Opening quotes and questions page 448.

MICRO SECTION: Price Theory.  "Microeconomics focuses on the choices of consumers, the operation of firms, and the earnings of resource suppliers."

We start the micro material in CH 19 by looking at markets for specific products, specifically the demand side of the market (overlap with marketing).  The next four chapters (CH 20-23), we will look at the supply side or production side of the market.

We look at: 1) interrelationships among markets and 2) the factors that influence demand for specific products. We look at prices - remember the role of prices - they coordinate the $11T of economic activity. Consumer demand, and changes in demand, largely determine prices, along with supply. Prices transmit information - consumer demand, and changes in consumer demand, transmits information to producers. Example: - basketball players salaries vs soccer players salaries. Our tastes/preferences are transmitted by prices - no survey is required - prices do the job invisibly and effortlessly.
 

FIVE PRINCIPLES OF CONSUMER BEHAVIOR

As consumers, we constantly make choices, and allocate our income among alternative purchases, based largely on prices, or more accurately Relative Prices: Relative prices implies either: a) the price of Good X versus Good Y, or b) the price of Good X today versus the price of Good X last year.  Consumer tastes, preferences, and behavior are constantly changing, and this is the challenge (and opportunity) for producers:  How to capture market share and sales, in a dynamic marketplace with continually changing (fickle?) consumers?  Role of the entrepreneur: "Discovery process" of finding new products that consumers want - determining and predicting consumer preferences.  Consumer sovereignty.

Example of dynamic consumer behavior: Consumer spending on food fell from 26% of total consumption in 1963 to 15% in 1999.      

GENERAL PRINCIPLES OF CONSUMER BEHAVIOR

1. Limited income (scarcity) necessitates choice. Our choices are influenced by, and actually determine, costs. When we choose one alternative, we have to give up something else. Another application of the Opportunity cost concept.

2. Consumers make decisions purposefully. In other words, we are careful (ruthless?) shoppers. "We want the most bang for the buck."  Assumption of consumer rationality when making consumption decisions.  Consumers value quality, service and low prices, and carefully evaluate purchases to achieve maximum value.  

3. One good can be substituted for another. There are substitutes for everything.

4. Consumers must make decisions without perfect information, but knowledge and past experience will help. Perfect information and perfect foresight are not possible. We make decisions under some uncertainty. We learn from experience - our own and others. Examples: a) Brand names and advertising provide low cost information to consumers. Zagats restaurant directory, travel guides, Internet, etc. b) word-of-mouth for movies, restaurants, courses, etc.

5. The Law of Diminishing Marginal Utility (DMU) applies to consumer behavior: As consumption of a good increases, the marginal, or additional utility (satisfaction) from each additional unit consumed, will eventually decrease.  Marginal utility eventually declines as consumption increases. Example: ice cream - the first scoop of ice cream tastes really good, the second tastes good, but not as good as the first, etc. As we continue to consume more and more ice cream, the marginal utility of each additional unit (scoop) starts to decline.

Example: Buy one pair of jeans at full price, get the second one at 1/2 price.

Marginal Utility and Choice - Our consumption decisions are determined by the costs and benefits of given goods and services. Specifically, we consume goods as long as the MB (marginal benefit) or MU (marginal utility) is greater than the MC (marginal cost). If the benefits (MB) rise or the cost (MC) falls, we will consume more. If the benefits fall, or the cost rises, we will consume less, ceteris paribus.

Examples: You used to like Country-Western music but you develop an appreciation of jazz or classical music, so the marginal benefits (MB) of an additional jazz CD increases, and you buy more. The MB of C-W music declines, so you buy fewer CDs.  If prices go up, the MC is higher and you buy less. If Prices go down, you buy more. Anything that changes MB or MC, will change consumer behavior, and affect the amount purchased.  
 
Implication of the Law of Diminishing MU: Downward sloping demand curve!  Demand curves reflect our willingness to pay for different levels of consumption. Since the MU (MB) declines as consumption increases, our willingness to pay decreases for additional units of consumption.   

Price Changes and Consumer Choice - The demand curve (schedule) on p. 451 shows various price-quantity demanded combinations for frozen pizza. The first law of demand says that the amount purchased is inversely related to price. Why?

1. Substitution Effect (switching) - as price falls (rises), consumers substitute away from other now more expensive goods toward the now cheaper good. Example: Coke and Pepsi are substitutes for some people. If the price of Pepsi falls, some consumers will switch from Coke to Pepsi.

We consume up until MB (MU) = MC. If price (MC) falls, we increase consumption. However, there is a limit to how much we increase consumption, due to the Law of DMU. If the price per pizza falls from $3.50 to $3.00, consumption increases from 1 pizza to 2 pizzas, but then at that point our MB (MU) is once again equal to MC.

2. Income Effect - If the price of one good falls (rises), a consumer's real income will rise (fall), which will also increase consumption because consumers can now afford more (assuming a constant nominal income). Example: if gas prices fall (rise), that is like an increase (decrease) in real income, we are made better (worse) off.

The two effects (substitution and income) usually reinforce each other.

Example:  If the price of steak falls, consumers will substitute away from other relatively higher-priced goods and buy more of the relatively cheaper steak, this is the substitution effect. A lower price of steak also increases a consumer's fixed money income, and they now have more money to spend on steak and other goods, this is the income effect.  
 

TIME COST and CONSUMER CHOICE

The monetary price is just one component of the cost of purchasing a product. Time is a non-monetary part of the total cost. TOTAL COST = $$$$ + Non- monetary costs (TIME, etc.) A lower (higher) time cost, like a lower (higher) money cost, will make a good more (less) attractive.

Examples: a) Convenience stores - money prices are higher, but time price is lower. A carton of milk at Meijer might be $1 and $1.25 at 7-11. The 25 cent difference reflects the difference in time involved in the purchase.

b) Price controls on gasoline in the 1970s caused huge lines at gas stations. The money cost was kept artificially low, below market clearing price, but the waiting time dramatically increased the TOTAL COST ($ + time).

c) Soviet Union - long lines for food, etc. because prices were artificially low.

Also, time-saving products are demanded because of their ability to save valuable time for consumers. Examples: microwave ovens, automatic dishwashers, air travel, prepared foods (deli, TV dinners), snowblowers, bread makers, etc.

Time costs differ among individuals - opportunity costs. Ceteris paribus, high- income consumers would chose more time saving products and fewer time intensive products. Examples: high income consumers would more likely eat in restaurants, travel by air or taxi, have their oil changed, take laundry to a dry cleaner, purchase dishwashers, riding lawnmower and prepared food than low income consumers. Low income consumers might be more likely to travel by bus, walk instead of taking a taxi, prepare food at home more often, iron their own shirts, do dishes by hand, change their own oil, etc.

Point: Money AND time cost both influence consumers behavior. Varies from individual to individual. Cost is subjective. Varies throughout ones life, as our income varies. At 18 you may travel by bus to Florida, at 35 you fly.
 

MARKET DEMAND

We all have our own unique, individual demand curves for the products we buy, reflecting our own personal and subjective tastes and preferences for food, clothing, cars, movies, music, travel, books, hobbies, etc. We are usually more interested in the market demand, which is just the sum of all individual consumers, as a group. GM is interested in the market demand for its vehicles.

Page 455 illustrates how we can go from demand curves for two individuals (Jones and Smith) to the market demand curve. Jones and Smith each have their own unique demand curve. Market demand curve is just the sum of the demand curves for Jones and Smith. With more consumers, the market demand is the demand curve for the entire group of consumers who are in the market for a good.
 

TOTAL VERSUS MARGINAL VALUE

Important point: Diamond-Water paradox. Early economists were puzzled that water was so cheap and diamonds were so expensive, even though water is necessary for life and diamonds are a luxury. The puzzle is explained by Marginal Analysis. Obviously the Total Value of water to consumers is greater than the Total Value of diamonds. But Market Price is determined by the cost and value of MARGINAL UNITS, reflecting MU and DMU. Water is abundant and diamonds are scarce. Because water (diamonds) is so abundant (scarce), its marginal value/price/cost/MU is very low (high).

Points:
a) Total Value of Water > Total Value of Diamonds,.

b) The Marginal Value of Diamonds > Marginal Value of Water because the Supply of water is huge and the Supply of diamonds is low.  

b) Market Prices reflect Marginal Values not Total Value, therefore the Price of Diamonds for each unit > Price of Water for each unit.  

In fact, the demand curve is a MB (MU) curve. This explains why P of Diamonds is greater than the Price of Water.
 

CONSUMER PREFERENCES - Economists can't explain exactly how preferences are determined - related to issues like consumer psychology. We do know this:

1. Preferences are based on complex human behavior. Preferences are subjective and individual. "De gustibus non disputandum."

2. Consumer preferences are influenced by attitudes toward time and risk.  Interest rates reflect our rate of time preference.  Interest rates are the price that we pay for current consumption when we borrow (credit card debt for example).  Interest rates are also the bribe that we accept to delay consumption until a later period when we save money in a bank.  Example: Instant refunds for taxes.  Choice: Wait two months for your $500 refund, or accept $400 today.  Interest rate about 150% on an annual basis.  Time preference differs among individuals and explains consumer behavior.  

Risk preference also differs among consumers and explain consumer behavior.  Will you pay more for a brand name or take a chance on a cheaper unknown brand? Will you pay AAA for towing insurance or take your chances?  Do you buy the optional insurance at Best Buy for an appliance, TV, VCR, computer or stereo? Consumers are either risk-averse (willing to pay to avoid risk, most consumers are like this), risk-neutral or risk-loving, and this determines their consumption choices.    
3. Advertising has a strong influence on consumer preferences. $100B is spent annually on advertising - we assume that advertising must pay off or firms wouldn't spend so much money on it. Some complaints about advertising?

Question: Is advertising wasteful, misleading, manipulative or is it useful to consumers?

1. Claim: "Advertising is Wasteful." Reply: Advertising transmits information, keeps up informed of new products, facilitates trade and increases efficiency. Consumers are under no obligation to buy advertised products. And if consumers feel that advertised products are more expensive we can always turn to cheaper, unadvertised products - generic brands.

Brand names - what value do they have for consumers? Companies spend millions of dollars to establish a brand name, what is the value for consumers????

What if there was a complete ban on advertising? How would that change your consumption behavior?????

2. Is advertising misleading? Federal and state laws protect consumers from unfair or deceptive advertising. FTC regulates advertising. BBB also helps monitor unfair business practices. Good Housekeeping Seal of Approval. "Caveat emptor."

3. Does advertising manipulate? Firms are profit maximizers, and the most direct route to maximize profits is to appeal directly to the actual preferences of consumers, not try to coerce or re-shape consumers. Resources spent on manipulation could be very wasteful and inefficient, and it could backfire if it causes resentment. Firms are concerned about their image, value of goodwill, most take a long range view. Consumer sovereignty prevails?
 

ELASTICITY OF DEMAND (E)

We want to understand the dynamics of the market, understand the continual changes that are taking place. The concept of Elasticity is a tool to help us understand and actually quantify or measure dynamic change in the market. The Law of Demand says that if Price goes up (down), Q_d goes down (up), but that is very general statement. Elasticity helps us answer the question: HOW MUCH? If Price goes up (down), HOW MUCH will Q_d fall (rise)? In other words, how RESPONSIVE are consumers (producers) to PRICE CHANGES??

Elasticity (E) is a quantitative measure of consumer (producer) responsiveness to price changes. Elasticity = responsiveness. If consumers are highly responsive to price changes, demand is said to be ELASTIC. If consumers are not very responsive to price changes, demand is INELASTIC.

ELASTIC: small price increase (decrease) leads to a large decrease (increase) in Q_d. (Consumers are VERY responsive to prices).

INELASTIC: large price increase (decrease) leads to only a small decrease (increase) in Q_d. (Consumers are not very responsive to prices).

Note: Law of Demand holds in both cases. Specifically, Elasticity (E = Price Elasticity of Demand) is calculated as:

E =  %ΔQ_d  /  %ΔP (E is called the Elasticity Coefficient)

Example 1 on page 459-460: Price for the Ford Taurus goes UP by 10%, other car prices remain the same, and Q_d for the Taurus goes DOWN by 30%,

E = -30%  / +10%  =  -3 (elasticity for Taurus cars).

Because of the Law of Demand (Price goes up, Q_d ALWAYS goes down), E is ALWAYS negative. Because E is always negative, we usually ignore the negative sign. We could say that E = 3 in this case.

Example 2 on p. 459: The price of ALL cars rises by 10% due to a new vehicle tax.  Assume that unit vehicle sales fall by 5%.  

E =  -5% /  +10% = 0.50 (elasticity for all cars).  

Note: Elasticity is greater for a specific vehicle (product) than for all vehicles (products).  Reason?  LOTS of substitutes for the Taurus, FEW substitutes for cars.

See page 462 for some actual estimated elasticity coefficients for different products.

Example of calculating elasticity: Price changes from P₀ to P₁, and Q_d changes from Q₀ to Q₁.

Note: Percentage change formula used below is a slight modification of the normal percentage change formula, because the denominator is the AVERAGE of the two values (Q₀ and Q₁), and NOT the original value Q₀ used in the more traditional calculation for percentage change.

%ΔQ_d = (Q₀ - Q₁) / {(Q₀ + Q₁) / 2}

%ΔP = (P₀ - P₁)  / {(P₀ + P₁) / 2}

E = %ΔQ_d / %ΔP

OR on page 459:

E = {(Q₀ - Q₁) / (Q₀ + Q₁) }   /    {(P₀ - P₁) / (P₀ + P₁)}

E =  { dQ / (Q₀ + Q₁)}  /   { dP / (P₀ + P₁) }

Example on p. 459-460: Trina's Cakes are originally selling at $7 and the amount sold is 50 cakes per week. If the price is cut to $6, then 70 cakes per week will be sold?

Questions: 1) What is the elasticity coefficient? and 2) Is the demand for Trina's Cakes elastic or inelastic?

E = (50 - 70) / (50 + 70) = - 2.17
          (7 - 6) / (7 + 6)

Interpretation: For a 1% change in price, the Q_d changes by 2.17%. If prices go up (down) by 1%, the amount purchased will go down (up) by 2.17%.

Economic meaning: When E is > 1, demand is ELASTIC, meaning very responsive to price changes. When E > 1, if price falls (rises) by 1%, Q_d goes up (falls) by MORE than 1%. Demand is responsive/sensitive to price changes.  %Q_d > %P, therefore E > 1.

When E < 1, demand is said to be INELASTIC, or relatively UNRESPONSIVE. For a 1% price change, Q_d changes by LESS than 1%. %Q_d < %P, therefore E < 1.
Example: cigarettes, other "addictive" products (caffeine?).

If E happens to be exactly equal to 1, demand is said to be UNITARY ELASTIC. For a 1% price change, Q_d also changes by exactly 1%.

FIVE General categories of Elasticity on p. 460.

1. Perfectly elastic demand curve. (vertical line) This type of demand curve does not really exist - mythical demand curve. It is unrealistic, because is says that at ANY price, consumers will still buy the same amount. Assumes NO substitutes are available, which is NEVER the case, there are substitutes for everything. Violates the Law of Demand. Shown for illustration purposes only.

2. Relatively inelastic demand. Fairly steep demand curve. Cigarettes for example. Demand is fairly UNRESPONSIVE to Price changes. Large price increases will only slightly decrease the Q_d. Example: Cigarettes in Canada were raised to $5/pack and the amount purchased only fell slightly.

3. Unitary Elastic demand. For an X% (10%) change in Price, Q_d changes by exactly X% (10%) also.

4. Relatively elastic demand. Usually the case when there are LOTS of good substitutes available - competitive markets. Example: demand for apples is relatively elastic (responsive to price changes) because there LOTS of excellent substitutes available for most people. What are the substitutes for apples????? If price goes up by just a little, consumers buy a lot fewer apples.

5. Perfectly elastic demand curve. Demand for an individual farmer's (Farmer Jones) wheat. If wheat is selling at $3/bushel in world markets, Jones would not accept less than $3/bu. (why sell at less than $3 if you can get $3?) and Jones would not be able to sell any wheat above $3 (what wheat buyer would be willing to pay more than the market price?).  Jones has to accept the market price and has to sell all of his wheat at that price.
 

WHAT DETERMINES ELASTICITY

Economists have calculated elasticity coefficients for many products, see page 462. There is a wide range of elasticity coefficients, from -.1 to -4.6. Some products have very elastic demand, some have very inelastic demand, and some are near unitary elasticity. What factors determine elasticity?

1. Availability of Substitutes - influences elasticity the MOST. Lots of close substitutes = elastic demand, it is easy to switch. Examples: fast food restaurants, lots of choice, easy to switch, very competitive market, lots of specials, price discounts, etc. Discount stores: Wal-Mart, K-Mart, Target, Value City, etc., easy to switch, very competitive. Consumers are extremely price conscious, price sensitive in these markets = elasticity is high, responsiveness to price changes is high.

How has Internet contributed to elasticity?????

Few close substitutes = inelastic demand, hard to switch. Consumers are not as sensitive/responsive for goods/services with inelastic demand. Examples: dental services, medical services, cigarettes, coffee, university education. What close substitutes are available for dental services? Medical services? Tobacco? Coffee? College diploma? When prices go up for these products, the Q_d falls, but not too much.

Elasticity also depends on whether the relevant category is defined broadly or narrowly. Example: the demand for cigarettes is inelastic. What about the demand for Marlboro cigarettes? The long-run demand for automobiles is inelastic (few good, close substitutes). What about the demand for Buick Centurys? See page 462.

2. Share of Total Budget Spent on Product also influences elasticity. The smaller (larger) the amount spent (as a % of budget), the more INELASTIC (ELASTIC) the demand. Examples: some products are so cheap that we spend very little on products like toothpicks, salt, matches, etc. If the price of toothpicks doubled, we really wouldn't care because the price is so low, and represents such a small fraction of our total spending.

What products/services do represent a major fraction of our budget???? We are more cost/price conscious of these products?

See page 463. Graphs of elastic demand and inelastic demand. Panel a is ELASTIC demand for ballpoint pens. Why is demand elastic??? If price goes from $1 to $1.50, Q_d falls from 100,000/wk to 25,000/wk, Elasticity = -3 (1.2 / .4). (For a 1% increase in price, Q_d falls by 3%). Consumers are sensitive/responsive to price changes, demand is Elastic.  

Panel b is INELASTIC demand for cigarettes. Why is demand inelastic??? If price goes from $1 to $1.50, Q_d only falls from 100m to 90m/week.

E = -.26 (.1053 / .4)  (For a 10% increase in price, Q_d falls by only 2.6%). Consumers of cigarettes are insensitive/unresponsive to price changes.
 

TIME and ELASTICITY

Second Law of Demand = Elasticity is greater in the long run (LR) than in the short run (SR). In other words, consumers can find MORE substitutes in the LR than in the SR, given a period of adjustment. Demand curves flatten out over time, become more elastic. Example: price of gasoline rose dramatically in the 1970s. In the short run, consumer's demand for gas was inelastic, but in the long run it became much more elastic as people found ways to reduce consumption of gas? POINT: Given time, you can substitute lower gas consumption for higher gas consumption. How did people reduce gas consumption in the 1970s???
 

TOTAL EXPENDITURES and ELASTICITY

If we know the elasticity for a product, we then also know what will happen to Total Revenues (TR) or Total Expenditures or Sales Revenue when the price changes. Why would this be important information for GM when they are considering a price change???

TR($) = P($) x Q_d (number of units sold)

When demand is inelastic, a large price increase leads to just a small reduction in Q_d, so that TR has to go UP. Example: when cigarette prices went from $1 to $1.50, TR went from up from $100m ($1 x 100m packs) to $135m ($1.50 x 90m). When demand is INELASTIC, TR goes in the same direction as P. If P goes up (down), TR goes up (down).

When demand is elastic, a small price increase lead to a large reduction in Q_d, so that TR goes down. Example: when ballpoint pen prices went from $1 to $1.50, TR went from down from $100,000 ($1 x 100,000) to only $35,000 ($1.50 x 25,000). When demand is ELASTIC, TR goes in the opposite direction. If P goes up (down), TR goes down (up).

See page 465 for a summary.
 

INCOME ELASTICITY

Measures the responsiveness of demand to a change in income. Measured as:

Income E_I = %Q_d / %Income

A measure that answers the question: For a X% change in income, what % does the Q_d change? If income goes up by 10% what happens to the Q_d for various products? Income elasticity is USUALLY positive, for goods that we call NORMAL goods, goods whose Income Elasticity is POSITIVE. Income goes up, we buy more normal goods.

Normal goods that are necessities have Income Elasticities between 0 and 1, considered to be LOW Income Elasticities. If income goes up by 10%, we spend less than 10% more on necessities, on goods like fuel, electricity, food, tobacco, medical care, etc.

LUXURY Goods are normal goods whose Income Elasticity is positive, but is positive and GREATER than 1. That is, if income goes up by 10%, we increase our spending by MORE than 10% on luxury goods like new cars, fine wines, private education, vacations, leather furniture, air travel, fancy clothes, etc. There are certain luxury goods that we will start to buy when our income goes way up, we spoil ourselves.....

INFERIOR GOODS have a negative income elasticity. If income goes up, we spend less on INFERIOR GOODS like bus travel, cheap cuts of meat, cockroach spray, margarine, etc.
 

PRICE ELASTICITY OF SUPPLY

Formula:  E_s = %Q_s  /  %P

If price goes up, we know that Q_s goes up, but by how much?  If price goes up by 10% and Q_s goes up by 5% (20%), then E_s = .5 (or 2.0).  Note: Elasticity of supply is always positive.
 

OTHER ELASTICITIES:

Advertising Elasticity:  E_a = %Q_d / %ADV