1. Chapter 4 Consumer Decision Making and Consumer Reaction to Price Changes

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-2 Did You Know That... There has been a proliferation of choices at U.S. grocery stores, which now stock an average of 40,000 items? One way of deriving the law of demand involves an analysis of the logic of consumer choice in a world of limited resources? In this chapter we discuss what is called utility analysis.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-3 Utility Theory Utility  The want-satisfying power of a good or service Utility Analysis  The analysis of consumer decision making based on utility maximization Util  A representative unit by which utility is measured

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-4 Utility Theory (cont'd) Marginal Utility  The change in total utility due to a one-unit change in the quantity of a good or service consumed Marginal utility = Change in total utility Change in number of units consumed

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-5 Graphical Analysis We can appreciate total and marginal utility by using graphical analysis.

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-6 Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-7 Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (b)

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-8 Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (c)

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-9 Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panels (b) and (c) Total utility is maximized... …where marginal utility equals zero.

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-10 Graphical Analysis (cont'd) Observations  Marginal utility falls as more is consumed.  Marginal utility equals zero when total utility is at its maximum.

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-11 Example: The High Cost of Certain Sources of Negative Marginal Utility Conventional wisdom says that it is impossible to put a price tag on happiness. Economists usually attempt to attach dollar values to economic goods. What is the amount of compensation required for economic “bads”?

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-12 Figure 20-2 Compensation for Economic “Bads” That Yield Negative Marginal Utility

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-13 Diminishing Marginal Utility  The principle that as more of any good or service is consumed, its extra benefit declines  Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period.

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-14 Example: Newspaper Vending Machines versus Candy Vending Machines How many people take more than one paper from the vending machine? Why not dispense candy the same way? The answer is found in the concept of diminishing marginal utility.

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-15 Optimizing Consumption Choices Consumer Optimum  A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-16 Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-17 Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26 (cont'd)

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-18 Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26 (cont'd)

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-19 Optimizing Consumption Choices A consumer’s money income should be allocated so that the last dollar spent on each good purchased yields the same amount of marginal utility (when all income is spent), because this rule yields the largest possible total utility.

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-20 Table 20-2 Steps to Consumer Optimum

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-21 Table 20-2 Steps to Consumer Optimum (cont'd)

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-22 Optimizing Consumption Choices (cont'd) A little math  The rule of equal marginal utilities per dollar spent  A consumer maximizes personal satisfaction when allocating money income in such a way that the last dollars spent on good A, good B, good C, and so on, yield equal amounts of marginal utility.

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-23 A little math  The rule of equal marginal utilities per dollar spent Optimizing Consumption Choices (cont'd) MU of good A Price of good A = MU of good B Price of good B MU of good Z Price of good Z ==...

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-24 How a Price Change Affects Consumer Optimum Recall from Table 20-1 Income = $26 Q d = 4 MU d PdPd 36.5 5 = = 7.3 Q s = 2 MU s PsPs 22 3 = = 7.3

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-25 How a Price Change Affects Consumer Optimum (cont'd) Assume Price of Music Falls to $4 Q d = 4 MU d PdPd 36.5 4 = = 9.125 Q s = 2 MU s PsPs 22 3 = = 7.3

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-26 How a Price Change Affects Consumer Optimum (cont'd) Assume Price of Music Falls to $4 Result Buy more downloads and MU d falls Now MU d PdPd > MU s PsPs

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-27 How a Price Change Affects Consumer Optimum (cont'd) Consumption decisions are summarized in the law of demand  The amount purchased is inversely related to price. A consumer’s response to a price change  At higher consumption rate, marginal utility falls.

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-28 Figure 20-3 Digital Music Download Prices and Marginal Utility

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-29 How a Price Change Affects Consumer Optimum (cont'd) The Substitution Effect  The tendency of people to substitute cheaper commodities for more expensive commodities

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-30 How a Price Change Affects Consumer Optimum (cont'd) The Principle of Substitution  Consumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower.

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-31 How a Price Change Affects Consumer Optimum (cont'd) Purchasing Power  The value of money for buying goods and services

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-32 How a Price Change Affects Consumer Optimum (cont'd) Real-Income Effect  The change in people’s purchasing power that occurs when, other things being constant, the price of one good that they purchase changes  When that price goes up (down), real income, or purchasing power, falls (increases).

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-33 How a Price Change Affects Consumer Optimum (cont'd) Question  What do you think: Which would usually have more of an impact on your purchases—the substitution effect or the real-income effect?

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-34 The Demand Curve Revisited Question  How is the demand curve derived? Answer  By assuming income, tastes, expectations, and the price of related goods are not changing as the price of the good changes

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-35 E-Commerce Example: Have You Got My Size? Retailers using Intellifit’s scanners can use data to provide customers with printouts of brands, styles, and sizes likely to fit best. Their objective is to push up prospective customers’ marginal utility at any given price of an apparel item, thereby boosting sales.

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-36 The Demand Curve Revisited (cont'd) Marginal utility, total utility, and the diamond-water paradox  Water is essential to life but cheap.  Diamonds are not essential to life but expensive.

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-37 Figure 20-4 The Diamond-Water Paradox

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-38 Behavioral Economics and Consumer Choice Theory Question  Does behavioral economics better predict consumer choices? Answer  Consumer choice remains alive and well.

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-39 Did You Know That... A 10% reduction in the price of beer is associated with an increase in the incidence of campus violence of just over 3.5%? Consumers respond to changing prices in ways that influence total revenues that businesses receive? Economists have a special name for quantity responsiveness—elasticity, which is the subject of this chapter?

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-40 Price Elasticity Price Elasticity of Demand (E p )  The responsiveness of quantity demanded of a commodity to changes in its price  Defined as the percentage change in quantity demanded divided by the percentage change in price

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-41 Price Elasticity (cont'd) Price Elasticity of Demand (E p ) E p = Percentage change in quantity demanded Percentage change in price

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-42 E p = –1% +10% = –.1 Price Elasticity (cont'd) Example  Price of oil increases 10%  Quantity demanded decreases 1%

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-43 Price Elasticity (cont'd) Question  How would you interpret an elasticity of –0.1? Answer  A 10% increase in the price of oil will lead to a 1% decrease in quantity demanded.

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-44 Price Elasticity (cont'd) Relative quantities only  Elasticity is measuring the change in quantity relative to the change in price. Always negative  An increase in price decreases the quantity demanded, ceteris paribus.  By convention, the minus sign is ignored.

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-45 Calculating Elasticity Elasticity formula: Change in Q Sum of quantities/2 Ep =Ep = Change in P Sum of quantities/2 or in Q (Q 1 + Q 2 )/2 Ep =Ep = in P (P 1 + P 2 )/2

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-46 Example: The Price Elasticity of Demand for Gasoline After Hurricane Katrina in 2005 the nationwide price of gasoline rose from $2.61 to $3.07. The total quantity of gasoline consumed in the United States declined from 9.42 to 9.04 million barrels. What is the price elasticity of demand?

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-47 Example: The Price Elasticity of Demand for Gasoline (cont'd) Use the elasticity formula: 9.42 – 9.04 ÷ $3.07 – $2.61 (9.42 + 9.04)/2 ($3.07 +$2.61)/2 The price elasticity of 0.25 means that a 1% increase in price generated a 0.25% decrease in the quantity of gasoline demanded.

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-48 Let’s do some more examples in class..

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-49 Price Elasticity Ranges Elastic Demand  Percentage change in quantity demanded is larger than the percentage change in price  Total expenditures and price are inversely related in the elastic region of the demand curve  E p > 1

50. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-50 Price Elasticity Ranges (cont'd) Unit Elasticity of Demand  Percentage change in quantity demanded is equal to the percentage change in price  Total expenditures are invariant to price changes in the unit-elastic region of the demand curve  E p = 1

51. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-51 Price Elasticity Ranges (cont'd) Inelastic Demand  Percentage change in quantity demanded is smaller than the percentage change in price  Total expenditures and price are directly related in the inelastic region of the demand curve  E p < 1

52. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-52 Price Elasticity Ranges (cont'd) Elastic demand  % change in Q > % change in P; E p > 1 Unit-elastic  % change in Q = % change in P; E p = 1 Inelastic demand  % change in Q < % change in P; E p < 1

53. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-53 Price Elasticity Ranges (cont'd) Extreme elasticities  Perfectly Inelastic Demand  A demand curve that is a vertical line  It has only one quantity demanded for each price.  No matter what the price, quantity demanded does not change.  A demand that exhibits zero responsiveness to price changes.

54. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-54 Figure 21-1 Extreme Price Elasticities, Panel (a)

55. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-55 Price Elasticity Ranges (cont'd) Extreme elasticities  Perfectly Elastic Demand  A demand curve that is a horizontal line  It has only one price for every quantity.  The slightest increase in price leads to zero quantity demanded.

56. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-56 Figure 21-1 Extreme Price Elasticities, Panel (b)

57. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-57 Policy Example: Who Pays Higher Cigarette Taxes? State governments impose cigarette taxes, which are assessed as an amount per pack sold. These taxes are paid by sellers of cigarettes from the revenues they earn from their total sales. To receive the same price per quantity the seller would need a price higher by the tax amount.

58. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-58 Figure 21-2 Price Elasticity and a Cigarette Tax, Panels (a) and (b)

59. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-59 Figure 21-2 Price Elasticity and a Cigarette Tax, Panel (c)

60. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-60 Elasticity and Total Revenues When demand is elastic, a negative relationship exists between changes in price and changes in total revenues. When demand is unit-elastic, changes in price do not change total revenues. When demand is inelastic, a positive relationship exists between changes in price and total revenues.

61. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-61 Elasticity and Total Revenues (cont'd) Elasticity-revenue relationship  Total revenues are the product of price times units sold.  The law of demand states along a given curve, price is inverse to quantity.

62. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-62 Elasticity and Total Revenues (cont'd) What happens to the product of price times quantity depends on which of the opposing forces exerts a greater force on total revenues. This is what price elasticity of demand is designed to measure: responsiveness of quantity demanded to a change in price.

63. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-63 Table 21-1 Relationship Between Price Elasticity of Demand and Total Revenues Example

64. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-64 Determinants of Price Elasticity of Demand Existence of substitutes  The closer the substitutes and the more substitutes there are, the more elastic is demand. Share of the budget  The greater the share of the consumer’s total budget spent on a good, the greater is the price elasticity.

65. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-65 Determinants of Price Elasticity of Demand (cont'd) The length of time allowed for adjustment  The longer any price change persists, the greater is the elasticity of demand.  Price elasticity is greater in the long run than in the short run.

66. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-66 Determinants of Price Elasticity of Demand (cont'd) How to define the short run and the long run  The short run is a time period too short for consumers to fully adjust to a price change.  The long run is a time period long enough for consumers to fully adjust to a change in price, other things constant.

67. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-67 In the short run, quantity demanded falls slightly Figure 21-4 Short-Run and Long- Run Price Elasticity of Demand With more time for adjustment the demand curve becomes more elastic and quantity demanded falls by a greater amount

68. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-68 Example: What Do Real-World Price Elasticities of Demand Look Like? Economists have found that estimated elasticities of demand are greater in the long run than in the short run. Remember that even though we are leaving off the negative sign, there is an inverse relationship between price and quantity demanded.

69. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-69 Table 21-2 Price Elasticities of Demand for Selected Goods

70. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-70 Cross Price Elasticity of Demand Cross Price Elasticity of Demand (E xy )  The percentage change in the demand for one good (holding its price constant) divided by the percentage change in the price of a related good

71. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-71 Cross Price Elasticity of Demand (cont'd) Formula for computing cross price elasticity of demand between good X and good Y % Change in demand for good X % Change in price of good Y E xy =

72. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-72 Cross Price Elasticity of Demand (cont'd) Substitutes  E xy would be positive  An increase in the price of X would increase the quantity of Y demanded at each price. Complements  E xy would be negative  An increase in the price of X would decrease the quantity of Y demanded at each price.

73. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-73 Example: Do People Substitute Wireless Phone Services for Wired Services Recently, two economists estimated that the cross price elasticity of demand between wireless and wired phone services is about 0.02. This estimate implies that a 10% increase in the price of land-wired phone services induces a 0.2% increase in the quantity of wireless phone services demanded. Thus, the two types of phone services appear to be substitutes, but the degree of substitution is very slight.

74. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-74 Income Elasticity of Demand Income Elasticity of Demand (E i )  The percentage change in demand for any good, holding its price constant, divided by the percentage change in income  The responsiveness of demand to changes in income, holding the good’s relative price constant

75. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-75 Income Elasticity of Demand (cont'd) Percentage change in demand Percentage change in income Ei =Ei =

76. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-76 Table 21-3 How Income Affects Quantity of DVDs Demanded

77. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-77 Income Elasticity of Demand (cont'd) Income Elasticity of Demand  Refers to a horizontal shift in the demand curve in response to changes in income Price Elasticity of Demand  Refers to a movement along the curve in response to price changes

78. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-78 Income Elasticity of Demand (cont'd) Calculating the income elasticity of demand E i = Change in quantity ÷ Change in income Average quantity Average income  The income elasticity of demand can be either negative or positive.  Remember that in calculating the income elasticity of demand, the price of the good is assumed to be constant.

79. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-79 Price Elasticity of Supply Price Elasticity of Supply (E s )  The responsiveness of the quantity supplied of a commodity to a change in its price  The percentage change in quantity supplied divided by the percentage change in price

80. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-80 Percentage change in quantity supplied Percentage change in price ES =ES = Price Elasticity of Supply (cont'd) Formula for computing price elasticity of supply

81. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-81 Price Elasticity of Supply (cont'd) Classifying supply elasticities  Perfectly Elastic Supply  Quantity supplied falls to zero when there is the slightest decrease in price  The supply curve is horizontal at a given price

82. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-82 Price Elasticity of Supply (cont'd) Classifying supply elasticities  Perfectly Inelastic Supply  Quantity supplied is constant no matter what happens to price  The supply curve is vertical at a given price

83. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-83 Figure 21-5 The Extremes in Supply Curves

84. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-84 Price Elasticity of Supply (cont'd) Price elasticity of supply and length of time for adjustment 1. The longer the time allowed for adjustment, the more resources can flow into (out of) an industry through expansion (contraction) of existing firms. 2. The longer the time allowed for adjustment, the entry (exit) of firms increases (decreases) production in an industry.

85. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21-85 Figure 21-6 Short-Run and Long- Run Price Elasticity of Supply As time passes the supply curve rotates from S 1 to S 2 and quantity supplied rises to Q 1 As more time passes the supply curve rotates from S 2 to S 3 and quantity supplied rises from Q 1 to Q 2

86. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4-86 Key Terms and Concepts elastic demand elasticity inelastic demand marginal utility price elasticity of demand principle of diminishing marginal utility unit-elastic demand utility utils