MNE Session 3 Chap 5 Consumers' Incentives

Chapter 5
Consumers and
Incentives
© 2015 Pearson Education, Ltd.

5 Consumers and Incentives
Chapter Outline
5.1 The Buyer’s Problem

5.2 From the Buyer’s Problem to the Demand
Curve
5.3 Consumer Surplus
5. Demand Elasticities

Key Ideas
1. The buyer’s problem has three parts; what

you like, prices, and your budget.
2. An optimizing buyer makes decisions at the
margin.
3. An individual’s demand curve reflects an
ability and willingness to pay for a good or
service.
Key Ideas
4. Consumer surplus is the difference between

what a buyer is willing to pay for a good and
what the buyer actually pays.
5. Elasticity measures a variable’s
responsiveness to changes in another
variable.

Why does the demand curve

have a negative slope?

Buyer’s Problem:
1. What do you like?

2. How much does it
cost?
3. How much money
do you have?

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:
1. We all want the “biggest bang for our buck”

2. 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:
1. Prices are fixed—no negotiation

2. We can buy as much as we want of something
without driving the price up (because of an
increase in demand)
How Much Money You Have to Spend: The Budget Set
How much money do you have?
There are lots of things to do with your money, but

we assume:
1. There is no saving or borrowing, only buying

2. That even though we use a straight line to
represent purchase choices, we only purchase
whole units
Exhibit 5.1 The Budget Set and the Budget Constraint for Your Shopping Spree

Why does the budget line have

a negative slope?
What does the slope represent?

5.2 Putting It All Together
Suppose Bill Gates offered to buy you a

Jaguar—a $100,000 car.
Would you accept

his offer?

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?

Putting It All Together
Exhibit 5.2 Your Buyer’s Problem ($300 available)

Exhibit 5.2 Your Buyer’s Problem ($300 available)

Consumer Equilibrium Condition:
MBs = MBj
Ps Pj

Price Changes

Price Changes
Exhibit 5.3 An Inward Pivot in the Budget Constraint from a Price Increase

Price Changes
Exhibit 5.4 A Rightward Pivot in the Budget Constraint from a Price Decrease

Price Changes
Consumer Equilibrium Condition:
MBs = MBj
Ps Pj

Income Changes
Exhibit 5.5 An Outward Shift in the Budget Constraint from an Increase in Income

5.3 From the Buyer’s Problem to the Demand Curve
Sweaters $25 Jeans $50

Quantity Total Marginal Marginal Total Marginal Marginal Marginal
Benefits Benefits Benefits Benefits Benefits Benefits Benefits
per Dollar per Dollar per Dollar
(A) (B) Spent = (C) (D) Spent = Spent =
(B) / $25 (D) / $50 (D) / $75
0 0 0
1 100 100 4 160 160 3.2 2.13
2 185 85 3.4 310 150 3 2
3 260 75 3 410 100 2 1.33
4 325 65 2.6 490 80 1.6 1.07
5 385 60 2.4 520 30 0.6 0.4
6 435 50 2 530 10 0.2 0.13
7 480 45 1.8 533 3 0.06 0.04
8 520 40 1.6 535 2 0.04 0.03
9 555 35 1.4 536 1 0.02 0.01
10 589 34 1.36 537 1 0.02 0.01
11 622 33 1.32 538 1 0.02 -0.02
12 654.5 32.5 1.3 539 1 0.02 -0.07

Exhibit 5.6 Your Demand Curve for Jeans

Why does the demand curve

have a negative slope?

How much are you willing to

pay for an A?

Consumer Surplus
The difference between what you are

willing to pay and what you have to
pay (the market price)

Exhibit 5.7 Computing Consumer Surplus

Exhibit 5.8 Market-Wide Consumer Surplus

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

Your Buyer’s Problem with an Extra $100

($300 → $400)

5.4 Demand Elasticities
Why are last-minute

airplane tickets so
expensive?
While last-minute
Broadway show tickets
are so cheap?
Elasticity
A measure of how sensitive one

variable is to changes in another

Three measures of elasticity:
1. Price elasticity of demand

2. Cross-price elasticity of demand
3. Income elasticity of demand

The Price Elasticity of Demand
1. Price elasticity of demand answers the question:
How much does quantity demanded

change when the good’s price changes?
Mathematically: the percentage change in quantity

demanded due to a percentage change in its price:

Price Elasticity of Demand
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) when price

increased by 100% ((25-50)/25), so
ED = -25%/100% = -0.25
Elasticity Measures
ED > 1 = Elastic
ED < 1 = Inelastic
ED = 1 = Unit Elastic
ED = ∞ = Perfectly Elastic
ED = 0 = Perfectly Inelastic

Elasticity Measures
Exhibit 5.13 Examples of Various Price Elasticities

Elasticity Measures
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) and

as a result, the optimal quantity fell to 3 (25%
decrease)
ED = -25%/20% = -1.25
Elasticity Measures
Exhibit 5.14 Examples of Various Cross-Price Elasticities

TR = P x Q
If demand is inelastic, when price increases,
quantity decreases—a little:
TR = Px 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.
TR = P x 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 = Px Q= TR

Determinants of the Price Elasticity of Demand
Determinants:
• 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
Why are last-minute

airplane tickets so
expensive?
While last-minute
Broadway show tickets
are so cheap?
The Cross-Price Elasticity of Demand
2. Cross-price elasticity of demand answers the

question:
How much does quantity demanded change of

one good when 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:

The Cross-Price Elasticity of Demand
Exhibit 5.14 Examples of Various Cross-Price Elasticities

The Income Elasticity of Demand
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

The Income Elasticity of Demand
Exhibit 5.15 Examples of Various Income Elasticities

MNE Session 3 Chap 5 Consumers&#39; Incentives

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Chapter 5

© 2015 Pearson Education, Ltd.

5.1 The Buyer’s Problem

© 2015 Pearson Education, Ltd.

1. The buyer’s problem has three parts; what

4. Consumer surplus is the difference between

© 2015 Pearson Education, Ltd.

Why does the demand curve

© 2015 Pearson Education, Ltd.

1. What do you like?

© 2015 Pearson Education, Ltd.

What do you like?

Everyone has different likes and dislikes, but we

1. We all want the “biggest bang for our buck”

How much does it cost?

We also assume two characteristics of prices:

1. Prices are fixed—no negotiation

How much money do you have?

There are lots of things to do with your money, but

1. There is no saving or borrowing, only buying

© 2015 Pearson Education, Ltd.

Why does the budget line have

What does the slope represent?

Suppose Bill Gates offered to buy you a

Would you accept

© 2015 Pearson Education, Ltd.

The next day, he calls and says he doesn’t

Will you go buy the car?

© 2015 Pearson Education, Ltd.

Exhibit 5.2 Your Buyer’s Problem ($300 available)

Exhibit 5.2 Your Buyer’s Problem ($300 available)

Consumer Equilibrium Condition:

© 2015 Pearson Education, Ltd.

© 2015 Pearson Education, Ltd.

© 2015 Pearson Education, Ltd.

© 2015 Pearson Education, Ltd.

Consumer Equilibrium Condition:

© 2015 Pearson Education, Ltd.

© 2015 Pearson Education, Ltd.

Sweaters $25 Jeans $50

© 2015 Pearson Education, Ltd.

Exhibit 5.6 Your Demand Curve for Jeans

© 2015 Pearson Education, Ltd.

Why does the demand curve

© 2015 Pearson Education, Ltd.

How much are you willing to

© 2015 Pearson Education, Ltd.

The difference between what you are

© 2015 Pearson Education, Ltd.

Exhibit 5.7 Computing Consumer Surplus

© 2015 Pearson Education, Ltd.

Exhibit 5.8 Market-Wide Consumer Surplus

© 2015 Pearson Education, Ltd.

Exhibit 5.9 Market-Wide Consumer Surplus When Prices Change

Your Buyer’s Problem with an Extra $100

© 2015 Pearson Education, Ltd.

Why are last-minute

A measure of how sensitive one

© 2015 Pearson Education, Ltd.

Three measures of elasticity:

1. Price elasticity of demand

© 2015 Pearson Education, Ltd.

1. Price elasticity of demand answers the question:

How much does quantity demanded

MNE Session 3 Chap 5 Consumers' Incentives

MNE Session 3 Chap 5 Consumers' Incentives