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Topic 5:The Consumer and Demand

Dr Micheál Collinsmlcollin@tcd.ie

Topic 5: Consumer and Demand

1. Introduction2. Utility3. The Water-Diamond Paradox4. Modern Consumer Theory5. Consumer Surplus6. Happiness

1. Introduction

• Building on the concept of Demand from Topic 2 and elasticity from Topic 4

• Explore how consumers behave in a bit more detail• How this influences the nature of demand• Explore how expenditure is allocated• Introduce the concept of Consumer Surplus

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2. Utility

• Economists think about how consumers behave using the concept of utility

Definition:Utility is the satisfaction or pleasure derived from consuming a product

▫ conceptual▫ abstract and subjective▫ talk about units of utility = utils

Two Additional Related Definitions

Total Utility (TU) is the total satisfaction that a consumer gains from the consumption of a given quantity of a product

Marginal Utility (MU) is the extra additional satisfaction that a consumer gains from consuming one extra unit of a product

Rational Consumers• Economists assume that individuals are rational• Acting ‘rationally’ means that consumers maximise TU

given their income• e.g.▫ say currently person buys 2 bottles of wine for €15 each▫ if we assume consumer is maximising their utility, then their

decision to spend €15 on the second bottle of wine is because U from 2nd bottle is greater than that available from an alternative use of the €15

▫ if there is a better alternative; then change

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• Thinking about this a little more:▫ really consumer is comparing marginal utilities▫ when buying extra bottle of wine consumer is comparing its

MU with the MU that can be gained from an alternative use of the same money

The Law of Diminishing Marginal Utilitythe utility derived from consuming additional units of a commodity will diminish with each successive unit consumed

▫ i.e. MU declines as consumption increases, ceteris paribus▫ Insomnia coffee enjoy the first have another a third? a fourth?...

▫ a hypothesis about how humans behave…plausible

Example and Curves▫ hypothetical data using bananas▫ utility data: “subjective and abstract”

▫ Diagrams 1 and 2: TU and MU curves

Quantity of Bananas Total Utility (TU) Marginal Utility (MU)

0 0 -

1 7 + 7

2 11 + 4

3 13 + 2

4 14 + 1

5 14 0

6 12 - 2

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Consumer Equilibrium▫ As consumers aim to maximise utility they face two

constraints:incomeprices

▫ The utility maximising outcome is achieved at a point where the MU from the last euro spent is the same for each commodity purchased

▫ To see this with an example

▫ 2 goods only: bananas and oranges▫ same price of €1 each; Budget of €8

Qty TU bananas TU oranges

0 - -

1 20 15

2 38 27

3 53 37

4 65 43

5 75 45

6 83 45

7 85 41

▫ 2 goods only: bananas and oranges▫ same price of €1 each; Budget of €8

Qty TU bananas TU oranges MU bananas MU oranges

0 - - - -

1 20 15 20 15

2 38 27 18 12

3 53 37 15 10

4 65 43 12 6

5 75 45 10 2

6 83 45 7 0

7 85 41 2 -4

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▫ Budget Options for €8

Budget Options TU bananas TU oranges Overall TU

7B + 1O 85 15 100

6B + 2O 82 27 110

5B + 3O 75 37 112

4B + 4O 65 43 108

3B + 5O 53 45 98

2B + 6O 38 45 83

1B + 7O 20 41 61

▫ Budget Options for €8

Budget Options TU bananas TU oranges Overall TU

7B + 1O 85 15 100

6B + 2O 82 27 110

5B + 3O 75 37 112

4B + 4O 65 43 108

3B + 5O 53 45 98

2B + 6O 38 45 83

1B + 7O 20 41 61

▫ This consumption-mix corresponds to a point where the MU’s are the same for both goods

Qty TU bananas TU oranges MU bananas MU oranges

0 - - - -

1 20 15 20 15

2 38 27 18 12

3 53 37 15 10

4 65 43 12 6

5 75 45 10 2

6 83 45 7 0

7 85 41 2 -4

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▫ This suggests:

The Law of Equi-Marginal ReturnsUtility is maximised when the utility for the last euro spent on each product is equalised

Algebraically:

▫ End up at a point where there is no tendency to change; an equilibrium outcome for a consumer

MUx=

MUy

Px Py

Consumer Equilibrium and Prices▫ Price changes will lead to a change in the composition of

consumption▫ If bananas become cheaper will buy more bananas and less oranges equilibrium combination will change will include more bananas at a lower price MU bananas will fall suggest a downward sloping D curve

▫ How many extra bananas? Depends on the marginal utility so, elasticity of demand depends on marginal utility

3. The Water-Diamond Paradox

• An historical puzzle▫ from Plato to Adam Smith▫ Smith’s question:Why is water, which is so useful/essential, of little valueWhy are diamonds, which are of little use, so valuable▫ Towards a solution via utility theory in the 1870s: the total utility we get from water is very high; but we consume

large quantities so its marginal utility is low the total utility of diamonds v’s water is low; but we consume few

and so its marginal utility is high

▫ Note: marginal utilities the key to understanding how people value commodities

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4. Modern Consumer Theory• As we cannot really measure utility, we can take a more

analytical progress by adopting an ordinal approach.• To find equilibrium, this combines:▫ a consumer’s preferences ▫ with their purchasing constraints (income and prices)

• Through comparative statics changes in income and prices can be modelled for different types of goods.

• Concepts:▫ Indifference curves▫ Budget lines▫ Consumer equilibrium

Indifference Preferences and Curves• First, we make four assumptions (rational consumers):

1. Consumer ranks alternatives according to tastes and preferences (independent of prices, income).

2. Consumers prefer more to less (with the exception of ‘bads’ such as pollution).

3. Axiom of Completeness: Any two bundles can be compared. A consumer must either prefer bundle A to B, B to A or be indifferent between the two.

4. Law of Transitivity: Preferences must satisfy this law. If a consumer chooses A over B and prefers B to C, then the consumer must be consistent and prefer A to C.

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• Definition: An indifference curve (IC) shows all the bundles or combinations of two products that give the same level of utility to the consumer1. Utility is constant along the ICs.2. ICs slope down from left to right. 3. Indifference curves are normally convex to the origin. 4. Indifferences curves do not intersect. 5. There is a multiple set of indifference curves (a preference

map).6. The higher the IC, the higher the utilityDiagram 3Diagrams 4, 5 and 6 (exceptions)

• Looking at the slope of the IC▫ at a particular point, the slope represents the consumers

willingness to trade between the two products▫ this is determined by tastes and preferences▫ slope is referred to as the :

Marginal rate of substitution for an individual consumer between two products X and Y represents the maximum number of units of product Y that the consumer is willing to sacrifice for an extra unit of product X.

▫ Diagram 7 (and variations)

Budget lines Illustrates the various maximum combinations of two products

that a consumer can purchase give income and prices

Splits the two dimensional space into two parts, the affordable and unaffordable.

The slope of the budget line is determined by the relative prices of the two goods. The slope measures the opportunity cost of one product in terms of the other:

Slope of budget line = - Pdrink / Pfood

Diagram 8 (and variations):

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Relative prices and the slope of the budget line

The budget line and changes in income

A change in price

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Consumer equilibrium• Bring the ICs and the Budget lines together• Diagrams 3 and 8 Diagram 9

• Consumer chooses combination of food and drink that maximises his/hers utility and uses all her income.

• Point X is the optimal consumption bundle.

• Graphically, this is where the budget line is tangent to the highest possible indifference curve.

• No tendency to change…▫ bundle R or S = desirable but

unattainable▫ bundle T or U = attainable

but undesirable▫ bundle W and V = not

optimal

Income and Price Changes• Using this, we can consider changes in income and

prices• Building on topic 2

Changes in income forNormal good (Diagram 10)

Inferior good (Diagram 11)

Price changes forNormal good (Diagram 12)

Inferior good (Diagram 13)

Giffen good (Diagram 14)

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A change in income

Diagram 10: Normal good Diagram 11: Inferior good

Two key definitions• Substitution effect: Change in demand that is caused

by the change in the relative prices of the two goods, holding utility or real income (purchasing power) constant.

• Income effect: Change in demand that is caused by the change in real income (purchasing power) alone.

• These combine to give the total price effect

Price change for a normal good: Substitution and income effects Diagram 12

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Price change of an inferior good: Substitution and income effect Diagram 13

Price change of a giffen good: Substitution and income effect Diagram 14

I0

income effect

I1X Y

ZB

B

0 Q3 Q1 Q2

Qf

QGiffen

substitutioneffect

total price effect

Summary of Price and Quantity Changes

Price change Type of Good Substitution effect

Income effect

Total effect

Normal Qd increases Qd increases Qd increases

Inferior Qd increases Qd decreases Qd increases

Giffen Qd increases Qd decreases Qd decreases

Normal Qd decreases Qd decreases Qd decreases

Inferior Qd decreases Qd increases Qd decreases

Giffen Qd decreases Qd increases Qd increases

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5. Consumer Surplus• Another important concept when trying the

understand the behaviour of consumers• Also relevant to suppliers and price setting

Definition:The excess of what a consumer is willing to pay for a good over what the consumer actually pays

Explaining willingness to pay:The maximum amount a buyer will pay for a good

• Calculating Consumer Surplus

▫ John is willing to pay €300 for a bicycle▫ He buys one in Argos for €250▫ His consumer surplus is €50

• Drawing Consumer Surplus▫ The demand curve shows the qty demanded at each price level▫ At price P1 the demand is Q1▫ At all prices above P1 there is some demand▫ This implies that consumers are willing to pay these prices▫ However, they are only paying P1▫ They experience consumer surplus▫ Diagram 15: the shaded area▫ Price changes and CS: diagrams 16 and 17

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• Applications for Consumer Surplus▫ more of this next year▫ e.g.▫ Cost-benefit analysis gives indication of what benefits people get both literatures from Dupuit what are benefits and how to set prices? different for different people?

6. Happiness• The major critique of utility theory is that it cannot

be measured▫ some attempt to overcome this by ordinal analysis▫ ideally we could measure people’s satisfaction▫ some recent improvements via happiness literature▫ happiness seen by some as a proxy for utility▫ measures of happiness surveys problems: subjective; static years improvements: intertemporal studies (panel data)

▫ ongoing developments… Neuroscience…

▫ some insights…

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• Consumer chooses combination of food and drink that maximises his/hers utility and uses all her income.

• Point X is the optimal consumption bundle.

• Graphically, this is where the budget line is tangent to the highest possible indifference curve.

• No tendency to change…▫ bundle R or S = desirable but

unattainable▫ bundle T or U = attainable

but undesirable▫ bundle W and V = not

optimal

A change in income

Diagram 10: Normal good Diagram 11: Inferior good

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Price change for a normal good: Substitution and income effects Diagram 12

Price change of an inferior good: Substitution and income effect Diagram 13

3

Price change of a giffen good: Substitution and income effect Diagram 14

I0

income effect

I1X Y

ZB

B

0 Q3 Q1 Q2

Qf

QGiffen

substitutioneffect

total price effect

Summary of Price and Quantity Changes

Price change Type of Good Substitution effect

Income effect

Total effect

Normal Qd increases Qd increases Qd increases

Inferior Qd increases Qd decreases Qd increases

Giffen Qd increases Qd decreases Qd decreases

Normal Qd decreases Qd decreases Qd decreases

Inferior Qd decreases Qd increases Qd decreases

Giffen Qd decreases Qd increases Qd increases

Illustration by Jac Depczyk

Economics focus

E pluribus tunumUniform prices for online music are no way to maximise profit Oct 22nd 2009

THE term “bargain basement” was supposedly coined to describe the first outlet of Filene’s Basement, an American discount shopping chain whose bags scream “I just got a bargain!” in large red letters. Those bags celebrate a feeling most shoppers will be familiar with: the pleasure of having bought something for less than they were willing to pay. This difference between the price paid and the most a buyer would have agreed to shell out is known as “consumer surplus” and is the part of the overall economic benefit from any trade that the buyer gets.

The rest of the surplus from a trade goes to the seller. To maximise his share of the economic surplus, a merchant wants to sell to each customer at a price as close as possible to the most that client would be willing to pay. Naturally this is impossible if everyone is charged the same price. Buyers who would have been willing to pay more get a big chunk of the surplus, leaving less for the seller. In addition those willing to pay less than the uniform price are simply left out, even though they may be willing to pay enough to allow costs to be covered. Lowering the price enough to attract them would reduce the amount that customers who value the product more could be charged, reducing overall profit.

Where possible, the solution is to tailor prices to people’s willingness to pay or price-sensitivity, much as vendors in street markets do when they offer naive tourists a higher price than seasoned locals. Most of the time it is hard to know how much people value things. But sellers can still encourage people to sort themselves into groups which can be charged different prices. Those who are particularly keen to get their hands on a copy of a new book, for instance, may be willing to pay a higher price for it, which may explain the persistence of expensive hardbacks. The logic behind cheaper student editions is similar.

These tactics and others, like selling things in bundles rather than individually, all exploit differences in people’s sensitivity to price. They ought to be better for sellers (and possibly for some customers too) than a uniform price. So many found Apple’s initial pricing strategy on iTunes, its popular online music-store, perplexing. Until April this year, when it switched to a multi-tiered pricing system, every song available on iTunes cost a uniform 99 cents in America, 79 pence in Britain and so forth. This had the benefit of simplicity. But it seemed likely that other ways to price music online would be more profitable.

Knowing how sellers and buyers would act under different pricing schemes requires information about how those who buy music online value different songs. New research* by Ben Shiller and Joel Waldfogel, two economists at the University of Pennsylvania’s Wharton business school, tries to answer this question. In January 2008 the researchers presented nearly 500 undergraduate students at Wharton with clips of the 50 most popular songs on iTunes earlier that month. Having listened to each clip, the students were then asked to write down the most they would be willing to pay to download the song in question. Data on more than 23,000 song valuations resulted, allowing the professors to get a sense of the actual demand curves for popular songs. Similar data were also collected in January this year, though this time some older and less popular tracks were also included.

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The exercises showed that even a uniform price per song that maximised revenue among the students was quite high—$2.30 in 2008 and $1.46 in 2009. Wharton students may be particularly fond of music, but it is also possible that the market would sustain a higher uniform price than 99 cents. More important, knowing the uniform price that maximised revenue also allowed the authors to evaluate other ways to price online music.

One alternative is song-specific pricing, much favoured by record companies. (Apple has already moved a bit in this direction with its multi-tier system.) But the research suggested that this would increase profits by a mere 3%. Part of the problem was that people who valued one song highly also tended to place a high value on others. This implies that person-specific, rather than song-specific, pricing would be more efficient. But sellers’ data are not refined enough to set different prices for different people. People may resent such pricing anyway, so it could harm sellers’ brands. Crude profiling—by race or sex, say—would be illegal. In any case, the authors found that basic demographic information did not tell them much about musical tastes.

Rhythm ’n’ choose

Charging an “entry fee” for use of the service and then a small, fixed per-song cost for downloads turned out to benefit both the seller and the buyer. The most revenue, according to the 2009 survey data, would be generated by charging the students $21.19 for entry and 37 cents a song. This could raise the producer surplus by 30% compared with uniform pricing. Consumer surplus would also rise in this instance, because some people would buy songs they would have not have done at a higher uniform price. Spotify, a rival to iTunes, has a model somewhat like this for its premium service, where it charges a monthly fee for songs without limit.

Selling several songs together in a bundle (much like an album) had almost identical results. The authors reckon that there is a range of prices for bundles that would make both buyers and sellers better off than a single price per song. For example, charging $16.95 for all 50 songs studied (which would have cost $49.50 to download) would leave profit unchanged because enough people would buy. But it would increase consumer surplus by around 50% by attracting new buyers. The costs of implementing pricing schemes go up with their complexity. But it should be possible to set prices that both increase profits and leave at least some music-lovers with the thrill of a bargain.

* “Music for a Song: An Empirical Look at Uniform Song Pricing and its Alternatives (http://www.nber.org/papers/w15390) ”, by Ben Shiller and Joel Waldfogel. NBER Working Paper 15390, 2009

Finance and Economics

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