Microeconomics

Lecture 12

Souvik Dutta
Indraprastha Institute of Information Technology Delhi
 Consumer Choice
• Suppose there are two goods: Education (E) and
Other Goods (O)

• Suppose Price of education is PE and Price of Other

Goods is 1.

• Income is I

• What is the Budget Line?

 Consumer Choice
• Budget Line:
– PE E + O = I

• Suppose the Government gives an additional education

subsidy of amount S which can only be spent on education.

• What happens to the budget Line?

• What is consumer’s choice if she has an utility function

U(E,O)
 Consumer Choice
• Suppose instead the government gave this
subsidy S as lump-sum.

• What happens to the budget line?

• What happens to consumer choice?

 CONSUMER CHOICE

When given a
subsidy that must
be spent on
education, the
consumer moves
from A to B, a
corner solution.
If, however, the
subsidy could be
spent on other
consumption as
well as education,
the consumer
would be better off
at C.
 Cash Gifts and In-Kind Gifts
• Suppose you receive a gift from your aunt on Diwali.

• Instead you receive cash from her of the same

value.

• What happens to the budget line?

• What happens to your choice?

 Buy One, Get One Free
• Buy one large pizza, get one large pizza free
(limit one free pizza per customer)

• Is it simply a 50 percent reduction in the price

of pizza?
Buy One, Get One Free
CONSUMER SURPLUS
 Consumer Surplus
• Consumers buy goods because it makes them
better off

• Producers take home profits. What do

consumers take home?

• Consumer Surplus measures how much better

off they are after consumption
 Consumer Surplus
• The difference between the maximum amount
a consumer is willing to pay for a good and the
amount actually paid.

• Can calculate consumer surplus from the

demand curve
 Consumer Surplus - Example
Price The consumer surplus
($ per 20 of purchasing 6 concert
ticket) tickets is the sum of the
19 surplus derived from
18 each one individually.

17
16
Consumer Surplus
15
6 + 5 + 4 + 3 + 2 + 1 =
14 21 Market Price

13 Will not buy more than 7

because surplus is negative

0 1 2 3 4 5 6 Rock Concert Tickets

 CONSUMER SURPLUS

For the market as a whole, consumer

surplus is measured by the area
under the demand curve and above
the line representing the purchase
price of the good.

Here, the consumer surplus is given

by the yellow-shaded triangle and is
equal to
1/2 × ($20 − $14) × 6500 = $19,500.

Applying Consumer Surplus

When added over many individuals, it measures the aggregate benefit that
consumers obtain from buying goods in a market.
When we combine consumer surplus with the aggregate profits that producers
obtain, we can evaluate both the costs and benefits not only of alternative market
structures, but of public policies that alter the behavior of consumers and firms in
those markets.
APPLICATION OF CONSUMER
SURPLUS
 Package Deals and Two-Part Pricing
• A seller can maximize profit by charging each
buyer just a little less than his/her total
benefit
• Leaves buyer with almost zero surplus
• Can be implemented in two ways –
– Package-deal pricing
– Two-part pricing
 PACKAGE DEAL

• A package deal is a pricing scheme comprising

a fixed payment for a fixed quantity of
consumption
 Two-Part Pricing

• A two-part pricing scheme is a pricing scheme

comprising a fixed payment and a charge
based on consumption
 Buyer surplus: Two-part pricing

• fixed payment
– Area under the demand curve
and above the usage charge.
fixed
– Leaves zero buyer surplus payment
usage
charge
• usage charge
 Buyer surplus: Two-part pricing
Business Provider Fixed Fee Usage Fee

Broadband PCCW Netvigator HK$298 per HK$2 per

access, Hong 3M Single User month additional
Kong Plan (incl. 100 hr
free hrs)
Mobile telephone Etisalat 125 dirham 0.24/0.18
service, UAE Corporation, connection dirham per
GSM Standard fee; 60 min (peak/
Service dirham per offpeak)
qtr
 PACKAGE DEAL

• Other examples:
• Internet Access, Banking (Credit Cards etc.)

• Amusement Park: A fixed entry fee + separate charges for

rides.
DEMAND ESTIMATION

21
 Market Demand
• Market Demand Curve : is a curve relating the
quantity of a good that all consumers in a market will
buy to its price
Determining the Market Demand Curve
Individual A Individual B Individual C Market (Units)
Price (Units) (Units) (Units)

1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
 Market Demand
• Two features of market demand Price
curve:
– Market Demand Curve shifts to 4
right as more consumers also Market Demand
affect market demand 3

– Factors that affect demand of 2

many individuals also affect
market demand
1

0
– Example: Aggregate Demand for
tea: Domestic demand of tea + 5 10 15 20 Quantity
Foreign Demand for tea
 Application: The Aggregate Demand of Indian Tea

• Domestic demand curve for tea is given by

•  
Where; is quantity if tea demanded domestically, P is the price per kg
• Export demand curve for tea is given by

Where; is quantity if tea demanded from abroad

• At what price is ?
• At what price is ?
• Will there be any demand for ?
• Will there be any demand for ?
• Will there be any demand for ?
 Application: The Aggregate Demand of Indian Tea

Price

• Total demand for Indian tea: 284.

5
A

• For P>178 Total Demand

200
C E
• For P<178
178

100

• Market Demand curve is given by F

the kinked line AEF 0 500 1000 1138 1500 2118
Quantity
 Least Square Regression
•• Aim: Find a smooth curve/line that does a
 
good job of approximating the data points
Y
A

• Least Square Regression: line that 𝑒^ 𝐴

𝑅𝑒𝑔𝑟𝑒𝑠𝑠𝑖𝑜𝑛𝐿𝑖𝑛𝑒 
minimizes the sum of squared deviation D
between the line and data points B
𝑒^ 𝐷

𝑒^ 𝐶 F
• Linear relationship between Y and X may C
𝑒^ 𝐸
 
be written as : E

X
 Least Square Regression
•• Software
  packages estimate parameter estimates such
that we get the smallest sum of squared errors
between line and actual data

• Regression line:

• Evaluation of model fit: t-statistic, p-values, , F-statistic

etc.
– p-value<0.05 or p-value<0.10
– : closer to 1 better it is
Least Square Regression
 Demonstration Problem
• FCI owns 10 apartment buildings in a college town, which it
rents exclusively to students. Each apartment building
contains 100 rental units, but the owner is having cash flow
problems due to an average vacancy rate of nearly 50
percent. The apartments in each building have comparable
floor plans, but some buildings are closer to campus than
others.

• The owner of FCI has data from last year on:

– the number of apartments rented,
– the rental price,
– the amount spent on advertising at each of the 10
apartments.
 Demonstration Problem
• The owner regressed the quantity demanded of
apartments on price, advertising, and distance.

– What is the estimated demand function for FCI’s rental

units?
– If FCI raised rents at one complex by $100, what would
you expect to happen to the number of units rented?
– If FCI raised rents at an average apartment building,
what would happen to FCI’s total revenues? What
inferences should be drawn from this analysis?
Table: Input & Output from a Multiple
Regression Model
Row No. Observation Quantity Price Advertising Distance

1 1 28 250 11 12

2 2 69 400 24 6

3 3 43 450 15 5
4 4 32 550 31 7
5 5 42 575 34 4
6 6 72 375 22 2

7 7 66 375 12 5

8 8 49 450 24 7
9 9 70 400 22 4

10 10 60 375 10 5

11 Average 53.10 420.00 20.50 5.70

Table: Input & Output from a Multiple
Regression
16 Regression Statistics
17

18 Multiple R 0.89
19 R Square 0.79
20 Adjusted R Square 0.69
21 Standard Error 9.18
22 Observations 10.00

23 Analysis of Variance

24   df SS MS F Significance F

25 Regression 3.00 1920.99 640.33 7.59 0.0182

26 Residual 6.00 505.91 84.32

27 Total 9.00 2426.90

 Table: Input & Output from a Multiple
Regression

• The results of the regression are reported through following

table

Standard
28   Coefficients T-Stat P-value Lower 95% Upper 95%
Error

29

30 Intercept 135.15 20.65 6.54 0.0006 84.61 185.68

31 Price -0.14 0.06 -2.41 0.0527 -0.29 0.00

32 Advertising 0.54 0.64 0.85 0.4296 -1.02 2.09

33 Distance -5.78 1.26 -4.61 0.0037 -8.86 -2.71

 Demonstration Problem: Solution
•• Letting
  P, A ,and D represent price, advertising, and distance
from campus, the estimated coefficients imply the following
demand for rental units at an apartment building:

• Since the coefficient of price is -0.14, a $100 increase in price

reduces the quantity demanded at an apartment building by
14 units. The own price elasticity of demand for FCI’s rental
units, calculated at the average price and quantity, is
 Demonstration Problem: Solution
• Since demand is elastic, raising the rent at an average
apartment building would decrease not only the number of
units rented, but total revenues as well.
 Demonstration Problem: Solution
• The R-square of .79 indicates that the regression explains 79
percent of the variation in the quantity of apartments rented
across the 10 buildings.

• The F-statistic suggests that the regression is significant at the

1.82 percent level, so the manager can be reasonably
confident that the good fit of the equation is not due to
chance.

• All the estimated parameters are statistically significant at

the 5 percent level, except for the coefficient of advertising.
Thus, it does not appear that advertising has a statistically
significant effect on the demand for the rental units.
 Demonstration Problem: Solution
• Distance from campus appears to be a very significant
determinant of the demand for apartments.

• The t-statistic for this coefficient is in excess of 4 in absolute

value, and the P-value is .37 percent. Based on the lower and
upper bound of its confidence interval, the owner can be 95
percent confident that for every mile an apartment is away
from campus, FCI loses between 2.71 and 8.86 renters
 Demonstration Problem: Solution
• Since FCI can’t relocate its apartments closer to campus, and
advertising does not have a statistically significant impact on
units rented, it would appear that all FCI can do to reduce its
cash flow problems is to lower rents at those apartment
buildings where demand is elastic.