the price of another good changes? Mathematically: the percentage change in demand of good 1 due to a percentage change in the price of good 2: Note: In the case of cross-price elasticity, both the sign and the magnitude are important. If the answer is positive that the goods are substitutes. If it is negative, it means that the goods are complements. The magnitude of the elasticity is a measure of how strong the relationship is between the two goods. A cross-price elasticity of 0.05 indicates a very weak relationship, for example. The closer the measure is to zero, the more likely it is that they actually have no relationship at all. Remind students that in the case of price elasticity of demand, the magnitude of the answer was the focus, not the sign, since it will always be negative. In the case of cross-price elasticity, both the sign and the magnitude are important. If the answer is positive, it means that an increase in the price of one good causes an increase in the demand for a second good. Remind them that you have discussed this relationship before. If it is positive, it means that the goods are substitutes. If it is negative, it means that the goods are complements. The magnitude of the elasticity is a measure of how strong the relationship is between the two goods. A cross-price elasticity of 0.05 indicates a very weak relationship, for example. The closer the measure is to zero, the more likely it is that they actually have no relationship at all.

Exhibit 5.14 Examples of Various Cross-Price Elasticities 5.4 Demand Elasticities The Cross-Price Elasticity of Demand Exhibit 5.14 Examples of Various Cross-Price Elasticities

3. Income elasticity of demand answers the question: 5.4 Demand Elasticities The Income Elasticity of Demand 3. Income elasticity of demand answers the question: How much does quantity demanded change when income changes? Mathematically: the percentage change in demand of a good due to a percentage change in income Again, both the sign and magnitude are important here. If the sign is positive, it means that an increase in income is causing an increase in demand, meaning that the good is a normal good. The opposite holds for inferior goods. Again, remind students that this relationship has been discussed before; the addition of elasticity just allows us to talk about measuring that relationship. The magnitude, again, measures the strength of the relationship.

Exhibit 5.15 Examples of Various Income Elasticities 5.4 Demand Elasticities The Income Elasticity of Demand Exhibit 5.15 Examples of Various Income Elasticities