Consumers and Incentives Microeconomics Seventh Edition Chapter 5 Consumers and Incentives If this PowerPoint presentation contains mathematical equations, you may need to check that your computer has the following installed: 1) MathType Plugin 2) Math Player (free versions available) 3) NVDA Reader (free versions available)

Learning Objective 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 (1 of 2) 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.

Key Ideas (2 of 2) 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.

Consumers and Incentives (1 of 3) Evidenced-Based Economics Example: Would a smoker quit the habit for $100 a month? = incentives What would motivate you? Tell students that this chapter is all about how individuals change their behavior because of incentives—encouragements to engage in a behavior or discouragements from engaging in a behavior. Incentives work in predictable ways, but the level of incentive it would take varies from person to person.

Consumers and Incentives (2 of 3) Why does the demand curve have a negative slope? Tell students that you’re going to end up where you started—at demand. Pose the question to them—why does the demand curve have a negative slope? They’ll probably tell you that the cheaper something is, the more people want it, or some variation. Tell them that is correct, but that’s answering the question when you begin with price—price falls, quantity demanded increases. But look at it as starting with quantity: why is it the case, that in order to be able and willing to buy another unit, the price has to fall? Tell them that you will answer this question as you go along. Along with another question…

Consumers and Incentives (3 of 3) 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? Pose this question to students and remember or jot down their answers. Many will probably have the right idea, but won’t yet use the terminology contained in the chapter. Tell them that the answer to this question will also be revealed as you go along.

The Buyer’s Problem What do you like? How much does it cost? How much money do you have? Tell students that all 3 of these components are equally important. Give examples that only address one. For example, if you just focus on what you like, you might buy a private jet, or an island. But you have to consider the price of these things and if you have enough money for them when it comes to actually purchasing them. If you only consider the price, you might only buy the cheapest thing without thinking if you really want it, etc.

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

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) 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.

How Much Money You Have to Spend: The Budget Set (1 of 4) 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

How Much Money You Have to Spend: The Budget Set (2 of 4) Exhibit 5.1 The Budget Set and the Budget Constraint for Your Shopping Spree Ask students if this is a demand curve. Point out that a demand curve is a relationship between the quantity of one good and its price, while this is a relationship between quantities of two goods. But also point out that the prices of each good are “hidden” in the graph. It’s most helpful if you start at the endpoints: 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.

How Much Money You Have to Spend: The Budget Set (3 of 4) Why does the budget line have a negative slope? Lead students to understand that 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.

How Much Money You Have to Spend: The Budget Set (4 of 4) What does the slope represent? Lead students to compute what the slope is (-2). Ask what that means in terms of jeans and sweaters. If necessary, remind them of the trade-off discussion from the previous slide. The slope is a way to quantify what those trade-offs are. So if you want to buy 2 more sweaters, you have to give up one pair of jeans. Or, conversely, if you’re willing to give up one pair of jeans, you will gain 2 sweaters. Ask students if this concept sounds familiar: what you give up if you choose something. Once opportunity cost has been given as the answer, ask if they needed a graph to determine what the opportunity cost of sweaters and jeans is. Lead them to understand that the prices of each good give the same information and the slope is = to the Pjeans/Psweaters. Also point out that this ratio is constant because prices are fixed; therefore, the opportunity cost of each good in terms of the other is constant.

Putting It All Together (1 of 8) Suppose Bill Gates offered to buy you a Jaguar—a $100,000 car. Would you accept his offer? Students will answer that of course they would accept the car.

Putting It All Together (2 of 8) The next day, he calls and says he doesn’t have time to buy the car and will just give you a check for $100,000 instead. Will you go buy the car? Most students will say that they will not buy the car. Ask them why—if they would accept the car valued at $100,000, why wouldn’t they take the money and go buy the car? Guide them to understand that they said they would not buy the car because there are other things that they value more than the car, which they would rather spend the money on. In other words, there are other things they could buy that would give them more utility per dollar than the car would.

Putting It All Together (3 of 8) Exhibit 5.2 Your Buyer’s Problem ($300 available) Blank Sweaters $25 Jeans $50 Quantity Total Benefits (A) Marginal (B) Marginal Benefits per Dollar Spent = (B) / $25 Blank 1 100 4 2 185 85 3.4 3 260 75 325 65 2.6 5 385 60 2.4 6 425 50 7 480 45 1.8 8 520 40 1.6 Quantity Total Benefits (C) Marginal Benefits (D) Marginal Benefits per Dollar Spent = (D) / $50 Blank 1 160 3.2 2 310 150 3 410 100 4 490 80 1.6 5 520 30 0.6 6 530 10 0.2 7 533 0.06 8 535 0.04 Direct students to the two columns of marginal benefit. Tell them to notice that marginal benefit falls as the consumption of sweaters and jeans increases. Ask why this might be so. Ask them to remember the example of eating their favorite food (this was in Chapter 3). You asked them if they would want one serving. They probably said yes. You asked if they wanted another serving. Some said yes; some said no. For those who said no, ask why not. Guide them to understand that the reason is because the marginal benefit of the second serving is less than that of the first. Of those who wanted a second serving, ask if they want a third. Some will say yes, others no. Repeat, demonstrating the concept of diminishing marginal benefit. Ask what would happen if you forced them to continue eating servings—what would happen to marginal benefit? They should recognize that it goes to zero and then becomes negative.

Putting It All Together (4 of 8) Exhibit 5.2 Your Buyer’s Problem ($300 available) Blank Sweaters $25 Jeans $50 Quantity Total Benefits (A) Marginal (B) Marginal Benefits per Dollar Spent = (B) / $25 Blank 1 100 4 2 185 85 3.4 3 260 75 325 65 2.6 5 385 60 2.4 6 425 50 7 480 45 1.8 8 520 40 1.6 Quantity Total Benefits (C) Marginal Benefits (D) Marginal Benefits per Dollar Spent = (D) / $50 Blank 1 160 3.2 2 310 150 3 410 100 4 490 80 1.6 5 520 30 0.6 6 530 10 0.2 7 533 0.06 8 535 0.04 Looking at the table, at marginal benefit per dollar spent, we see the following: 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.

Putting It All Together (5 of 8) Consumer Equilibrium Condition: MBs = MBj Ps Pj What if MBs = $75 and MBj = $100? Remind students that equilibrium just means there is no incentive to change your behavior. Ask students 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. If 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.

Price Changes (1 of 4) Remind students of how the original budget constraint was formed. 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).

Price Changes (2 of 4) Exhibit 5.3 An Inward Pivot in the Budget Constraint from a Price Increase Show that they were correct—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. Guide them to noticing that the opportunity cost has changed because the prices have changed.

Price Changes (3 of 4) Exhibit 5.4 A Rightward Pivot in the Budget Constraint from a Price Decrease Close this section by showing that they were correct about 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.

Consumer Equilibrium Condition: MBs = MBj Ps Pj Price Changes (4 of 4) Consumer Equilibrium Condition: MBs = MBj Ps Pj Refer students back to the equilibrium condition and ask what would happen if the price of sweaters increased to $50. That means that the marginal benefit per dollar spent on sweaters is now lower than it was before, so they would buy fewer sweaters.

Income Changes Exhibit 5.5 An Outward Shift in the Budget Constraint from an Increase in Income Finally, return to the original condition of the price of a sweater = $25 and the price of jeans = $50. Now ask students what would happen if they had $600 instead of $300. Again, if all they buy is sweaters, they could now afford 24; jeans, 12. Point out that 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.

Putting It All Together (6 of 8) Ask students to remember the consumer equilibrium condition and ask if they utilize this formula when they shop. Ask them if, when they reach for a box of cereal, if they think to themselves, “I’m going to get $5 worth of marginal benefit from this box!” They will probably answer no. Tell them that, of course, no one does that kind of calculation, at least consciously. But tell them that they act as if they do…

Putting It All Together (7 of 8) Tell them to imagine that they are approaching a stop light that has just turned red. Tell them to imagine that they are applying the brake. Then ask them to tell you what the mathematical formula is that uses the weight of their car, the speed at which they are travelling, and the distance to the light to bring them to a stop at the appropriate place. This is ridiculous—no one who isn’t a physicist could tell you the formula. But point out to them that they act as if they are applying the formula.

Putting It All Together (8 of 8) Now ask how many of them have ever caught a fly ball. Or watched a ball game. Ask them to tell you the formula that describes the parabola the ball forms as it flies through the air. Ask them if the outfielder could describe the formula. Again, make the point that the ball player’s behavior indicates that he knows what the formula is because he gets under the ball and makes the catch. The point here is that we unconsciously carry out actions that have mathematical formulas behind them. We don’t know what those formulas are, but that doesn’t prevent us from acting as if we do. Applying the consumer equilibrium condition is the same. Even when people don’t know what that formula is, they act in a way (maximizing their benefit) that makes it seem as if they do.

From the Buyer’s Problem to the Demand Curve (1 of 4) Blank Sweaters $25 Jeans $50 Quantity Total Benefits (A) Marginal (B) Marginal Benefits per Dollar Spent = (B) / $25 Blank 1 100 4 2 185 85 3.4 3 260 75 325 65 2.6 5 385 60 2.4 6 425 50 7 480 45 1.8 8 520 40 1.6 Quantity Total Benefits (C) Marginal Benefits (D) Marginal Benefits per Dollar Spent = (D) / $50 Marginal Benefits per Dollar Spent = (D) / $75 Blank   1 160 3.2 2.13 2 310 150 3 410 100 1.33 4 490 80 1.6 1.07 5 520 30 0.6 0.4 6 530 10 0.2 0.13 7 533 0.06 0.04 8 535 0.03 Go back to the table with marginal benefits (Exhibit 5.2). Remind students that when the price of jeans is $50, the optimal quantity of jeans is 3. Ask them what happens to the optimal number of jeans if the price of jeans increases to $75. Ask them to 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.

From the Buyer’s Problem to the Demand Curve (2 of 4) Exhibit 5.6 Your Demand Curve for Jeans Plotting the price of jeans against each of these optimal quantities gives us the demand curve.

From the Buyer’s Problem to the Demand Curve (3 of 4) Why does the demand curve have a negative slope? Return to the question: why does the demand curve have a negative slope? Again, students will say that when the price is lower, people will want to buy more. Draw their attention to the other direction: why is it that you are only willing to buy another unit if the price falls? Remind them of what happens to marginal benefit when they consume another unit (it falls). If marginal benefit falls with another unit, the only way they’d be willing to buy that unit would be if the price also fell.

From the Buyer’s Problem to the Demand Curve (4 of 4) 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? Pose this question again. If they are still not sure, guide them to 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.

How much are you willing to pay for an A? Consumer Surplus (1 of 4) How much are you willing to pay for an A? Remind students that you posed this question back in Chapter 4. Ask them again to decide on a dollar amount that they are willing to pay. Then tell them that the market price for an A is $30. Ask how many students would have been willing to pay more than that. Of those that hold up their hands, ask one of them what his/her maximum price was, then subtract $30 from that. For example, if the student was willing to pay $50, remind him/her that this is the value of the benefit of an A to him/her. Therefore, any price less than that represents an additional benefit from purchasing an A. Therefore, the $20 difference (or whatever the difference is) is the added benefit, or consumer surplus.

Consumer Surplus (2 of 4) The difference between what a buyer is willing to pay for a good and what the buyer actually pays. Ask if another student was willing to pay more than $30, but less than the first student. Point out that while this second student’s consumer surplus is less than the first student’s, there is still added benefit from purchasing an A. Ask if there is anyone who was only willing to pay $30. Ask what this student’s consumer surplus would be.

Consumer Surplus (3 of 4) Exhibit 5.7 Computing Consumer Surplus These separate amounts can be represented as in the graph for jeans.

Consumer Surplus (4 of 4) Exhibit 5.8 Market-Wide Consumer Surplus 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.

An Empty Feeling: Loss in Consumer Surplus When Price Increases Exhibit 5.9 Market-Wide Consumer Surplus When Prices Change 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.

Consumers and Incentives (1 of 4) Evidenced-Based Economics Example: Would a smoker quit the habit for $100 a month? = incentives What would motivate you? Returning to the opening question: Tell students to remember the framework of this chapter—tastes and preferences; prices; and income. Which component does an increase of $100 per month represent? Income How does an increase in income affect the budget constraint? (see next slide)

Consumers and Incentives (2 of 4) Exhibit 5.10 Experimental Results from Smoking Study This change in income is represented here.

Consumers and Incentives (3 of 4) Your Buyer’s Problem with an Extra $100 ($300 → $400) Blank Sweaters $25 Jeans $50 Quantity Total Benefits (A) Marginal (B) Marginal Benefits per Dollar Spent = (B) / $25 Blank 1 100 4 2 185 85 3.4 3 260 75 325 65 2.6 5 385 60 2.4 6 425 50 7 480 45 1.8 8 520 40 1.6 Quantity Total Benefits (C) Marginal Benefits (D) Marginal Benefits per Dollar Spent = (D) / $50 Marginal Benefits per Dollar Spent = (D) / $75 Blank   1 160 3.2 2.13 2 310 150 3 410 100 1.33 4 490 80 1.6 1.07 5 520 30 0.6 0.4 6 530 10 0.2 0.13 7 533 0.06 0.04 8 535 0.03 Invite students to 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. You 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.

Consumers and Incentives (4 of 4) The question becomes, then, how much is smoking worth? If you give it up, you will gain 2 sweaters and one pair of jeans. Is it worth it? And that’s not all you will gain. You will also gain the money you spend on cigarettes, so income would really go up by more than $100 a month, so you would gain more than the 2 sweaters and one pair of jeans. The evidence shows that this kind of incentive actually does work, so people really do make these kinds of calculations.

Demand Elasticities (1 of 10) Why are last-minute airplane tickets so expensive? Students can sometimes get close to this answer—whether someone gets it or not, defer answering it completely until you have covered elasticity fully. For now, just pose the question. Why are last-minute Broadway show tickets so cheap?

Demand Elasticities (2 of 10) 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? Students usually have quick answers for this one. Regardless of which one they choose, you can press them for why they answered the way they did. Lay out the situation in a more formal way: 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. Lead students to understand that the answer to this question depends on who they think will come to hear the band. Will it be friends and family? Or will others (with no allegiance to them) also come? Finish by reminding them that we know that a relationship exists between price and quantity. Now we will talk about how strong that relationship is and quantify it so that we can answer these kinds of questions.

Demand Elasticities (3 of 10) Letting the Data Speak Should McDonald’s Be Interested in Elasticities? How do hamburger sales and revenues respond to price changes? The example of the McDonald’s is a good one not only because students can relate to it but because it provides an easy memorization shortcut for calculating elasticity (Q/P and expanded on following slides) Students will have quick answers for this one. They typically point out that if hamburger prices increase, fewer hamburgers will be sold and vice versa. What happens if the prices of hamburgers at Burger King have any effect on the sales of McDonald’s hamburgers. What happens if customers all of the sudden have less income to spend on hamburgers? Lead students to see how the answers to these questions are determined by how sensitive consumers are to price changes of the product itself as well as for other products and how sensitive demand for hamburgers is to changes in income.

Demand Elasticities (4 of 10) Elasticity A measure of how sensitive one variable is to changes in another Elasticities help us answer the questions on the previous slide

Demand Elasticities (5 of 10) Three measures of elasticity: 1. Price elasticity of demand 2. Cross-price elasticity of demand 3. Income elasticity of demand Remind students of the determinants of demand: own price, prices of other goods, income, tastes and preferences, etc. Remind them that they already know that when any one of these factors changes, demand changes. Elasticity is just a way to measure how much quantity changes when one of the factors change. We will focus on three.

The Price Elasticity of Demand (1 of 5) Price elasticity of demand answers the question: How much does quantity demanded b change when the good’s price changes? Mathematically: the percentage change in quantity demanded due to a percentage change in price:

The Price Elasticity of Demand (2 of 5) Price elasticity of demand answers the question: Speaking of hamburgers…a nice way to remember the elasticity equation: Quarter Pounder Give students an easy way to remember that the equation for elasticity is percent change in Quantity over percent change in Price: the famous hamburger from McDonald’s can help with this. Quarter Pounder, QP it is always Q over P. Even when we look at cross price elasticities, the source of the “P” is from another product, but it’s still Q over P With income elasticities we simply replace the “P” in the equation with something else we value with a dollar sign: Income. So it becomes Q over I This is a nice memorization technique for students who are trying to learn the concept of elasticities for the first time It may be silly but it will help them to remember!

The Price Elasticity of Demand (3 of 5) DQ Average Q DP Average P It might seem like overkill but students often need to be walked through the steps required to calculate elasticity. It can help to just slow down at this point and talk about the individual pieces. Remind them that it seems easy (because it is) but come exam day remembering all of the components required to calculate elasticity may not come so easy.

The Price Elasticity of Demand (4 of 5) An algebraic short cut to calculating elasticity: We can simplify the math a bit and use this shortcut to calculate PED It is not as intuitive as the previous formula, but this one is cleaner and shorter. Remind students that they can commit this to memory for the exam and it will save them some time and stress. Also remind them if they get stuck or have some anxiety, they can simply revert to the intuitive “Quarter Pounder” method

The Price Elasticity of Demand (5 of 5) 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) Price increased by 100% ((25-50)/25) 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. Remind them that the sign doesn’t matter here because of the law of demand; however, the sign is critically important when using cross and income elasticity measures

Elasticity Measures (1 of 3) 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? Remind them of 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.

Elasticity Measures (2 of 3) Exhibit 5.13 Examples of Various Price Elasticities Goods Category Price Elasticity3 Olive Oil 1.92 Peanut Butter 1.73 Ketchup 1.36 Wine 1.00 Laundry Detergent 0.81 Shampoo 0.79 Potato Chips 0.45 Cigarettes 0.40

Elasticity Measures (3 of 3) Let’s look at another point on the demand curve for jeans: Original price = $25; original quantity = 4 pair What if price increased to $30 (20% increase) As a result, the optimal quantity fell to 3 (25% decrease) ED = -25%/20% = | -1.25 | Doing another example can help students understand what these numbers mean—ask if this is elastic or inelastic— and again remind them about the negative number. Then ask if consumers are responding a lot or a little to the change in price.

Demand Elasticities (6 of 10) 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? Go back to this question. Lead them to understand that the answer depends on how elastic the demand is for their performances.

Demand Elasticities (7 of 10) TR = P × Q If demand is inelastic, when price increases, quantity decreases—a little: TR = P × 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 demand is inelastic, then any given increase in the cover charge will result in a smaller relative decrease in attendance. So of the two components of TR, the price increase is relatively larger than the quantity decrease, so the overall effect on total revenue is that it increases.

Demand Elasticities (8 of 10) TR = P × Q 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 × Q = TR If demand is elastic, then any given increase in the cover charge will result in a larger relative decrease in attendance. Of the two components of total revenue, a price increase will be more than offset by a quantity decrease, so total revenue will fall. So the correct answer to the question depends on whether price elasticity of demand is elastic or inelastic. If it’s inelastic (only friends and family are coming), then the right thing to do may be to raise price to increase total revenue.

Demand Elasticities (9 of 10) How price elasticity of demand relates to total revenues Price Elasticity of Demand Value Increasing price Decreasing price Elastic ED > 1 Decreases Revenue Increases Revenue Unitary Elastic ED = 1 No change Inelastic ED < 1 Remind students that an easy way to determine whether or not the demand for a product or service is elastic or inelastic is to look at what happens to revenue (or expenditures) when price changes. If I own a business, and I raise price and revenues increase then it’s inelastic demand - a good example is insulin. No close substitutes If I own a business, and I raise price and revenues decrease then it’s elastic demand - a good example is ketchup. Many close substitutes

Determinants of the Price Elasticity of Demand (1 of 2) Number and closeness of substitutes Budget share spent on the good Time horizon available to adjust to price changes

Determinants of the Price Elasticity of Demand (2 of 2) Why are last-minute airplane tickets so expensive? Back to this question—if they are still stuck, ask them to think about 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. Why are last-minute Broadway show tickets so cheap?

The Cross-Price Elasticity of Demand (1 of 3) 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: 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.

The Cross-Price Elasticity of Demand (2 of 3) How to interpret the cross-price elasticity of demand Cross-Price Elasticity of Demand Type of Good or Service Negative Complement Zero Independent Positive Substitute

The Cross-Price Elasticity of Demand (3 of 3) Exhibit 5.14 Examples of Various Cross-Price Elasticities Goods Cross-Price Elasticity4 Meat and Fish 1.6 Clothing and Entertainment 0.6 Whole Milk and Low-Fat Milk 0.5 Meat and Potatoes −0.2 Food and Entertainment −0.7

The Income Elasticity of Demand (1 of 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.

The Income Elasticity of Demand (2 of 3) How to interpret the income elasticity of demand Income Elasticity of Demand Type of Good or Service Less than 0 Inferior Less than 1 and greater than 0 Normal and Necessity Greater than 1 Normal and Luxury

The Income Elasticity of Demand (3 of 3) Exhibit 5.15 Examples of Various Income Elasticities Goods Income Elasticity5 Foreign Vacation 2.10 Domestic Vacation 1.70 Vacation Home 1.20 Healthcare 1.18 Meats 1.15 Housing 1.00 Fruits and Vegetables 0.61 Gasoline 0.48 Cereal 0.32 Environment 0.25 Electricity 0.23 Rice −0.44 Public Transit −0.75

Demand Elasticities (10 of 10) Letting the Data Speak Should McDonald’s Be Interested in Elasticities? How do hamburger sales and revenues respond to price changes? Return to the example of the McDonald’s hamburgers (and maybe throw in a reminder of the Quarter Pounder memory technique) As we discussed in this chapter, the secret to determining how revenues change when prices change is elasticity. As we showed, when demand is inelastic, an increase in McDonald’s hamburger prices will lead to an increase in revenues. On the other hand, when demand is elastic, an increase in the price of burgers will cause a decrease in revenues. What happens to sales of quarter pounders when the price of a whopper changes? What happens to sales when consumers are moving up in income? McDonald’s and other businesses are quite interested in elasticities because of the valuable answers the measures provide to these questions

Copyright