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CHAPTER 8 Consumer Choice and Demand in Traditional and Network Markets It is not the province of economics to determine the value of life in “hedonic units” or any other units, but to work out, on the basis of the general principles of conduct and the fundamental facts of social situation, the laws which determine prices of commodities and the direction of the social economic process. It is therefore not quantities, not even intensities, of satisfaction with which we are concerned. . . .or any other absolute magnitude whatever, but the purely relative judgment of comparative significance of alternatives open to choice. Frank Knight eople adjust to changes in some economic conditions with a reasonable degree of predictability. When department stores announce lower prices, customers will pour through the doors. The lower the prices go, the larger the crowd will be. When the price of gasoline goes up, drivers will make fewer and shorter trips. If the price stays up, drivers will buy smaller, more economical cars. Even the Defense Department will reduce its planned purchases when prices rise. Behavior that is not measured in dollars and cents is also predictable in some respects. Students who stray from the sidewalks to dirt paths on sunny days stick to concrete when the weather is damp. Professors who raise their course requirements and grading standards find their classes are shrinking in size. Small children shy away from doing things for which they have recently been punished. When lines for movie tickets become long, some people go elsewhere for entertainment. On an intuitive level you find these examples reasonable. Going one step beyond intuition, the economist would say that such responses are the predictable consequences of rational behavior. That is, people who desire to maximize their utility can be expected to respond in these ways. Their responses are governed by the law of demand, a concept we first introduced in Chapter 3 and now take up in greater detail. Predicting Consumer Demand The assumptions about rational behavior described early in the book provide a good general basis for explaining behavior. People will do those things whose expected benefits exceed their expected costs. They will avoid doing things for which the opposite is true. By themselves, however, such assumptions do not allow us to predict future P Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 2 behavior. The law of demand, which is a logical consequence of the assumption of rational behavior, does allow us to make predictions. The alert reader may sense an inconsistency in logic. Rational behavior is based on the existence of choice, but a true choice must be free—it cannot be predetermined or predicted. If we can predict a person’s behavior, can that individual be free to choose? Choice is not completely free, nor is complete freedom required by the concept of rationality. As discussed earlier, the individual’s choices are constrained by time and by physical and social factors that restrict his or her opportunities. There are limits to a person’s range of choice. Freedom exists within those limits. Our ability to predict is also limited. We cannot specify with precision every choice the individual will make. For instance, we cannot say anything about what Judy Schwartz wants or how much she wants the things she does. Before we can employ the law of demand, we must be told what she wants. Even given that knowledge, we can only indicate the general direction of her behavior. Theory does not allow us to determine how fast or how much her behavior will change. To see how consumer behavior can be predicted, we will derive the law of demand from the behavior of an individual consumer. Rational Consumption: The Concept of Marginal Utility The essence of the economist’s notion of rational behavior can be summed up this way: more goods and services are preferable to less (assuming that the goods and services are desired). This statement implies that the individual will use his entire income, in consumption or in saving or in some combination of the two, to maximize his satisfaction. It also implies that the individual will use some method of comparing the value of various goods. Generally speaking, the value the individual places on any one unit of a good depends on the number of units already consumed. For example, you may be planning to consume two hot dogs and two Cokes for your next meal. Although you may pay the same price for each unit of both goods, there is no reason to assume that you will place the same value on each. The value of the second hot dog—its marginal utility—will depend on the fact that you have already eaten one. The formula for marginal utility is change in total utility MU = change in quantity consumed Achieving Consumer Equilibrium Marginal utility determines the variety of a quantity of goods and services you consume. The rule is simple. If the two goods, Cokes and hot dogs, both have the same price, you will allocate your income so that the marginal utility of the last unit of each will be equal. Mathematically, the formula can be stated as MU c = MU h Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 3 Where MU c equals the marginal utility of a Coke and MU h equals the marginal utility of a hot dog. If you are rational, and if the price of a Coke is the same as the price of a hot dog, the last Coke you drink will give you the same amount of enjoyment as the last hot dog you eat. When the marginal utilities of goods purchased by the consumer are equal, the resulting state is called consumer equilibrium. Consumer equilibrium is a state of stability in consumer purchasing patterns in which the individual has maximized his or her utility. Unless conditions—income, taste, or prices—change, the consumer’s buying patterns will tend to remain the same. An example will illustrate how equilibrium is reached. Suppose for the sake of simplicity that you can buy only two goods, Cokes and hot dogs. Suppose further that one of each cost the same price, $1, and you are going to spend your whole income. (How much your total income is and how many units of Coke or hot dogs you will purchase is unimportant. We simply assume that you purchase some combination of those two goods.) We will also assume that utility (joy, satisfaction) can be measured. As you remember from an earlier chapter, a unit of satisfaction is called a util. Finally, suppose that the marginal utility of the last Coke you consume is equal to 20 utils, and the marginal utility of the hot dog is 10 utils. Obviously you have not maximized your utility, for the marginal utility of your last Coke is greater than (>) the marginal utility of your last hot dog: MU c > MU h You could have purchased one less hot dog and used the dollar saved the to buy an additional Coke. In doing so, you would have given up 10 utils of satisfaction (the marginal utility of the last hot dog purchased), but you would have acquired an additional 20 utils from the new Coke. On balance, your total utility would have risen by 10 utils (20 – 10). If you are rational, you will continue to adjust your purchases of Coke and hot dogs until their marginal utilities are equal. Even if you would prefer to spend your first dollar on a hot dog, after eating several you might wish to spend your next dollar on a Coke. Purchases can be adjusted until they reach equilibrium because as more of a good is purchased, its relative marginal utility decreases—a phenomenon known as the law of diminishing marginal utility. According to the law of diminishing marginal utility, as more of a good is consumed, its marginal utility or value relative to the marginal value of the good or goods given up eventually diminishes. Thus, if MU h > MU c , and MU h falls relative to MU c as more hot dogs and fewer Cokes are consumed, sooner or later the result will be MU h = MU c . Adjusting for Differences in Price and Unit Size Cokes and hot dogs are not usually sold at exactly the same price. To that extent, our analysis has been unrealistic. If we drop the assumption of equal prices, the formula for maximization of utility becomes: Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 4 MU c = MU h P c P h Where MU c equals the marginal utility of a Coke, MU h the marginal utility of a hot dog, P c the price of a Coke, a P h the price of a hot dog. This is the same formula we used before, but because the price of the goods was the same in that example, the denominators canceled out. When prices differ, the denominator must be retained. The consumer must allocate his or her money so that the last penny spent on each commodity yields the same amount of satisfaction. Suppose a Coke costs $0.50 and the price of a hot dog is $1. If you buy hot dogs and Cokes for lunch and the marginal utility of the last Coke and hot dog you consume are the same, say 15 utils, you will not be maximizing your satisfaction. In relation to price, you will value your Coke more than your hot dog. That is, MU c /P c (or 15 utils/$0.50) exceeds MU h /P h (or 15 utils/$1). You can improve your welfare by eating fewer hot dogs and drinking more Cokes. By giving up a hot dog, you can save a dollar, which you can use to buy two Cokes. You will lose 15 utils by giving up the hot dog, something you would probably prefer not to do. You will regain that loss with the next Coke purchased, however, and the one after that will permit you to go beyond your previous level of satisfaction. Therefore, if you are rational, you will adjust your purchases until the utility-price ratios of the two goods are equal. As you consume more Coke, the relative value of each additional Coke will diminish. If you reach a point where the next Coke gives you 10 utils and the next hot dog yields 20 utils, you will no longer be able to increase your satisfaction by readjusting your purchases. By giving up the next hot dog, you save $1 and lose 20 utils of satisfaction. Now the most you can accomplish by using that $1 to buy two Coke instead is to recoup your loss of 20 utils. In fact, the value of the second new Coke may be less than 10 utils, so you may actually lose by giving up the hot dog. So far we have been talking in terms of buying whole units of Cokes and hot dogs, but the same principles apply to other kinds of choices as well. Marginal utility is involved when a consumer chooses a 12-ounce rather than a 16-ounce can of Coke, or a regular-size hot dog rather than a foot-long hot dog. The concept could also be applied to the decision whether to add cole slaw and chili to the hot dog. The pivotal question the consumer faces in all these situations is whether the marginal utility of the additional quantity consumed is greater or less than the marginal utility of other goods that can be purchased for the same price. Most consumers do not think in terms of utils when they are buying their lunch, but in a casual way, they do weigh the alternatives. Suppose you walk into a snack bar. If your income is unlimited, you have no problem. If you can only spend $3 for lunch, however, your first reaction may be to look at the menu and weigh the marginal values of the various things you can eat. If you have twenty cents to spare, do you not find yourself mentally asking whether the difference between a large Coke and a small one is worth more to you than lettuce and tomato on your hamburger? (If not, why do you choose a small Coke instead of a large one?) You are probably so accustomed to making decisions of this sort that you are almost unaware of the act of weighing the marginal values of the alternatives. Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 5 Consumers do not usually make choices with conscious precision. Nor can they achieve a perfect equilibrium—the prices, unit sizes, and values of the various products available may not permit it. They are trying to come as close to equality as possible, The economist’s assumption is that the individual will move toward equality, not that he will always achieve it. Changes in Price and the Law of Demand Suppose your marginal utility for Coke and hot dogs is as shown in the table below. Marginal Utility of Marginal Utility of Unit Consumed Cokes (at $0.50) Hot Dogs (at $1) First 10 utils 30 utils Second 9 utils 15 utils Third 3 utils 12 utils If a Coke is priced at $0.50 and a hot dog at $1, $3 will buy you two hot dogs and two Cokes—the best you can do with $3 at those prices. Now suppose the price of Coke rises to $0.75 and the price of hot dogs falls to $0.75. With a budget of $3 you can still buy two hot dogs and two Cokes, but you will no longer be maximizing your utility. Instead you will be inclined to reduce your consumption of Coke and increase your consumption of hot dogs. At the old prices, the original combination (two Cokes and two hot dogs) gave you a total utility of only 64 utils (45 from hot dogs and 19 from Coke). If you cut back to one Coke and three hot dogs now, your total utility will rise to 67 utils (57 from hot dogs and 10 from Coke). Your new utility-maximizing combination—the one that best satisfies your preferences—will therefore be one Coke and three hot dogs. No other combination of Coke and hot dogs will give you greater satisfaction. (Try to find one.) To sum up, if the price of hot dogs goes down relative to the price of Coke, the rational person will buy more hot dogs. If the price of Coke rises relative to the price of hot dogs, the rational person will buy less Coke. This principle will hold true for any good or service and is commonly known as the law of demand. The law of demand states the assumed inverse relationship between product price and quantity demanded, everything else held constant. If the relative price of a good falls, the individual will buy more of the good. If the relative price rises, the individual will buy less. Figure 8.1 shows the demand curve for Coke—that is, the quantity of Coke purchased at different prices. The inverse relationship between price and quantity is reflected in the curve’s downward slope. If the price falls from $1 to $0.75, the quantity the consumer will buy increases from two Cokes to three. The opposite will occur if the price goes up. Thus the assumption of rational behavior, coupled with the consumer’s willingness and ability to substitute less costly goods when prices go up, leads to the law of demand. Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 6 We cannot say how many Cokes and hot dogs a particular person will buy to maximize his or her satisfaction. That depends on the individual’s income and preferences, which depend in turn on other factors (how much he likes hot dogs, whether he is on a diet, and how much he worries about the nutritional deficiencies of such a lunch). We can predict the general response, whether positive or negative, to a change in prices. FIGURE 8.1 The Law of Demand Price varies inversely with the quantity consumed, producing a downward-sloping curve like this one. If the price of Coke falls from $1 to $0.75, the consumer will buy three Cokes instead of two. Price is whatever a person must give up in exchange for a unit of goods or services purchased, obtained, or consumed. It is a rate of exchange and is typically expressed in dollars per unit. Note that price is not necessarily the same as cost. In an exchange between two people—a buyer and a seller—the price at which a good sells can be above or below the cost of producing the good. What the buyer gives up to obtain the good does not have to match what the seller-producer gives up in order to provide the good. Nor is price always stated in dollars and cents. Some people have a desire to watch sunsets—a want characterized by the same downward-sloping demand curve as the one for Coke. The price of the sunset experience is not money. Instead it may be the lost opportunity to do something else, or the added cost and trouble of finding a home that will offer a view of the sunset. (In that case, price and cost are the same because the buyer and the producer are one and the same.) The law of demand will apply nevertheless. The individual will spend some optimum number of minutes per day watching the sunset and will vary that number of minutes inversely with the price of watching. From Individual Demand to Market Demand Thus far we have discussed demand solely in terms of the individual’s behavior. The concept is most useful, however, when applied to whole markets or segments of the population. Market demand is the summation of the quantities demanded by all consumers of a good or service at each and every price during some specified time period. To obtain the market demand for a product, we need to find some way of adding up the wants of the individuals who collectively make up the market. Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 7 The market demand can be shown graphically as the horizontal summation of the quantity of a product each individual will buy at each price. Assume that the market for Coke is composed of two individuals, Anna and Betty, who differ in their demand for Coke, as shown in Figure 8.2. The demand of Anna is D A and the demand of Betty is D B . Then to determine the number of Cokes both of them will demand at any price, we simply add together the quantities each will purchase, at each price (see Table 8.1). At a price of $11, neither person is willing to buy any Coke; consequently, the market demand must begin below $11. At $9, Anna is still unwilling to buy any Coke, but Betty will buy two units. The market quantity demanded is therefore two. If the price falls to $5, Anna wants two Cokes and Betty, given her greater demand, wants much more, six. The two quantities combined equal eight. If we continue to drop the price and add the quantities bought at each new price, we will obtain a series of market quantities demanded. When plotted on a graph they will yield curve D A+B , the market demand for Coke (see Figure 8.2). ___________________________________ FIGURE 8.2 Market Demand Curve The market demand curve for Coke, D A+B , is obtained by summing the quantities that individuals A and B are willing to buy at each and every price (shown by the individual demand curves D A and D B ). This is, of course, an extremely simple example, since only two individuals are involved. The market demand curves for much larger groups of people, however, are derived in essentially the same way. The demands of Fred, Marsha, Roberta, and others would be added to those of Anna and Betty. As more people demand more Coke, the market demand curve flattens out and extends further to the right. Elasticity: Consumers’ Responsiveness to Price Changes In the media and in general conversation, we often hear claims that a price change will have no effect on purchases. Someone may predict that an increase in the price of prescription drugs will not affect people’s use of them. The same remark is heard in connection with many other goods and services, from gasoline and public parks to medical services and salt. What people usually mean by such statements is that a price Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 8 change will have only a slight effect on consumption. The law of demand states only that a price change will have an inverse effect on the quantity of a good purchased. It does not specify how much of an effect the price change will have. TABLE 8.1 Market Demand for Coke Quantity Quantity Quantity Demanded Price Demanded by Demanded by by both Anna and Betty of Coke Anna (D A ) Betty (D B ) (D A+B ) (1) (2) (3) (4) $11 0 0 0 10 0 1 1.0 9 0 2 2.0 8 0.5 3 3.5 7 1.0 4 5.0 6 1.5 5 6.5 5 2.0 6 8.0 4 2.5 7 9.5 3 3.0 8 11.0 2 3.5 9 12.5 1 4.0 10 14.0 Note: The market demand curve, D A+B , in Figure 8.2 is obtained by plotting the quantities in column (4) against their respective prices in column (1). In other words, we have established only that the market demand curve for a good will slope downward. The actual demand curve for a product may be relatively flat, like curve D 1 in Figure 8.3, or relatively steep, like curve D 2 . Notice that at a price of P 1 , the quantity of the good or service consumed is the same in both markets. If the price is raised to P 2 , however, the response is substantially greater in market D 1 than in D 2 . In D 1 , consumers will reduce their purchases all the way to Q 1 . In D 2 , consumption will drop only to Q 2 . Economists refer to this relative responsiveness of demand curves as the price elasticity of demand. Price elasticity of demand is the responsiveness of consumers, in terms of the quantity purchased, to a change in price, everything else held constant. Demand is relatively elastic or inelastic, depending on the degree responsiveness to price change. Elastic demand is a relatively sensitive consumer response to price changes. If the price goes up or down, consumers will respond with a strong decrease or increase in the quantity demanded. Demand curve D 1 in Figure 8.3 may be characterized as relatively elastic. Inelastic demand is a relatively insensitive consumer response to price changes. If the price goes up or down, consumers will respond with only a slight decrease or increase in the quantity demanded. Demand curve D 2 in Figure 8.3 is relatively inelastic. The elasticity of demand is a useful concept, but our definition is imprecise. What do we mean by “relatively sensitive” or “relatively insensitive”? Under what Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 9 circumstances is consumer response sensitive or insensitive? There are two ways to add precision to our definition. One is to calculate the effect of a change in price on total consumer expenditures (which must equal producer revenues). The other is to develop mathematically values for various levels of elasticity. We will deal with each in turn. FIGURE 8.3 Elastic and Inelastic Demand Demand curves differ in their relative elasticity. Curve D 1 is more elastic than curve D 2 , in the sense that consumers on curve D 1 are more responsive to a price change than are consumers on curve D 2 . Analyzing Total Consumer Expenditures An increase in the price of a particular product can cause consumers to buy less. Whether total consumer expenditures rise, fall, or stay the same, however, depends on the extent of the consumer response. Many people assume that businesses will charge the highest price possible to maximize profits. Although they sometimes do, high prices are not always the best policy. For example, if a firm sells fifty units of a product for $1, its total revenue (consumers’ total expenditures) for the product will be $50 (50 x $1). If it raises the price to $1.50 and consumers cut back to forty units, its total revenue could rise to $60 (40 x $1.50). If consumers are highly sensitive to price changes for this particular good, however, the fifty-cent increase may lower the quantity sold to thirty units. In that case total consumer expenditures would fall to $45 ($1.50 x 30). 1 1 To prove this result, let’s look at marginal revenue MR, or the change in total revenue in response to a change in quantity Q. Taking the derivative of P(Q) • Q with respect to Q, we obtain Q dQ dP QP dQ QQPd •+= • = )( ])([ MR Factoring price out of the right-hand side of this equation gives us       •+= P Q dQ dP P 1MR which, because E =       − dP dQ , is the same as Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 10 The opposite can also happen. If a firm establishes a price of $1.50 and then lowers it to $1, the quantity sold may rise, but the change in total consumer expenditures will depend on the degree of consumer response. In other words, consumer responsiveness determines whether a firm should raise or lower its price. (We will return to this point later.) We can define a simple rule of thumb for using total consumer expenditures to analyze the elasticity of demand. Demand is elastic: • if total consumer expenditures rise when the price falls, or • if total consumer expenditures fall when the price rises. Demand is inelastic: • if total consumer expenditures rise when the price rises, or • if total consumer expenditures fall when the price falls. Determining Elasticity Coefficients Although we have refined our definition of elasticity, it still does not allow us to distinguish degrees of elasticity or inelasticity. Elasticity coefficients do just that. The elasticity coefficient of demand (E d ) is the ratio of the percentage change in the quantity demanded to the percentage change in price. Expressed as a formula, percentage change in quantity E d = percentage change in price The elasticity coefficient will generally be different a different points on the demand curve. Consider the linear demand curve in Figure 8.4. At every point on the curve, a price reduction of $1 causes quantity demanded by rise by ten units, but a $1 decrease in price at the top of the curve is a much smaller percentage change than a $1 decrease at the bottom of the curve. Similarly, an increase of ten units in the quantity demanded is a much larger percentage change when the quantity is low than when it is high. Therefore the elasticity coefficient falls as consumers move down their demand curve. Generally, a straight-line demand curve has an inelastic range at the bottom, a unitary elastic point in the center, and an elastic range at the top. 2 1 if 0 1 if 0 1 if 0 1 1MR << == >>       −= E E E E P From this it follows immediately that an increase in Q (a decrease in P) increases total revenue if E > 1, has no effect on total revenue if E = 1, and reduces total revenue if E < 1. 2 To prove this, we recognize that the equation for a linear domain curve can be expressed mathematically as Q P B A − = where P represents price, Q is quantity demanded, and A and B are positive constants. The total revenue associated with this demand curve is given by [...]... or service is any good or service for which demand rises with an increase in income and falls with a decrease in income The demand for a few luxury goods actually outstrips increases in income A luxury good or service is any good or service for which 17 18 Chapter 8 Consumer Choice and Demand in Traditional and Network Markets demand rises proportionally faster than income An inferior good or service... of the consumer surplus.6 Figure 8. 15 Two-Part Pricing A uniform price can lead the individual to buy Y2 and X2 However, a two-part price can lead the individual to buy the same amount of X while reducing the purchases of Y to T1 , leaving the consumer on a lower utility curve and the seller with more income Two-part pricing strategies in the real world are not usually... The individual reduced bus-service consumption when this service was given free of charge This can only occur if the individual regards bus service as an inferior good, which most people do The gift increases the recipient's real income and motivates a reduction in the consumption of an inferior good as long as the relative price of that good remains constant And since we assume that the individual... expanding demand, and profits, in the future.11 9 Dwight Lee and David Kreutzer, “Lagged Demand and a ‘Perverse’ Response to Threatened Property Rights,” Economic Inquiry, vol 20 (October 1 982 ), pp 57 9-5 88 10 Lee and Kreutzer, “Lagged Demand and Property Rights,” p 580 11 Such a cartel may also dissolve because of rampant cheating involving price increases, with all firms seeking to benefit from the... illustrated by computing the arc elasticity between two sets of points, ab on curve D1 and cd on curve D2 Arc elasticity between points a and b: 25 - 35 5 - 4 Ed = ½(25 + 35) ÷ ½(5 + 4) = 1.50 Arc elasticity between points c and d: 70 - 80 5 - 4 Ed = ½(70 + 80 ) ÷ ½(5 + 4) = 0.60 Government too must consider elasticity of demand, for the consumer’s demand for taxable items is not inexhaustible If a government... others This is not true The indifference-curve approach to utility maximization can be used to explain charitable behavior Nothing in our analysis prevents an individual's utility from being influenced by the consumption of others as well as by his or her own consumption For example, let's assume that we are considering two individuals – individual D (the donor) and individual R (the recipient) – and that... felt that the individual actually needed X units of bus transportation _ Figure 8. 17 In-Kind Charitable Contributions An in-kind charitable contribution can lead to a person buying more of the good, as is the case when the individual moves from A to D (although he would prefer to move to G, but can’t) However The charitable contribution can also lead to the individual consuming less... packs, or she can divide her expenditures in any number of ways to yield various combinations of books and pens By plotting all the possible combinations, we obtain the student’s budget line, B1 P1 in Figure 8. 11 All combinations on the budget line are possible for the student She can choose point a, twenty-five books and fifteen pen packs, or point b, forty-five books and three 21 Chapter 8 Consumer Choice... others. 8 Good examples of network goods include telephones, fax machines, and computer software One person’s telephone is useless someone else owns a phone, and the more people who buy phones, the greater the value of the phone is to everyone, because more people can be called 8 Franklin M Fisher, Direct Testimony, U.S vs Microsoft Corporation, Civil Action No 9 8- 1 233 (TPJ), filed October 14, 19 98, p... unit purchased However, relatively crude or simple price-discrimination schemes can be implemented that allow suppliers to capture more of the consumer surplus than they could under a uniform pricing policy Such a price-discrimination scheme is illustrated in Figure 8. 15 with the aid of an individual's indifference-curve map We assume the individual is initially at Y , consuming Y units of good Y and . elasticity between points a and b: 25 - 35 5 - 4 E d = ½(25 + 35) ÷ ½(5 + 4) = 1.50 Arc elasticity between points c and d: 70 - 80 5 - 4 E d = ½(70 + 80 ) ÷ ½(5 + 4) = 0.60 Government. ½ (10 + 9) = - 15 ÷ 9.5 = - 15 = -6 .33 or 6.33 in absolute value. Arc elasticity between points c and d: 90 – 100 2 – 1 10 1 E d = ½ (90 + 100) ÷ ½ (2 + 1) = -9 5 ÷ 1.5 = - 0.16 or 0.16. increases in income. A luxury good or service is any good or service for which Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 18 demand rises proportionally faster