© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien c h a p t e r six Prepared by: Fernando & Yvonn Quijano Consumer Choice and Elasticity

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 2 of 36 After studying this chapter, you should be able to: Define utility and explain how consumers choose goods and services to maximize their utility. Explain how social influences can affect consumption choices. Describe how people can improve their decision making by taking into account nonmonetary opportunity costs, ignoring sunk costs, and being more realistic about their future behavior. Define the price elasticity of demand and understand how to calculate it. Understand the determinants of the price elasticity of demand. Understand the relationship between the price elasticity of demand and total revenue. Can LeBron James Get You to Drink Powerade? LEARNING OBJECTIVES Firms must understand consumer behavior to determine whether strategies such as using celebrities in their advertising are likely to be effective. 5 6

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 3 of 36 Consumer Choice and Elasticity Elasticity A measure of how much one economic variable responds to changes in another economic variable.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 4 of 36 Utility and Consumer Decision Making LEARNING OBJECTIVE 1 The Economic Model of Consumer Behavior in a Nutshell Utility Utility The enjoyment or satisfaction that people receive from consuming goods and services. The Principle of Diminishing Marginal Utility Marginal utility The additional utility a person receives from consuming one additional unit of a good or service. Law of diminishing marginal utility Consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 5 of 36 Utility and Consumer Decision Making Total and Marginal Utility from Eating Pizza on Super Bowl Sunday

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 6 of 36 Utility and Consumer Decision Making The Rule of Equal Marginal Utility per Dollar Spent Budget constraint The limited amount of income available to consumers to spend on goods and services. Total Utility and Marginal Utility from Eating Pizza and Drinking Coke 6 – 1 NUMBER OF SLICES OF PIZZA TOTAL UTILITY FROM EATING PIZZA MARGINAL UTILITY FROM THE LAST SLICE NUMBER OF CUPS OF COKE TOTAL UTILITY FROM DRINKING COKE MARGINAL UTILITY FROM THE LAST CUP  652 11

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 7 of 36 Utility and Consumer Decision Making The Rule of Equal Marginal Utility per Dollar Spent Converting Marginal Utility to Marginal Utility per Dollar 6 – 2 (1) Slices of Pizza (2) Marginal Utility (MU Pizza ) (3) Marginal Utility per Dollar (4) Cups of Coke (5) Marginal Utility (MU Coke ) (6) Marginal Utility per Dollar  --6 11

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 8 of 36 We can compactly summarize the two conditions for maximizing utility as follows: Spending on pizza + Spending on Coke = Amount available to be spent Utility and Consumer Decision Making The Rule of Equal Marginal Utility per Dollar Spent Equalizing Marginal Utility per Dollar Spent 6 – 3 Combinations of Pizza and Coke with Equal Marginal Utilities per Dollar Marginal Utility per Dollar (Marginal Utility/Price)Total SpendingTotal Utility 1 Slice of Pizza and 3 Cups of Coke10$2 + $3 = $ = 65 3 Slices of Pizza and 4 Cups of Coke5$6 + $4 = $ = 96 4 Slices of Pizza and 5 Cups of Coke3$8 + $5 = $ = 105

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 9 of 36 Finding the Optimal Level of Consumption Number of Ice Cream Cones Total Utility from Ice Cream Cones Marginal Utility from Last Cone Number of Cans of Lime Fizz Total Utility from Cans of Lime Fizz Marginal Utility from Last Can LEARNING OBJECTIVE 1

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 10 of 36 Finding the Optimal Level of Consumption (continued) LEARNING OBJECTIVE 1 Ice Cream ConesCans of Lime Fizz QuantityMU What if the Rule of Equal Marginal Utility per Dollar Does Not Hold?

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 11 of 36 Utility and Consumer Decision Making Where Demand Curves Come From Income effect The change in the quantity demanded of a good that results from the effect of a change in price on consumer purchasing power, holding all other factors constant. Substitution effect The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 12 of 36 Utility and Consumer Decision Making Deriving the Demand Curve for Pizza

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 13 of 36 Social Influences on Decision Making LEARNING OBJECTIVE 2 The Effects of Celebrity Endorsements Network Externalities Network externalities Network externalities exist when the usefulness of a product increases with the number of consumers who use it.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 14 of 36 Why Do Firms Pay Tiger Woods to Endorse Their Products? When consumers buy the same products as celebrities they feel fashionable and closer to the celebrities.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 15 of 36 Social Influences on Decision Making Does Fairness Matter? BUSINESS IMPLICATIONS OF FAIRNESS The Market for Tickets to the Producers

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 16 of 36 Professor Krueger Goes to the Super Bowl Should the NFL charge the highest price it can for Super Bowl tickets?

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 17 of 36 The Price Elasticity of Demand and Its Measurement LEARNING OBJECTIVE 4 Price elasticity of demand The responsiveness of the quantity demanded to a change in price, measured by dividing the percentage change in the quantity demanded of a product by the percentage change in the product’s price. Measuring the Price Elasticity of Demand

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 18 of 36 The Price Elasticity of Demand and Its Measurement Elastic Demand and Inelastic Demand Elastic demand Demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value. Inelastic demand Demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price, so the price elasticity is less than 1 in absolute value. Unit-elastic demand Demand is unit-elastic when the percentage change in quantity demanded is equal to the percentage change in price, so the price elasticity is equal to –1.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 19 of 36 The Price Elasticity of Demand and Its Measurement An Example of Computing Price Elasticities Elastic and Inelastic Demand Curves

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 20 of 36 The Price Elasticity of Demand and Its Measurement The Midpoint Formula Price elasticity of demand =

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 21 of 36 The Price Elasticity of Demand and Its Measurement When Demand Curves Intersect, the Flatter Curve is More Elastic Don’t Confuse Inelastic with Perfectly Inelastic

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 22 of 36 The Price Elasticity of Demand and Its Measurement Polar Cases of Perfectly Elastic and Perfectly Inelastic Demand Perfectly inelastic demand Demand is perfectly inelastic when a change in price results in no change in quantity demanded. Perfectly elastic demand Demand is perfectly elastic when a change in price results in an infinite change in quantity demanded.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 23 of 36 What Determines the Price Elasticity of Demand for a Product? LEARNING OBJECTIVE 5 The key determinants of price elasticity of demand are as follows:  Availability of close substitutes  Passage of time  Necessities versus luxuries  Definition of the market  Share of good in the consumer’s budget

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 24 of 36 What Determines the Price Elasticity of Demand for a Product? Summary of the Price Elasticities of Demand 6 – 4

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 25 of 36 What Determines the Price Elasticity of Demand for a Product? The Price Elasticity of Demand 6 – 4 (continued)

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 26 of 36 The Price Elasticity of Demand for Breakfast Cereal What happens when the price of cereal rises? CEREAL PRICE ELASTICITY OF DEMAND Post Raisin Bran-2.5 All family breakfast cereals-1.8 All types of breakfast cereals-0.9

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 27 of 36 The Relationship Between Price Elasticity and Total Revenue LEARNING OBJECTIVE 6 Total revenue The total amount of funds received by a seller of a good or service, calculated by multiplying price per unit by the number of units sold The Relationship Between Price Elasticity and Total Revenue

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 28 of 36 The Relationship Between Price Elasticity and Total Revenue Elasticity and Revenue with a Linear Demand Curve IF DEMAND IS...THEN... BECAUSE... elastic an increase in price reduces revenue the decrease in quantity demanded is proportionally greater than the increase in price. elastic a decrease in price increases revenue the increase in quantity demanded is proportionally greater than the decrease in price. inelastic an increase in price increases revenue the decrease in quantity demanded is proportionally smaller than the increase in price. inelastic a decrease in price reduces revenue the increase in quantity demanded is proportionally smaller than the decrease in price. unit-elastic an increase in price does not affect revenue the decrease in quantity demanded is proportionally the same as the increase in price. unit-elastic a decrease in price does not affect revenue the increase in quantity demanded is proportionally the same as the decrease in price. The Relationship between Price Elasticity and Revenue 6 – 5

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 29 of 36 The Relationship Between Price Elasticity and Total Revenue Elasticity is Not Constant Along a Linear Demand Curve 6 - 6

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 30 of 36 Price and Revenue Don’t Always Move in the Same Direction LEARNING OBJECTIVE 6 Verify that increasing a product’s price is not the only way to increase the revenue from selling a product.

© 2007 Prentice Hall Business Publishing Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 31 of 36 A Celebrity Endorser Who Doesn't Offend? Slim Chance

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 6: Consumer Choice and Elasticity 32 of 36 Behavioral economics Budget constraint Elastic demand Elasticity Endowment effect Income effect Inelastic demand Law of diminishing marginal utility Marginal utility ( MU ) Network externalities Opportunity cost Perfectly elastic demand Perfectly inelastic demand Price elasticity of demand Substitution effect Sunk cost Total revenue Unit-elastic demand Utility