Microeconomics

Second Edition, Global Edition EC 101.03

Chapter 5

Consumers and
Incentives

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Learning Objective

5.1 The Buyer’s Problem

5.2 Putting It All Together

5.3 From the Buyer’s Problem to the Demand Curve

5.4 Consumer Surplus

5.5 Demand Elasticities

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Key Ideas (1 of 2)

1. The buyer’s problem has three parts: what you like,

prices, and your budget.

2. An optimizing buyer makes decisions at the margin.

3. An individual’s demand curve reflects an ability and

willingness to pay for a good or service.

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Key Ideas (2 of 2)

4. Consumer surplus is the difference between

what a buyer is willing to pay for a good and

what the buyer actually pays.

5. Elasticity measures a variable’s

responsiveness to changes in another

variable.
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Consumers and Incentives (1 of 3)
Evidenced-Based
Economics Example:

Would a smoker quit the

habit for $100 a month?

= incentives

What would motivate you?

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Consumers and Incentives (2 of 3)

Why does the demand curve have a negative

slope?

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Consumers and Incentives (3 of 3)

Why does a soda machine only dispense one bottle or

can at a time, but a newspaper vending machine opens
up so that you can take as many as you want?

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The Buyer’s Problem

1. What do you like?

2. How much does it

cost?

3. How much money

do you have?

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What You Like: Tastes and Preferences

What do you like?

Everyone has different likes and dislikes, but we

assume everyone has two things in common:

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

2. What we actually buy reflects our tastes and

preferences
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Prices of Goods and Services

How much does it cost?

We also assume two characteristics of prices:

1. Prices are fixed—no negotiation

2. We can buy as much as we want of something
without driving the price up (because of an
increase in demand)

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How Much Money You Have to Spend:
The Budget Set (1 of 4)

How much money do you have?

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

we assume:

1. There is no saving or borrowing, only buying

2. That even though we use a straight line to
represent purchase choices, we only purchase
whole units
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How Much Money You Have to Spend:
The Budget Set (2 of 4)
Exhibit 5.1 The Budget Set and the Budget Constraint for
Your Shopping Spree

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How Much Money You Have to Spend:
The Budget Set (3 of 4)
Why does the budget line have a negative slope?

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How Much Money You Have to Spend:
The Budget Set (4 of 4)
What does the slope represent?

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Putting It All Together (1 of 8)
Suppose Bill Gates offered to buy you a Jaguar—a
$100,000 car.

Would you accept his

offer?

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Putting It All Together (2 of 8)

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

time to buy the car and will just give you a check for

$100,000 instead.

Will you go buy the car?

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Putting It All Together (3 of 8)
Exhibit 5.2 Your Buyer’s Problem ($300 available)
Blank Sweaters $25 Jeans $50

Quantity Total Marginal Marginal Quantity Total Marginal Marginal

Benefits Benefits Benefits per Benefits Benefits Benefits per
Dollar Spent Dollar Spent
(A) (B) = (B) / $25 (C) (D) = (D) / $50
0 0 Blank Blank
0 0 Blank Blank
1 100 100 4
1 160 160 3.2
2 185 85 3.4
2 310 150 3
3 260 75 3
3 410 100 2
4 325 65 2.6
4 490 80 1.6
5 385 60 2.4
5 520 30 0.6
6 425 50 2
6 530 10 0.2
7 480 45 1.8
7 533 3 0.06
8 520 40 1.6
8 535 2 0.04

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Putting It All Together (4 of 8)
Exhibit 5.2 Your Buyer’s Problem ($300 available)
Blank Sweaters $25 Jeans $50

Quantity Total Marginal Marginal Quantity Total Marginal Marginal

Benefits Benefits Benefits per Benefits Benefits Benefits per
Dollar Spent Dollar Spent
(A) (B) = (B) / $25 (C) (D) = (D) / $50
0 0 Blank Blank
0 0 Blank Blank
1 100 100 4
1 160 160 3.2
2 185 85 3.4
2 310 150 3
3 260 75 3
3 410 100 2
4 325 65 2.6
4 490 80 1.6
5 385 60 2.4
5 520 30 0.6
6 425 50 2
6 530 10 0.2
7 480 45 1.8
7 533 3 0.06
8 520 40 1.6
8 535 2 0.04

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Putting It All Together (5 of 8)

Consumer Equilibrium Condition:

MBs = MBj
Ps Pj

What if MBs = $75 and MBj = $100?

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Price Changes (1 of 4)

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Price Changes (2 of 4)
Exhibit 5.3 An Inward Pivot in the Budget Constraint from a
Price Increase

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Price Changes (3 of 4)
Exhibit 5.4 A Rightward Pivot in the Budget Constraint from a
Price Decrease

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Price Changes (4 of 4)

Consumer Equilibrium Condition:

MBs = MBj

Ps Pj

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

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Putting It All Together (6 of 8)

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Putting It All Together (7 of 8)

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Putting It All Together (8 of 8)

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 From the Buyer’s Problem to the Demand
Curve (1 of 4)
Blank Sweaters $25 Jeans $50

Quantity Total Marginal Marginal Quantity Total Marginal Marginal Marginal

Benefits Benefits Benefits per Benefits Benefits Benefits Benefits
(A) (B) Dollar Spent (C) (D) per per
= (B) / $25 Dollar Dollar
Spent = Spent =
(D) / $50 (D) / $75

0 0 Blank Blank 0 0 Blank Blank

1 100 100 4 1 160 160 3.2 2.13

2 185 85 3.4 2 310 150 3 2

3 260 75 3 3 410 100 2 1.33

4 325 65 2.6 4 490 80 1.6 1.07

5 385 60 2.4 5 520 30 0.6 0.4

6 425 50 2 6 530 10 0.2 0.13
7 480 45 1.8 7 533 3 0.06 0.04
8 520 40 1.6 0.03
8 535 2 0.04

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From the Buyer’s Problem to the Demand
Curve (2 of 4)
Exhibit 5.6 Your Demand Curve for Jeans

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From the Buyer’s Problem to the Demand
Curve (3 of 4)

Why does the demand curve have a negative

slope?

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From the Buyer’s Problem to the Demand
Curve (4 of 4)

Why does a soda machine only dispense one bottle

or can at a time, but a newspaper vending machine
opens up so that you can take as many as you
want?

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Consumer Surplus (1 of 4)

How much are you willing to pay for an A?

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Consumer Surplus (2 of 4)

The difference between what a buyer is

willing to pay for a good and what the buyer

actually pays.

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Consumer Surplus (3 of 4)
Exhibit 5.7 Computing Consumer Surplus

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Consumer Surplus (4 of 4)
Exhibit 5.8 Market-Wide Consumer Surplus

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

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Consumers and Incentives (1 of 4)

Evidenced-Based Economics
Example:

Would a smoker quit the

habit for $100 a month?

= incentives

What would motivate you?

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Consumers and Incentives (2 of 4)
Exhibit 5.10 Experimental Results from Smoking Study

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 Consumers and Incentives (3 of 4)
Your Buyer’s Problem with an Extra $100 ($300 →
$400)
Blank Sweaters $25 Jeans $50

Quantity Total Marginal Marginal Quantity Total Marginal Marginal Marginal

Benefits Benefits Benefits per Benefits Benefits Benefits Benefits
(A) (B) Dollar Spent (C) (D) per per
= (B) / $25 Dollar Dollar
Spent = Spent =
(D) / $50 (D) / $75

0 0 Blank Blank 0 0 Blank Blank

1 100 100 4 1 160 160 3.2 2.13

2 185 85 3.4 2 310 150 3 2

3 260 75 3 3 410 100 2 1.33

4 325 65 2.6 4 490 80 1.6 1.07

5 385 60 2.4 5 520 30 0.6 0.4

6 425 50 2 6 530 10 0.2 0.13
7 480 45 1.8 7 533 3 0.06 0.04
8 520 40 1.6 0.03
8 535 2 0.04

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Consumers and Incentives (4 of 4)

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Demand Elasticities (1 of 10)

Why are last-minute

airplane tickets so
expensive?

Why are last-minute

Broadway show tickets so
cheap?

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Demand Elasticities (2 of 10)

Suppose you play in a band. Your band has a

steady gig with a bar that gives you the cover
charge without taking a cut. You and your band are
interested in increasing the money you make from
this gig and are talking about changing the cover
charge.

Should you increase it or decrease it?

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Demand Elasticities (3 of 10)

Letting the Data Speak

Should McDonald’s Be Interested in Elasticities?

How do hamburger sales and revenues respond to

price changes?

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Demand Elasticities (4 of 10)

Elasticity

A measure of how sensitive one variable is to

changes in another

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Demand Elasticities (5 of 10)

Three measures of elasticity:

1. Price elasticity of demand

2. Cross-price elasticity of demand

3. Income elasticity of demand

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The Price Elasticity of Demand (1 of 5)

1. Price elasticity of demand answers the question:

How much does quantity demanded b change when

the good’s price changes?

Mathematically: the percentage change in quantity

demanded due to a percentage change in price:

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The Price Elasticity of Demand (2 of 5)
Price elasticity of demand answers the question:

Speaking of hamburgers…a nice way to remember

the elasticity equation:

Quarter
Pounder

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The Price Elasticity of Demand (3 of 5)
%Q
Price Elasticity of Demand 
%P
DQ Q2  Q1
 Q2  Q1  %  Q
Average Q  
 2 

P2  P1
DP
 P2  P1  %  P
Average P  
 2 
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The Price Elasticity of Demand (4 of 5)
An algebraic short cut to calculating elasticity:

%Q
Price Elasticity of Demand 
%P
  Q   P  Pavg  Qavg

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The Price Elasticity of Demand (5 of 5)
Jeans example from Exhibit 5.6:

• The lowest price was $25, and the optimal quantity was 4
pairs.

• The second price was $50, and the optimal quantity was 3
pairs.

• Quantity decreased by 25% ((4-3)/4) %Q

• Price increased by 100% ((25-50)/25) %P

ED = -25%/100% = | -0.25 |
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Elasticity Measures (1 of 3)

ED > 1 = Elastic

ED < 1 = Inelastic

ED = 1 = Unit Elastic

ED = ∞ = Perfectly Elastic

ED = 0 = Perfectly Inelastic

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Elasticity Measures (2 of 3)
Exhibit 5.13 Examples of Various Price Elasticities
Goods Category Price Elasticity3

Olive Oil 1.92

Peanut Butter 1.73
Ketchup 1.36
Wine 1.00
Laundry Detergent 0.81
Shampoo 0.79
Potato Chips 0.45
Cigarettes 0.40

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Elasticity Measures (3 of 3)
Let’s look at another point on the demand curve for
jeans:

Original price = $25; original quantity = 4 pair

• What if price increased to $30 (20% increase)

• As a result, the optimal quantity fell to 3 (25%

decrease)

ED = -25%/20% = | -1.25 |
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Demand Elasticities (6 of 10)

Suppose you play in a band. Your band has a

steady gig with a bar that gives you the cover
charge without taking a cut. You and your band are
interested in increasing the money you make from
this gig and are talking about changing the cover
charge.

Should you increase it or decrease it?

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Demand Elasticities (7 of 10)
TR = P × Q
If demand is inelastic, when price increases,
quantity decreases—a little:

TR = P× Q= TR
The price increase pushes total revenue up, the
quantity decrease pushes total revenue down, but
the price increase is more than the quantity
decrease, so the final result is that total revenue
increases.

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Demand Elasticities (8 of 10)
TR = P × Q

If price decreases, total revenue also decreases. As

a result of the lower price, quantity increases, but
because demand is inelastic, quantity increases
only slightly. The net result on total revenue is that it
decreases.

TR = P× Q= TR
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Demand Elasticities (9 of 10)
How price elasticity of demand relates to total
revenues

Price
Increasing Decreasing
Elasticity of Value
price price
Demand
Decreases Increases
Elastic ED > 1
Revenue Revenue

Unitary Elastic ED = 1 No change No change

Increases Decreases
Inelastic ED < 1
Revenue Revenue

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Determinants of the Price Elasticity of
Demand (1 of 2)

Determinants:

• Number and closeness of substitutes

• Budget share spent on the good

• Time horizon available to adjust to price changes

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Determinants of the Price Elasticity of
Demand (2 of 2)
Why are last-minute
airplane tickets so
expensive?

Why are last-minute

Broadway show tickets
so cheap?
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The Cross-Price Elasticity of Demand (1 of
3)

2. Cross-price elasticity of demand answers the

question:
How much does the quantity demanded of one
good change when the price of another good
changes?
Mathematically: the percentage change in demand
of good 1 due to a percentage change in the price
of good 2:

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The Cross-Price Elasticity of Demand (2 of
3)

How to interpret the cross-price elasticity of demand

Cross-Price
Type of Good or Service
Elasticity of Demand

Negative Complement

Zero Independent

Positive Substitute

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The Cross-Price Elasticity of Demand (3 of
3)

Exhibit 5.14 Examples of Various Cross-Price Elasticities

Cross-Price
Goods Elasticity4
Meat and Fish 1.6
Clothing and Entertainment 0.6
Whole Milk and Low-Fat Milk 0.5
Meat and Potatoes −0.2
Food and Entertainment −0.7

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The Income Elasticity of Demand (1 of 3)
3. Income elasticity of demand answers the
question:
How much does quantity demanded change
when income changes?
Mathematically: the percentage change in demand
of a good due to a percentage change in income

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The Income Elasticity of Demand (2 of 3)
How to interpret the income elasticity of demand

Income Elasticity
Type of Good or Service
of Demand

Less than 0 Inferior

Less than 1 and

Normal and Necessity
greater than 0

Greater than 1 Normal and Luxury

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The Income Elasticity of Demand (3 of 3)
Exhibit 5.15 Examples of Various Income Elasticities

Goods Income Elasticity5

Foreign Vacation 2.10
Domestic Vacation 1.70
Vacation Home 1.20
Healthcare 1.18
Meats 1.15
Housing 1.00
Fruits and 0.61
Vegetables
Gasoline 0.48
Cereal 0.32
Environment 0.25
Electricity 0.23
Rice −0.44
Public Transit −0.75

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Demand Elasticities (10 of 10)

Letting the Data Speak

Should McDonald’s Be Interested in Elasticities?

How do hamburger sales and revenues respond to

price changes?

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