Chapter 8 Consumer Choice and Demand in
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27
reflected by the budget constraint segment aY , then the consumer can buy additional
units of good X at the much lower price indicated by the segment Xa of the budget
constraint. Faced with such a pricing policy, the consumer will be willing to sacrifice
Y
– Y
1
units of good Y, to buy X
2
units, thereby dissipating all of the consumer surplus.
6
__________________________________
Figure 8.15. Two-Part Pricing
A uniform price can lead the individual to buy
Y
2
and X
2
. However, a two-part price can lead
the individual to buy the same amount of X
while reducing the purchases of Y to T
1
, 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 calibrated accurately
enough to capture an individual’s entire consumer surplus. Also, the same two-part
pricing policy normally applies to everyone, even though preferences – and therefore
indifference curves – vary from consumer to consumer. Thus, any given two-part pricing
strategy will capture more consumer surplus from some than from others. However, such
a strategy generally allows suppliers to motivate consumers to pay more for a given
quantity of a good than they would under a uniform pricing policy.
Given the advantage that suppliers can realize from a two-part pricing strategy, it
is not surprising that different variations of such pricing strategies are often encountered.
For example, suppliers of electricity almost universally employ at least a two-part pricing
schedule, so that the first few kilowatts of power used during the billing period cost the
consumer more than subsequent kilowatts. A variation on two-part pricing is the
membership fee – an initial charge that entitles the consumer to purchase a product at a
lower price. As shown in Figure 8.15, this produces the same effect as straight two-part
pricing. Assume that on paying an initial fee of
Y
Y
−
, the consumer can buy all the units
of X desired at the reduced price, reflected in the budget constraint
YX
. We can see that
the consumer will respond to this pricing policy by paying the fee and purchasing X
2
units of good X, allowing the supplier to capture all the consumer surplus. Automobile-
rental firms use a form of this pricing policy when they impose a daily charge plus a per-
mile charge. Computer time is commonly obtained by paying a lump-sum rental, which
then entitles the individual to use the computer at a low hourly charge. Amusement parks
6
Actually, the consumer is indifferent between buying no X and buying X
2
units of X. But if the consumer
buys any of good X at all, it will be X
2
units, and only the slightest decrease in the price of good X along
either segment of the budget constraint will make the purchase of X the most attractive alternative.
Chapter 8 Consumer Choice and Demand in
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28
usually charge an entry fee and then attach no marginal charge to the rides. Surely you
can think of other examples of two-part pricing policies.
Application: Charity Versus Corner Solutions
The underlying assumption that individuals are motivated to maximize their own utility
may leave the impression that there is no room in our analysis for concern for 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 D's utility is a function not only of his own consumption but
of R's as well. D's preferences can be expressed with indifference curves showing
combinations of D's and R's consumption that provides D with the same utility. Two
such indifference curves are shown in Figure 8.16. These curves indicate that when D
has a high income relative to R's income, D is willing to transfer come income to R. As
expected, however, as D's income declines relative to R's income, the slope of the
indifference curve becomes shallower, indicating that D is willing to sacrifice less
income to increase R's income by an additional dollar. And if R's income increases too
much relative to D's income, envy sets in and individual R's income becomes a “bad” (a
“good” with negative value) to D. This is shown by the upward-sloping portions of the
indifference curves. Once envy sets in, D's income will have to be increased before he is
willing for R's income to increase.
_______________________________________
Figure 8.16 Sometimes It Is Better to Give
Than to Receive
The donor, D, has an initial starting income that
is higher than the recipient’s, R’s. By giving
income TT’ to R, D moves to a higher
indifference curve. This is a case in which R’s
welfare affects D’s, leaving D better off by
giving than receiving.
_________________________________
Now let's assume that D can transfer income costlessly to R, or that R receives an
additional dollar for each dollar D gives up. This is reflected in Figure 8.16 by – 1 slope
of TT, which shows the different income combinations that D can realize by transferring
Chapter 8 Consumer Choice and Demand in
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29
income to R. (Here I
D
and I
R
represent D's and R's initial incomes, respectively.) Subject
to this constraint, D attempts to maximize his utility through charitable contributions,
reaching indifference curve I
1
by donating I
D
– I
D
' dollars to R. This increases R's
income from I
R
to I
R
'.
Next we will assume that R's income increases to I
R
" without any transfers from
D. The relevant constraint D faces in donating income to R is now given by T'T' in
Figure 8.16. But with this constraint, D maximizes utility by not donating any income to
R. At point A, the constraint is steeper than the indifference curve, resulting in a corner
solution. D does not donate any income increase to R: the first dollar that D donated
would increase R's income by a lesser amount than is required to make D willing to
sacrifice $1 of income.
Application: Charity and Paternalism
Due to an underlying fear that the recipients will not spend the money in their best
interests, few organized charities, either public or private, simply transfer income to the
needy. Instead of money, charitable contributions normally consist of particular goods
and services that the donors believe the recipients should have. It will be helpful to use
the indifference-curve approach to consumer behavior to analyze the effect of these in-
kind gifts in terms of the intent of the donors and the utility of the recipients.
The three indifference curves I
1
, I
2
, and I
3
in Figure 8.17 belong to an individual
who is to be the recipient of a donated good – say, bus transportation. Before the
donation, the individual's budget constraint with respect to bus transportation and all
other goods is defined by line BC. Given this constraint, the individual will maximize
utility by choosing bundle A (point A) and consuming bus rides at the rate of X
1
per
week. Now we will assume that this individual qualifies for public relief, which takes the
form of free bus transportation – something the transit authorities feel people should be
encouraged to consume. Letting
X
be the quantity of free bus transportation received,
the budget constraint becomes BDE. Beyond point D, the slope of this budget constraint
is the same as BC, reflecting the fact that the regular price must be paid for bus
transportation in excess of
X
. Faced with this new budget constraint, the consumer will
maximize utility by choosing bundle D, point D at the kink in the constraint.
Consumption of bus transportation will increase from X
1
to
X
, and utility will also
increase because the individual moves from indifference curve I
1
to I
2
.
Two objectives have been accomplished by this contribution. First, the recipient's
well being was improved; second, the recipient's consumption of bus transit was
increased – something those controlling the contribution thought was important. It is
worth noting that these two objectives are somewhat in conflict with one another. For
example, if the only objective had been to increase the recipient's well being as much as
possible, the contribution would have been made in the form of money or some other
form of general purchasing power. If instead of
X
bus tokens, the recipient had received
enough money to buy
X
bus tokens, then the budget constraint would have been FDE.
Given this constraint, the individual would have chosen bundle G at point G, consumed
Chapter 8 Consumer Choice and Demand in
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30
only X
2
units of bus transportation, and reached indifference curve I
3
, thereby attaining a
higher utility level than that achieved when the in-kind gift of bus rides was given. Of
course, this increase in utility would have been attained at the expense of the people who
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 of
the charitable good, which is what happens when
the individual moves from A’ to B’.
_________________________________
Next, we will consider an individual who, before the receipt of
X
units of free
bus transportation, was consuming a greater quantity than that. The preferences of this
individual are represented in Figure 8.17 by indifference curves I
1
' and I
2
'. Before the
gift, BC is the budget constraint and the individual maximizes utility by choosing bundle
A' at point A' and consuming X
1
' units of bus transportation. But after the receipt of
X
units of bus transit, the budget constraint shifts to BDE and the consumer maximizes
utility by choosing bundle B' and point B' and reducing consumption to X
2
' units of bus
transportation. 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 was consuming
more than
X
before the gift, the relative price of the marginal unit consumed is not
affected by the gift. The effect of giving the recipient
X
units of bus transportation is the
same as giving the individual enough money to purchase that much bus service.
This analysis can be applied to the current food-stamp program in the United
States. As that program is now structured, people who qualify are given food stamps in
specific dollar amounts that can be redeemed for food. If the dollar value of the stamps
exceeds the amount the recipients are spending on food, then the program can be
expected to motivate a larger increase in food consumption than would result from an
equivalent income transfer. But if more money was being spent on food before the
program was initiated than the dollar value of the food stamps received after the program
Chapter 8 Consumer Choice and Demand in
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31
was begun, then there is no effective difference between providing recipients with food
stamps or with equivalent amounts of cash.
The Demand for Public Goods
Early in the book we distinguished two types of goods, private and public goods. To this
point we have developed the market demand for a private good. The development of a
community’s demand for a public (or community) good is substantially different from the
previous construction of the demand for a private good. As we will see, the nature of a
public good prevents its provision by private firms in an efficient manner.
We can construct the demand for a public good by first noting that each individual
has a downward sloping demand for public goods national defense, environmental
quality, etc. However, if a unit of a public good is provided, all within the relevant group
can receive benefits from it. This is not true of a private good; a unit of a private good
benefits only the person who possesses it. Consequently, the community’s demand for a
public good must be obtained by vertically adding up the values (as measured by the
price) that all within the group place on each unit. The reason for this is simply that all
can benefit from each unit; and the relevant question is what is the total value, which all
within the group place on all units. This is why we vertically add each unit, to find the
total value.
To illustrate in the simplest possible terms, consider a community made up of
only two people. There is some good, like police protection, from which both can receive
benefits simultaneously. Suppose, however, that individual B has a greater demand for
police protection than A. This condition is illustrated in Figure 8.18. For the first unit of
police protection, A is willing to pay as much as $3, which is an indication of the relative
value he places on that unit. B, on the other hand, is willing to pay more, $5 in this
example. Both can benefit from the first unit of police protection, and the collective
value attached to this unit is $8 ($3 + $5). Since each individual’s demand curve is
downward sloping, the relative value attached to each unit declines as the quantity is
increased. For the second unit, A is willing to pay $2 and B, $4. Collectively, they are
willing to pay as much as $6. For the fourth unit, A is unwilling to pay anything;
however, B is still willing to pay as much as $2. From that point on, the collective value
of police protection is simply equal to the value which B places on the good.
The prices which A and B are willing to pay for each unit are shown and added
together in Table 8.2. If we plot the collective value which A and B place on each unit
(P
A + B
in the table) against the quantity, we will obtain a demand curve represented by
the darker line in Figure 8.18. This curve represents the demand for a public good or
service. It represents what the people in the community are willing to pay in total (if they
have to) for each unit of police protection. We talk in terms of the collective value of the
community because all people can share in the benefits of the good or service if it is
provided.
Public officials may be unable to obtain a very accurate picture of the public’s
demand for a service like police protection. When people vote for representatives or in a
referendum, they vote for or against or yes or no. Their votes are only a crude indication
Chapter 8 Consumer Choice and Demand in
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32
of the intensity of their preferences for the public good. This is so because all votes count
the same. The politicians are forced to try to sense the mood of the people, and in doing
that they may provide many people with an opportunity to misrepresent their true demand
for the good, that is, how much they are willing to pay. More will be said on this in later
chapters. The important point to understand at this juncture is the difference in the
construction of the demand for public and private goods.
_________________________________
FIGURE 8.18 The Public Good Demand Curve
The public good demand curve, D
A+B
, is equal to
the vertical summation of the demands of the
individuals A and B. The curves are added
vertically because both individuals A and B can
simultaneously benefit from each unit of police
protection provided.
_________________________________
TABLE 8.2 Construction of a Public Goods Demand Curve
Units of Police
Protection
(1)
Price A Is Willing To
Pay for Each Unit
(DA)
(2)
Price B Is Willing To
Pay for Each Unit
(DB)
(3)
Public Goods Demand:
Price A and B Are
Willing to Pay for
Each Unit When They
Act Collectively
(DA+B)
(4)
0.5 $3.50 $5.50 $9
1 3 5 8
2 2 4 6
3 1 3 4
4 0 2 2
5 0 1 1
6 0 0 0
Note: The Public Goods demand curve in Figure 8.9 (the darker line) is obtained by plotting the prices that
A and B are collectively willing to pay for each unit in column (4) against their respective units in column
(1).
Chapter 8 Consumer Choice and Demand in
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33
Irrationality and the Law of Demand
So far we have been discussing demand in terms of rational behavior. Even if some
consumers behave irrationally, the law of demand will apply. As long as some people in
the market respond rationally, demand will change with a change in price. For instance,
many people buy cigarettes because they are addicted to them. At times habitual smokers
may not consider price in making their purchases. Therefore we cannot expect the
quantity they buy always to vary with price (except to the extent that it affects their total
purchasing power). If occasional smokers take price into consideration when they buy,
however, their demand for cigarettes will produce the normal downward sloping curve.
If we add the quantity bought by smokers who are addicted to the quantity bought by
those who are not, the total market demand curve will slope downward (see Figure 8.19).
At a price of P
1
, Q
1
cigarettes will be bought by addicted consumers, and Q
3
– Q
1
cigarettes will be bought by occasional consumers. If the price then rises to P
2
, the total
quantity bought will fall to Q
2
, reflecting a predictable drop in the quantity purchased by
occasional consumers.
This kind of reasoning can be extended to impulse buying. Some people respond
more to the packaging and display of products than to their price. Their demand may not
slope downward. As long as some people check prices and resist advertising, however,
the total demand for any good will slope downward. Store managers must therefore
assume that changes in price will affect the quantity demanded. The fact that some
people may behave irrationally reduces the elasticity of demand but does not invalidate
the concept of demand.
7
___________________________________
FIGURE 8.19 Demand Including Irrational
Behavior
If irrational consumers demand Q
1
cigarettes no
matter what the price, but rational consumers take
price into consideration, market demand will be D
1
.
The quantity purchased will still vary inversely
with the price.
7
In fact, one economist has demonstrated rather convincingly that the assumption of rational behavior is
unnecessary to the construction of a downward-sloping demand curve. The curve, he argues, can emerge
from completely random behavior on the part of consumers. Gary S. Becker, Economic Theory (New
York: Alfred A Knopf, 1972), pp. 19—23.
Chapter 8 Consumer Choice and Demand in
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34
Lagged Demands and Network Externalities
Almost all microeconomics textbook do what we have done with demand, they provide a
lengthy discussion of the demand for a “standard” good. They will explain that the
quantity of the good purchased will be related to the price of the good in question and a
number of other considerations (such as weather, income, and the prices of other goods),
as we have stressed. The lower the price of a candy bar, for example, the greater the
quantity purchased, and vice versa. This inverse relationship between price and quantity
is so revered in economics that it has a special label, the “law of demand.” Nothing will
be said by most textbooks about how the benefits received by any one candy bar buyer in
one time period will affect the benefits received in subsequent time periods, or, rather,
how the consumption level today will affect the demand in the future. Little or nothing
will also be written about how the benefits (and demand) depend upon how many other
people have bought candy bars, all of which is understandable. The benefit that one
person gets from eating a candy bar in one time period does not materially affect the
benefits received from eating another bar later and is also not materially affected by how
many other people buy bars in the various time periods. People just buy and consume
candy bars independent of one another, and couldn’t care less about how much other
people enjoy their candy bars.
This is not true for two special classes of goods called lagged demand goods and
network goods. A lagged demand good is one in which consumption today affects
consumption tomorrow (or future time periods). A lagged demand good has one defining
feature: the greater the quantity purchased today, the greater the demand tomorrow.
Good examples of lagged demand goods include cigarettes, alcohol, and street drugs,
given that they tend to be addictive in consumption. As we will see, the theory of lagged
demand is similar to the theory of “rational addiction,” or the view that before
consumption begins, people can rationally weigh the long-term costs and benefits, or pros
and cons, of consuming goods that can be physically compelling in consumption.
A network good is a product or service the value of which to consumers depends
intrinsically on how many other people buy the good. A network good has one defining
feature: The greater the number of buyers, the greater the benefits most, if not all, buyers
receive. These goods are said to exhibit “network effect” or “network externalities,”
which has been appropriately described by one economist as “a phenomenon in which the
attractiveness of a product to customers increases with the use of that product by 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. 98-1233 (TPJ),
filed October 14, 1998, p. 15. (as downloaded from http://www.usdoj.gov/atr/cases/f2000/2057.pdf).
Chapter 8 Consumer Choice and Demand in
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35
As you can see, lagged demand and network goods have much in common, the
interconnectedness of consumption, which has important implications for pricing
strategy.
Lagged Demands
One of the authors of this book, Lee, was involved in the development of the theory of
lagged demands.
9
He and David Kreutzer have argued that, for some purposes, the
demands that apply to a given product but that are evident in different time periods
should be viewed as interdependent, with consumption in the future critically tied to
consumption in the current time period, whatever the elasticity of the current demand (or
whatever the technical capacity of consumers to respond to price changes in the current
time period) might be. From this perspective, a lagged demand good is one in which the
future good is a complement to the current good; they go together. According to Lee and
Kreutzer,
The crucial assumption behind our analysis is that lags exist in the demand
for the resource; future demands are influenced by current availability.
The demand for petroleum is clearly an example of such a lagged demand
structure, with future demand for petroleum significantly influenced by
investment decisions made in response to current availability.
10
Hence, it follows that like all complements, the future demand for a product depends
upon the current price for the same good. Behind such an obvious point lie important
insights that might otherwise go unrecognized from the usual view of demand (and, as we
will see, excise taxes and other policy topics).
As a consequence of the complementarity in consumption over time, firms faced
with lagged demand have an incentive to lower their current price in order to stimulate
future sales. They might even might charge a price in (or marginally lower their price
toward) the inelastic range of their current demand curves, in spite of the fact that they
lose current revenues from doing so, just so they can stimulate a greater future demand,
which will permit them to raise their future prices and which can lead to greater generate
profits in the future. This is true, of course, so long as the producers’ rights to exploit
future profits are not threatened.
What is interesting about this perspective is that under conditions of lagged
demand, a cartel may form not with the intent of raising the group’s current price, but
with the intent of lowering the current price and 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 1982), pp. 579-588.
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 greater demand stimulated by lower prices charged by other cartel members.
Chapter 8 Consumer Choice and Demand in
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36
Also, it needs to be noted that the conventional treatment of demand, under which
the demand tomorrow is unrelated to the consumption level today, holds that the potential
for future threats to the stability of property rights could lead to “over-production” during
the current time period. This is the case because if a firm – for example, an oil company
– fears it will lose its property rights to its reserves, then it has an incentive to increase
production and expand sales today. Never mind that the added supply oil might depress
the current price. The oil firm can reason that if it doesn’t pump the oil out of the ground
in the short term, it will not have rights to the oil in the future.
For goods subject to the lagged demand phenomenon, any looming threat to
property rights can cause some firms to do the opposite, reduce production of oil (or the
exploitation of any other resource), hike the current price, and extract whatever profits
remain. When its property rights are threatened, the firm no longer has an incentive to
artificially suppress its current price in order to cultivate future demand.
Rational Addiction
Two economists from the University of Chicago, Gary Becker and Kevin
Murphy, have developed a similar line of argument. The major difference is that their
purpose was primarily to develop an economic theory of “addiction,” which is a general
concept also intended to suggest a tie between current and future consumption of a good
or activity.
12
The tie-in, however, is physical (or maybe chemical) as in the case of
cigarettes. People’s future demand for smokes can be tied to their current consumption
simply because of the body’s chemical dependency on the intake of nicotine. As in the
case of lagged demand goods, producers of addictive goods have an incentive to suppress
the current price of their good – cigarettes – in order to stimulate the future demand for it.
The lower the current price, the greater the future demand and the greater the future
consumption.
This complementarity in consumption for an addictive (and lagged demand) good
is illustrated in Figure 8.20. At price P
1
in the current time period, the consumption will
be Q
1
in the current time period. However, because of that current consumption level, the
demand in the future rises to D
2
. At a price of P
2
, current consumption rises to Q
2
, but
the future demand rises to D
3
. You can imagine that at even lower prices, P
3
, there will
be some even higher demand curve, D
3
, in the future time period. You can see in the
illustration why firms have an incentive to lower the current price: the future demand
rises. With other complement goods, if the price of one complement goes down and
more of it is sold, then the demand for the other complement will go up, with its price
rising. The same thing happens in this case. The only difference is that the complements
are the same good but consumed in different time periods.
The current demand for one addictive good, cigarettes, might be highly inelastic,
as is commonly presumed in microeconomics, but this does not mean that the long-run
demand is necessarily inelastic. As illustrated in Figure 8.20, the short-term demand
12
Becker and Murphy, “Rational Addiction.”
. of the public’s
demand for a service like police protection. When people vote for representatives or in a
referendum, they vote for or against or yes or. To
Pay for Each Unit
(DA)
(2)
Price B Is Willing To
Pay for Each Unit
(DB)
(3)
Public Goods Demand:
Price A and B Are
Willing to Pay for
Each