Chapter 5

Consumers and
Incentives

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5 Consumers and Incentives

Chapter Outline

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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5 Consumers and Incentives

Key Ideas

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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5 Consumers and Incentives

Key Ideas

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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5 Consumers and Incentives

Evidenced-Based Economics Example:

Would a smoker quit the habit for $100 a month?

Incentives:
encouragements to engage in a behavior or
discouragements from engaging in a behavior

What would motivate you?

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5 Consumers and Incentives

Why does the demand curve

have a negative slope?

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5.1 The Buyer’s Problem
How do consumers arrive at a choice as to what to purchase?

Buyer’s Problem:

1. What do you like?

(preferences)
2. How much does it cost?
(prices)
3. How much money do you have?
(income)

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5.1 The Buyer’s Problem
What Do You Like: Tastes and Preferences

What do you like?

Everyone has different likes and dislikes, but we assume everyone has
three things in common:

1. As consumers, we attempt to maximize the benefits from

consumption
2. We all want the “biggest bang for our buck”
3. What we actually buy reflects our tastes and preferences

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5.1 The Buyer’s Problem
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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5.1 The Buyer’s Problem
Prices of Goods and Services
• Prices allow us to formally define the relative cost of goods.
• Using prices we can calculate the opportunity cost of a specific good
in terms of another good:

Example:
Suppose that one pair of jeans costs $50 and one sweater costs $25.

• Then, the opportunity cost of one pair of jeans is two sweaters.

• If you choose to buy one pair of jeans, you give up the
opportunity of owning two new sweaters.

• The price of one pair of jeans relative two a sweater is 2.

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5.1 The Buyer’s Problem
How Much Money You Have to Spend: The Budget Set
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
• This means that your expenditure on all available goods and
services must be equal to your income
2. That even though we use a straight line to represent purchase
choices, we only purchase whole units
• You cannot buy half of a sweater or a single left shoe!

Budget set – the set of all possible bundles of goods and services a
consumer can purchase with his/her income.
5.1 The Buyer’s Problem
How Much Money You Have to Spend: The Budget Set

Exhibit 5.1 The Budget Set and the Budget Constraint for Your Shopping Spree
Price of a pair of jeans is $50, price of a sweater is $25 and you have $300 to spend.
Why does the budget line have a negative slope?
(trade-offs; see notes below)
5.1 The Buyer’s Problem
How Much Money You Have to Spend: The Budget Set

Exhibit 5.1 The Budget Set and

the Budget Constraint for Your
Shopping Spree

Price of a pair of jeans is

$50, price of a sweater is $25
and you have $300 to spend.

Explore the three areas defined by this budget constraint:

1. Bundles on the line—combinations of jeans and sweaters that exactly spend $300
2. Bundles inside the line (including buying no jeans and no sweaters)—bundles you can afford,
but that don’t spend your income. Remember that there is no saving, so if the $300 is not
spent, it is lost—there is no other use for it than buying jeans and/or sweaters
3. Bundles outside the constraint—these are bundles that you can’t afford (that would cost more
than $300). Remember there is no borrowing, so these bundles are unattainable.
5.1 The Buyer’s Problem
How Much Money You Have to Spend: The Budget Set

What does the slope of the budget constraint represent?

• The slope corresponds to the quantity of sweaters that has to be given up when you
increase your consumption of jeans by one pair.
• In other words, the slope of the budget constraint is the opportunity cost of jeans in
terms of sweaters.
5.2 Putting It All Together (try to fill the table yourself)
Sweaters $25 Jeans $50
Quantity Total Marginal Marginal Total Marginal Marginal
Benefits Benefits Benefits per Benefits Benefits Benefits
Dollar Spent per
(A) (B) (B)/$25 (C) (D) Dollar
Spent
(D)/$50
0 0 - - 0 - -
1 100 160
2 185 310
3 260 410
4 325 490
5 385 520
6 435 530
7 480 533

Exhibit 5.2 Your Buyer’s Problem ($300 available)

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5.2 Putting It All Together

Exhibit 5.2 Your Buyer’s Problem ($300 available)

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5.2 Putting It All Together: 1st sweater vs. 1st pair of jeans
Let’s start the shopping spree. Now initially decide between the 1st pair of jeans and 1st
sweater. Which one would this consumer buy?

• The 1st sweater increases our well-being by 100 (i.e. marginal benefit of the 1st
pair of jeans is 100). Therefore, by paying $25 on the 1st sweater this consumer
get a marginal benefit of 100/25=4 per dollar spent on sweaters.
• The 1st pair of jeans yields a marginal benefit of 160. Hence, buying the 1st pair
of jeans yields a marginal benefit of 160/50=3.2 per dollar.

• Each dollar spent on the 1st sweater has a marginal benefit of 4, whereas each dollar
spent on the 1st pair of jeans yields a marginal benefit of 3.2.
• Thus, each dollar spent on the 1st sweater benefits this consumer more than each
dollar spent on the 1st pair of jeans.
• As a rational person, this consumer than would start shopping by purchasing a
sweater first.
5.2 Putting It All Together: 2nd sweater vs. 1st pair of jeans
Our consumer has made her first purchase. But she still has $275 to spend, so she
continues shopping.

Now the decision is between the 2nd sweater and the 1st pair of jeans.

Which purchase would take place at this step?

• The 2nd sweater has a marginal benefit of 85/$25=3.4 per dollar.

• We already know that the 1st pair of jeans has a marginal benefit of 160/$50=3.2 per
dollar.

• The rational consumer would purchase another sweater after the first one, since
the 2nd sweater has a higher marginal benefit per dollar compared to the 1st pair
of jeans (3.4>3.2)
5.2 Putting It All Together: 3rd sweater vs. 1st pair of jeans
Our consumer has made her second purchase. But she still has $255 to spend, so she
continues shopping.

Now the decision is between the 3rd sweater and the 1st pair of jeans.

Which purchase would take place at this step?

• The 3rd sweater has a marginal benefit of 75/$25=3 per dollar.

• We already know that the 1st pair of jeans has a marginal benefit of 160/$50=3.2 per
dollar.

• The rational consumer would now make her first jean purchase, as the 1 st pair
of jeans has a higher marginal benefit per dollar compared to the 3rd sweater
(3.2>3)
5.2 Putting It All Together
Consumer Equilibrium Condition:

Consumers continue shopping up until they equalize the marginal benefit per dollar
from each good.
• Once a consumer satisfies the equilibrium condition, she cannot increase her total
benefit by changing the composition of her consumption bundle (buying more from
one good and less from the other).
• Equalization of marginal benefit per dollar across goods results in the maximization
of total benefit given the consumer’s income.
• In our example, optimal choice involves 6 sweaters and 3 pairs of jeans.
5.2 Putting It All Together
Price Changes

What would happen if the price of sweaters doubles, to $50?

Exhibit 5.3 An Inward Pivot in the Budget Constraint from a Price Increase

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5.2 Putting It All Together
Price Changes

What would happen if instead, the price of jeans decreases to $25?

Exhibit 5.4 A Rightward Pivot in the Budget Constraint from a Price Decrease

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5.2 Putting It All Together
Income Changes

What would happen if instead, income doubles?

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

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5.3 From the Buyer’s Problem to the Demand Curve
  Sweaters $25 Jeans $50
Quantity Total Marginal Marginal Total Marginal Marginal Marginal
Benefits Benefits Benefits Benefits Benefits Benefits Benefits
    per Dollar     per Dollar per Dollar
(A) (B) Spent = (C) (D) Spent = Spent =
(B) / $25 (D) / $50 (D) / $75

0 0     0      
1 100 100 4 160 160 3.2 2.13
2 185 85 3.4 310 150 3 2
3 260 75 3 410 100 2 1.33
4 325 65 2.6 490 80 1.6 1.07
5 385 60 2.4 520 30 0.6 0.4
6 435 50 2 530 10 0.2 0.13
7 480 45 1.8 533 3 0.06 0.04
8 520 40 1.6 535 2 0.04 0.03
9 555 35 1.4 536 1 0.02 0.01
10 589 34 1.36 537 1 0.02 0.01
11 622 33 1.32 538 1 0.02 -0.02
12 654.5 32.5 1.3 539 1 0.02 -0.07

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5.3 From the Buyer’s Problem to the Demand Curve
• Recall that the optimal choice of the consumer was 6 sweaters and 3 pairs of jeans
when unit prices were $25 and $50, respectively (also note that the consumer’s
income was $300).

• Now suppose that the price of a pair of jeans jumps to $75. Would the initial
optimal consumption bundle (6 sweaters and 3 pairs of jeans) be affordable at these
prices?
o No! 6 sweaters and 3 pairs of jeans now cost $375, therefore this bundle is not
affordable anymore!

o Furthermore, with these prices at 6 sweaters and 3 pairs of jeans the equilibrium
condition is not satisfied:

o As a result, 6 sweaters and 3 pairs of jeans is not the optimal consumption

bundle anymore.
5.3 From the Buyer’s Problem to the Demand Curve
• Then, what is the new optimal bundle when the price of a pair of jeans is $75?
• Recall the equilibrium condition again:
(or alternatively )
• We know that and . Therefore the opportunity cost of sweaters in terms of jeans is .
• Therefore, at the new optimal bundle according to the equilibrium condition we
need to have:

• This is satisfied when 6 sweaters and 2 pairs of jean are purchased. Thereby, we can
conclude that the new optimal bundle includes 6 sweaters and 2 pairs of jeans.
(Also note that when the consumer buys this bundle, all the income is used)
5.3 From the Buyer’s Problem to the Demand Curve

Exhibit 5.6 Your Demand Curve for Jeans

5.3 From the Buyer’s Problem to the Demand Curve
• Why does the demand curve have a negative slope?

• When people increase their consumption of a certain good, this good’s

marginal benefit declines (recall that this principle was called as
diminishing marginal benefit in the previous chapter).

• If the marginal benefit of a good decreases, then people’s willingness to

pay for an extra unit of that good declines.

• Our willingness to pay for the 1st pair of jeans is greater than the 2nd pair. The
willingness to pay for the 2nd pair is greater than the 3rd pair… so on and so
forth.

• As a result, because of diminishing marginal benefit, our demand curve for

jeans (and most of the goods in general), exhibits a negative slope.
5.4 Consumer Surplus

Consumer Surplus

The difference between what you are willing to pay

and what you have to pay (the market price)
5.4 Consumer Surplus (Individual)

Exhibit 5.7 Computing Consumer Surplus

5.4 Consumer Surplus (Market)
Summing across all the individual demand curves gives us a market curve, along with a market
consumer surplus. We can get an exact measure by using the formula for the area of a triangle.

Exhibit 5.8 Market-Wide Consumer Surplus

5.4 Consumer Surplus
An Empty Feeling: Loss in Consumers Surplus When Price
Increases

Exhibit 5.9 Market-Wide Consumer Surplus When Prices Change

5 Consumers and Incentives

Evidenced-Based Economics Example:

Economic experiment (from the book):

Smokers who are spending $100 each month on cigarettes are offered
$100 in return of quitting smoking.

Would a smoker quit the habit for $100 a month?

(= incentives)

What would motivate these people?

1. $100 received due to accepting the offer.
2. Can you think of anything else ?
5 Consumers and Incentives

Exhibit 5.10 Experimental Results from Smoking Study

• Incentivized group exhibits a much higher quitting rate (16.3% vs 4.6%)

• However, the effect is short-lived:
once the experiment stops and incentivized group stops receiving financial help,
their quitting rate drops to only 6.5 % (6 months after the experiment).
5 Consumers and Incentives

Your Buyer’s Problem with an Extra $100

($300 → $400)
5 Consumers and Incentives

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5.4 Demand Elasticities

Why are last-minute

airplane tickets so
expensive?

While last-minute
Broadway show
tickets are so cheap?
5.4 Demand Elasticities
Elasticity
A measure of how sensitive one variable is to changes in another
variable

Remember the determinants of demand:

own price, prices of other goods, income, tastes and preferences, etc.

Remember that we already know that when any one of these factors
changes, demand changes.

Elasticity is just a way to measure how much quantity changes when one
of the factors change.

We will focus on three.

5.4 Demand Elasticities
Three measures of elasticity:

1. Price elasticity of demand

2. Cross-price elasticity of demand
3. Income elasticity of demand
5.4 Demand Elasticities : The Price Elasticity of Demand
1. Price elasticity of demand answers the question:

How much does quantity demanded change when

the good’s price changes?

Mathematically: the percentage change in quantity demanded due to a

percentage change in its price:
5.4 Demand Elasticities : The Price Elasticity of Demand
Jeans example from exhibit 5.6:
The first price was $25, and the optimal quantity was 4 pairs.
The second price was $50, and the optimal quantity was 3 pairs.

Quantity decreased from 4 to 3:

when price increased from 25 to 50:

Why the sign is negative?

5.4 Demand Elasticities
Elasticity Measures

Elastic:
when price increases by 1%, quantity declines by more than 1%

Inelastic:
when price increases by 1%, the decline in quantity demanded is less than 1%

Unit Elastic:
when price increases by 1%, quantity demanded also increases by 1%.

Perfectly Elastic:
when price increases 1%, quantity demanded directly drops to zero.

Perfectly Inelastic:
when price increases by 1%, quantity demanded does not change at all.
Exhibit 5.12 Examples of Various Demand Curves with Different
Degrees of Price Elasticity

a) Perfectly elastic demand with respect to price

b) Unit elastic demand with respect to price
c) Perfectly inelastic demand with respect to price
5.4 Demand Elasticities
Elasticity Measures
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) and as a result,
the optimal quantity fell to 3
(25% decrease)

ED =
Exhibit 5.11 Jacob’s Demand Curve for Trout Preservation

• Price elasticity of demand is varies across each point located on the demand
curve.
• The slope of the demand curve and the price elasticity of demand are not
the same concepts!
5.4 Demand Elasticities
Determinants of the Price Elasticity of Demand
Determinants:
• Number and closeness of substitutes:
• As the number of available substitutes grows, the price
elasticity of demand increases.

• Budget share spent on the good:

• As you spend more of your budget on a good, the price
elasticity of demand increases.

• Time horizon available to adjust to price changes:

• Consumers, in general, respond much less to price changes
in the short-run than in the long-run.
5.4 Demand Elasticities
Elasticity Measures

Exhibit 5.13 Examples of Various Price Elasticities

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5.4 Demand Elasticities
Determinants of the Price Elasticity of Demand

Why are last-minute

airplane tickets so
expensive?

While last-minute
Broadway show tickets
are so cheap?
© 2015 Pearson Education, Ltd.
5.4 Demand Elasticities
The Cross-Price Elasticity of Demand

2. Cross-price elasticity of demand answers the

question:

How much does quantity demanded change of

one good when 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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5.4 Demand Elasticities
Elasticity Measures

• If two goods have a positive cross-price elasticity, then they are substitutes: as
one good becomes more expensive you start to consume the other.
• If two goods have a negative cross-price elasticity, then they are complements:
you tend to consume both goods together, if the price increases for one of them –
you reduce your consumption of both goods.
5.4 Demand Elasticities
The Income Elasticity of Demand

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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5.4 Demand Elasticities
The Income Elasticity of Demand

Exhibit 5.15 Examples of Various Income Elasticities

5.4 Demand Elasticities
The Income Elasticity of Demand
• Normal goods: A good is normal if the quantity demanded is directly
related to income; when income rises, consumers buy more of a
normal good.
o The demand for normal goods exhibits positive income
elasticity

• Inferior goods: A good is inferior if the quantity demanded is

inversely related to income; when income rises, consumers buy less of
an inferior good.
o The demand for inferior goods exhibits negative income
elasticity