Chapter 5: Consumers and Incentives
Microeconomics Third Edition Chapter 5: Consumers and Incentives
Learning Objectives
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: Refers to individual tastes and preferences regarding goods and services.
Prices: The cost of goods and services and how they affect purchasing decisions.
Your Budget: The financial constraints that limit purchasing power.
An Optimizing Buyer:
Makes decisions at the margin, meaning they evaluate the additional benefits in relation to the additional cost.
An Individual’s Demand Curve:
Reflects the consumer's ability and willingness to pay for a good or service. This means demand curves depict how much of a good a buyer will purchase at various prices.
Key Ideas (2 of 2)
Consumer Surplus:
Defined as the difference between what a buyer is willing to pay for a good and what the buyer actually pays for it. This surplus represents the benefit consumers receive when they pay less than what they were prepared to pay.
Elasticity:
Measures a variable’s responsiveness to changes in another variable, essentially indicating how consumers react to changes in price or income.
Evidence-Based Economics
Question: Would a smoker quit the habit for $100 a month?
Consumers and Incentives (1 of 4)
Question: Why does the demand curve have a negative slope?
Consumers and Incentives (2 of 4)
Question: Would rising gas prices change the type of vehicle you drive?
The Buyer’s Problem (1 of 2)
What Do You Like?
How Much Does It Cost?
How Much Money Do You Have?
The Buyer’s Problem (2 of 2)
Knowing these three ingredients leads to powerful implications about consumer choices in the marketplace.
What You Like: Tastes and Preferences
Assumptions:
Everyone seeks the “biggest bang for their buck,” aiming for maximum utility per dollar spent.
What individuals purchase reflects their unique tastes and preferences.
Question: What do our buying decisions signal about us as consumers?
Prices of Goods and Services
Cost Assumptions:
Prices are fixed, meaning there is no room for negotiation in the market.
Consumers are assumed to buy as much as they want without impacting the price through their demand, i.e., they are price takers.
How Much Money You Have to Spend: The Budget Set (1 of 6)
Budget Assumptions:
There is no saving or borrowing—consumption is the only option.
Purchase choices are depicted by straight lines, indicating whole unit purchases only.
How Much Money You Have to Spend: The Budget Set (2 of 6)
Exhibit 5.1: The Budget Set and the Budget Constraint for Your Shopping Spree:
Four Bundles on the Budget Constraint:
Bundle A: Quantity of Sweaters: 12, Quantity of Jeans: 0
Bundle B: Quantity of Sweaters: 8, Quantity of Jeans: 2
Bundle C: Quantity of Sweaters: 4, Quantity of Jeans: 4
Bundle D: Quantity of Sweaters: 0, Quantity of Jeans: 6
How Much Money You Have to Spend: The Budget Set (3 of 6)
Opportunity Cost Definition:
Opportunity Cost is defined as the loss incurred when one alternative is chosen over another. It can be calculated as follows:
Loss in Jeans / Gain in Sweaters = Opportunity Cost of Sweaters
Loss in Sweaters / Gain in Jeans = Opportunity Cost of Jeans
How Much Money You Have to Spend: The Budget Set (4 of 6)
Exhibit 5.1 Notes:
Example at Point D:
Given 12 Sweaters and 6 Jeans purchased, the opportunity lost in terms of jeans can be calculated as $2 per sweater.
Putting It All Together (1 of 12)
Hypothetical Scenario: Suppose Bill Gates offered to buy you a Jaguar priced at $100,000. Would you take the offer?
Putting It All Together (2 of 12)
Follow-Up Scenario: Bill Gates calls back, stating he’ll send a check for $100,000 instead. Would you still prefer the car? Discuss your reasoning.
Putting It All Together (3 of 12)
Exhibit 5.2: Your Buyer’s Problem with a $300 budget:
Pricing Structure and Benefits:
Quantity of Sweaters:
Total Benefits (A): $25
Marginal Benefits (B): $25
Marginal Benefits per Dollar Spent: rac{B}{25}
Quantity of Jeans:
Total Benefits (C): $50
Marginal Benefits (D): $50
Marginal Benefits per Dollar Spent: rac{D}{50}
Data Summary for Quantities purchased from 0 to 8 and related economic calculations provided in tabular format.
Putting It All Together (4 of 12)
Consumer Equilibrium Condition:
Represents the allocation where the marginal benefit per dollar spent is equal across all goods purchased. Thus, if MBs = 75 and MBj = 100, consider if the ratios are consistent with prices of $25 and $100 for sweaters and jeans, respectively.
Putting It All Together (5 of 12)
Continued Tabular Analysis of total benefits and marginal benefits described further in Exhibits 5.2 to 5.8 for deeper examination of budgets and consumer preferences.
Consumer Surplus (1 of 6)
Definition of Consumer Surplus:
Reflects market-created benefits wherein total benefits often surpass the prices paid for goods.
Mathematically, defined as: Consumer Surplus = ext{Total Willingness to Pay} - ext{Total Paid}
Consumer Surplus (2 of 6)
Market-Wide Consumer Surplus Example:
Illustrated through graphical exhibits that show variations across differing market price points.
Demand Elasticities (1 of 37)
Key Questions:
Why are last-minute airplane tickets notoriously expensive?
Why do last-minute Broadway show tickets tend to be cheaper?
Demand Elasticities (2 of 37)
Scenario: Suppose you play in a band with a consistent bar gig. How would altering the cover charge impact overall revenue? Should you increase or decrease it?
Demand Elasticities (3 of 37)
Data Interpretation: Specifically for businesses such as McDonald's, understanding how hamburger sales fluctuate in response to variations in price and demand is crucial for pricing strategies.
Demand Elasticities (4 of 37)
Definition of Elasticity:
A measure of how sensitive one variable is to changes in another, particularly relevant for assessing price sensitivity among consumers.
Demand Elasticities (5 of 37)
Three Measures of Elasticity:
Price Elasticity of Demand: - Evaluates how much quantity demanded changes with price alterations.
Cross-Price Elasticity of Demand: - Examines how quantity demanded of one good shifts in relation to another good's price change.
Income Elasticity of Demand: - Determines how quantity demanded varies with income changes.
Demand Elasticities (6 of 37)
Formula for Price Elasticity of Demand:
Calculated as:
e_d = rac{ ext{Percentage change in quantity demanded}}{ ext{Percentage change in price}}
Demand Elasticities (7 of 37)
Memory Aid for Elasticity Calculation:
Use a metaphor like ‘quarter pounder’ to help memorize dimensions of the elasticity equation.
Demand Elasticities (8 of 37)
Key Insights About Elasticities:
The slope across the demand curve remains consistent, yet the elasticity varies significantly across its range.
Elasticities differ depending on how far along the curve it is evaluated (in the exact middle, elasticity = 1).
Demand Elasticities (9 of 37)
Exhibit 5.11 showcasing Jacob's demand curve for specific items illustrates underlying elasticity trends.
Demand Elasticities (12 of 37)
Example of Calculating Arc Elasticity:
Utilizing: ext{Arc elasticity of demand} = rac{(Q2 - Q1) / rac{(Q2 + Q1)}{2}}{(P2 - P1) / rac{(P2 + P1)}{2}}
This captures percentage changes in quantity relative to price shifts over a given demand range.
Demand Elasticities (23 of 37)
Cross-Price Elasticity Interpretation: - Negative value implies complements, Zero indicates independence, Positive indicates substitutes.
Demand Elasticities (27 of 37)
Relating Price Elasticity of Demand to Total Revenue:
If demand is inelastic, an increase in price leads to an increase in total revenue, whereas a decrease results in decreased total revenue.
Demand Elasticities (28 of 37)
Determinants Influencing Price Elasticity of Demand:
Closeness of substitutes available.
The proportion of budget allocated toward the good.
Time available for consumers to adjust to price changes.