How do households make decisions?

Consumer & Incentives Chapter 5 TB

The buyer’s problem

1. What are 3 elements of the buyer’s problems?
- What do you like? Prices of goods or services and How much do you have?

2. What are the assumptions made on the prices of goods or services?

The assumptions made are:
- Goods prices are fixed. Buyers are price takers and there is no negotiation.
- Consumers can buy as much as they want without driving the price up

3. In a perfectly competitive market, what’s the rationale behind consumers buying as

much of any good as they want at the fixed price if they have sufficient money to pay for
it?
- The individual consumer tends to buy only a tiny fraction of the total amount of a
produced good.
- Because each buyer is only a small part of the market, an individual purchase will not
have an effect on the market as a whole.

4. When purchasing a good, why do I take into account the price of other available goods?
- The relative prices of goods determine what you give up when you purchase something,
so they are important when making the purchase decision.

5. What are the assumptions made on the amount of money a buyer has to spend?
- There is no savings or borrowings
- Budget constraint plotted as a straight line even though consumers purchase units

6. What is a budget set?

- A budget set is a set of all possible bundles of goods and services that can be
purchased with a consumer’s income

7. What is a budget constraint?

- A budget constraint is a bundle of goods and services that will exhaust the consumer’s
entire budget
8. How to calculate the slope of the budget constraint?
- Height of triangle divided by the base of the triangle (12/6=2)

9. How will a price change affect the budget constraint?

- An increase in price will cause the budget constraint to pivot inwards
- A decrease in price will cause the budget constraint to pivot outwards

10. How does a price change affect buyers’ problems?

- When price changes, opportunity cost changes. This causes buyers to change optimal
quantities consumed.

11. How does an income change affect the budget constraint?

- An increase in income causes the budget constraint to shift right/outward
You can buy more when your income increases. The slope does not change as the
opportunity cost of purchasing does not change when income changes.
- A decrease in income causes the budget constraint to shift left/inward

12. What is the decision rule in marginal thinking?

 marginal benefit of x / Price of x = Marginal benefit of y / Price of y
If MB/P of x is higher than MB/P of y, consumers should buy more of x
If MB/P of y is higher than MB/P of x, consumers should buy more of y

13. What’s the formula behind this decision rule?

- If marginal benefits are not equal, the consumer can do better and optimize by shifting
consumption towards goods that has higher marginal benefit per dollar spent. In
equilibrium, the ratio of marginal benefit to price must be identical across goods.

14. The optimal bundle of goods and services is achieved when?

- It satisfies the equal bang for your buck rule
- It is purchased on the budget constraint

15. How is the individual demand curve obtained?

- An individual’s willingness to pay measured over different quantities of the same good
makes up the individual demand curve

Consumer’s surplus

16. What is consumer surplus?

- Consumer surplus refers to the difference between willingness to pay and market price.

17. What’s the formula to calculate consumer surplus?

- Base of triangle x height of triangle / 2
 18. What’s the relationship between consumer surplus and price?
- When price increase, consumer surplus decrease
- When price decrease, consumer surplus increase

Demand elasticities
19. What is elasticity?
- Elasticity measures the sensitivity of one economic variable to a change in another.
Elasticity is a ratio of change in variance.

20. What is the price elasticity of demand?

- Price elasticity of demand measures the percentage change in quantity demanded
resulting from a percentage change in price.
- It is calculated by % change in quantity demanded / % change in price

21. What is arc elasticity?

- The method of calculating elasticities that measure at the midpoint of the demand curve

22. What does the price elasticity of > 1 indicate?

- Price elasticity of > 1 indicates that the product is elastic. The percentage change in
quantity demanded is greater than the percentage change in price.

23. What does a price elasticity of < 1 indicate?

- Price elasticity of < 1 indicates that the product is inelastic. The percentage change in
quantity demanded is less than the percentage change in price.

24. What does the price elasticity of 1 indicate?

- Price elasticity of 1 indicates that the product is unit elastic. The percentage change in
quantity demanded will be exactly equal to the percentage change in price.

25. What does the price elasticity ∞ indicate?

- Price elasticity ∞ indicates that the product is perfectly elastic. Demand is highly responsive to
change in price. The smallest increase in price will cause consumers to stop using the goods.

26. What does price elasticity of 0 mean?

- Price elasticity of 0 indicates that the product is perfectly inelastic. Quantity demanded is
unaffected by price.

27. How will revenue be affected by a product which has an elastic demand?
- If demand is elastic, when the price increases, the quantity demanded decreases a lot
more. The price increase triggers a very responsive decrease in quantity, overwhelming
the effect of price increase, hence decreasing revenue.

28. How will revenue be affected by a product which has an inelastic demand?
- If demand is inelastic, when price increases, quantity demanded decreases a little
The effect of price increase is more than the unresponsive decrease in quantity, hence
increasing total revenue

29. How does the graph of different elasticities look like?

30. What are the determinants of elasticity?

- Number and closeness of substitutes, increase in the number of available substitutes,
increase in price elasticity of demand
- Budget share spent on good, importance of good in your consumption bundle, budget
share higher means price elasticity higher
- Available time to adjust to price changes, more time to adjust, elasticity increase

31. What is cross-price elasticity of demand?

- The cross-price elasticity of demand measures the percentage change in quantity
demanded due to the percentage change in the price of another good
- It is measured by % change in quantity demanded of good x / % change in the price of
good y

32. What does negative cross-price elasticity of demand indicate?

- Two goods are complements

33. What does zero cross-price elasticity of demand indicate?

- Two goods are independent

34. What does positive cross-price elasticity of demand indicate?

- Two goods are substitutes

35. What is income elasticity of demand?

- Income elasticity of demand measures the percentage change in quantity demanded
due to percentage change in the consumer’s income
- It is measured by % change of quantity demanded / % change in income

36. What does income elasticity of demand of less than 0 indicate?

- Inferior goods

37. What does income elasticity of demand of less than 1 but greater than 0 indicate?
- Normal and necessity good

38. What does income elasticity of demand of greater than 1 indicate?

- Normal and luxury good
 Quiz
1. The slope of the budget constraint is determined by?
- The relative price of the goods determines the slope of the budget constraint. Income
level determines the position of the budget constraint but not the slope of the budget
line.

2. Nadiah would be willing to pay $50 to see Titanic, but the market price is $30. How much
does Nadiah value the performance at and how much is her consumer surplus?
- Nadiah value the performance at $50 and her consumer surplus is $20

3. Suppose the government imposes a tax on Good X. In order to estimate the effect of the
tax on the quantity demanded Good Y, a related good, we can use the concept of..
- Cross price elasticity of demand.

4. Suppose that a consumer spends her income on two goods: music CDs and DVDs. If
the price of a CD is $8, the price of a DVD is $20, and we graph the budget constraint by
placing the quantity of CDs purchased on the horizontal axis, what is the slope of the
budget constraint?
- -0.4
- Price of CD (horizontal axis): $8
- Price of DVD (vertical axis): $20
- The slope of budget constraint: horizontal/vertical = -8/20 = -0.4
*Clarification: why not rise over run? vertical/horizontal.

5. A decrease in consumer income...

- Has no effect on the slope of budget constraint. A decrease in consumer income will
shift the budget constraint inward. The relative price of goods remain unchanged and
hence a change in income will not change the slope of the budget constraint.
 6. An optimizing consumer makes her purchase decision based on..
- The marginal benefits per dollar spent. The optimal bundle is derived where the marginal
benefit per dollar spend for good X is the same as the marginal benefit per dollar spend
for good Y. The bundle of good X and good y must be purchased on the budget
constraint for it to be an optimal bundle.

7. Suppose Ali, Alisha, and Reema all purchase bulletin boards for their rooms for $15
each. Ali’s willingness to pay is $35, Alisha’s willingness to pay is $25 and Reema’s
willingness to pay is $30. Total consumer surplus would be?
- $20 + $10 + $15 = $45

8. A consumer that does not spend all her income...

- Would be at a point inside her budget constraint. Spending all her income would place
her on the budget constraint or budget line. Not spending all her income means points
strictly inside the budget constraint. A simple example of spending zero income is the
point of origin.

9. The price of gin has risen from $7 to $9 per bottle, the price of the cocktail has fallen
from $6 to $5 per jar, jielin’s income has been fixed at $46 a week. Since the price
change, jielin has been buying 4 bottles of gin and 2 jars of cocktail per week. At the
original prices, 4 bottles of gin and 2 jars of the cocktail will be..
- Cost less than her income. The cost of 4 bottles (org price $7) and 2 jars of cocktail (org
price $6) is (4x7)+(2x6)=40, which is less than her income.

10. Which of the following is not true when the price of a good or service falls?
- Some new buyers, who are now willing to buy, enter the market - TRUE
- The total value of purchases before and after the price change is the same - FALSE
- Buyers who were already buying the good or service are better off - TRUE
- The total consumer surplus in the market increases - TRUE
The total value of purchases = price x quantity. When price decreases, the number of goods
purchased will increase most likely given a downward sloping demand curve. The product of
price and quantity may increase or decrease or remain unchanged, depending on whether the
demand is price elastic, inelastic, or unit elastic. Therefore, generally, it is not true that PQ will
always remain the same when P decreases.

11. How does the number of available substitutes determine the price elasticity of demand
- As more substitutes for a good become available, all else constant, it makes it easier for
buyers to decrease their consumption of the good if it becomes more expensive as there
are goods that they can buy instead. The greater the number of available substitutes, all
else constant, the more elastic is demand
 12. How is cross-price elasticity of demand used to determine whether two goods are
substitutes or complements?
If good X and good Y are substitutes (used in place of each other), then an increase in the price
of good Y increases the demand for good X àCross price elasticity of demand between X and Y
is (+) The more positive, the stronger is the substitutability If good X and good Y are
complements (used together), then an increase in the price of good Y decreases the demand
for good X Cross price elasticity of demand between X and Y is (–) The more negative, the
stronger is the complementarity

13. If a good is considered to be a luxury good, does it mean that the Law of Demand does
not hold?
- When this good is a luxury good, it means that all else is constant, if income increases
then demand increases à An increase in income shifts the demand curve to the right,
However, this new demand curve is still downward sloping, which means that the Law of
Demand still holds.