Consumer Behaviour (Microeconomics, Ch 4)

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1 Consumer Behaviour (Microeconomics, Ch 4) Lectures Jan 23/26/28, 2017

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3 change in Q is 100 ( Q/Q). So the elasticity of demand at price P is Consumer Behaviour (Microeconomics, Ch 4) DQ/Q2 E d 5 % change in amount demanded % change in price DP/P 2 5 1DQ/Q 2 1DP/P 2 (3) Application 2.5 Elasticities of Demand for New Cars The elasticity of demand for a product at a given price depends on how readily consumers will switch to other products if the product s price increases a little. That depends in turn on the prices and characteristics of the other available products. In the The Nissan Sentra new car market, consumers who are considering lower-price cars, such as the Nissan Sentra, can choose from among many fairly similar alternatives. Those consumers also tend to keep a close eye on their budgets. So we d expect the elasticity of demand for these cars to be high. In contrast, those who are considering certain luxury cars, such as the BMW 7 The BMW 750Li series, have fewer alternatives and are less concerned about their budgets. Each of those luxury cars also has a much more distinctive cachet that inspires strong loyalty among some buyers. As a result, we d expect the elasticities for these cars to be relatively low. In a study of the demand for cars from 1970 to 1990, economists Steven Berry, James Levinsohn, and Ariel Pakes estimated the elasticities of demand for various models. 9 For low-priced cars like the Nissan Sentra, Mazda 323, and Ford Escort, elasticities of demand were roughly 6. That is, a 1 percent increase in price would cause them to lose about 6 percent of their sales. In contrast, the BMW 735i and Lexus LS400 had demand elasticities of roughly 3. This value implies that they would suffer much smaller percentage reductions in sales in response to a 1 percent increase in price. Between these two extremes were cars like the Honda Accord (with an elasticity of 4.8), the Ford Taurus (with an elasticity of 4.2), and the Lincoln Town car (with an elasticity of 4.3). 8 You might wonder why we calculate the percentage change in the elasticity formula relative to the initial price and quantity demanded, P and Q, and not the final price and

4 Consumer product Behaviour for each (Microeconomics, 1 percent other Chproduct, 4) or equivalently, the percentage change in the amount demanded for each 1 increase in the price of the percent increase in the price of the other product: other product. EP d O 5 1DQ/Q2 1DP O /P O 2 With products that are substitutes (see Section 2.1), the cross-price elasticity is positive. Results are from -With Steven products that Berry, are complements, James it Levinsohn, is negative. and Ariel Pakes, Automobile Prices respect into Market other factors, Equilibrium, such as the prices of inputs Econometrica or other outputs. 63, July 1995, pp Application 2.7 Cross-Price Elasticities for the Honda Accord In a similar fashion, we can measure the elasticities of supply for a product with similarity of substitute products affects not only The a product s elasticity of demand with respect to its own price, but also its cross-price elasticities with other products. Recall from Application 2.5 that the elasticity of demand for a Honda Accord was 4.8: when its price went up by 1 percent, it experienced a 4.8 percent reduction in sales. What happened to the sales of other cars? According to economists Berry, Levinsohn, and Pakes, the Nissan Sentra, Ford Escort, The Honda Accord and Ford Taurus relatively similar cars to the Accord all had cross-price elasticities with the Accord of about 0.2. That is, each experienced roughly a 0.2 percent increase in sales when the price of a Honda Accord rose 1 percent. In contrast, the much more upscale BMW 735i and Lexus LS400 experienced almost no change in their sales their crossprice elasticities with the Honda Accord were essentially zero.

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24 4.3 MARKET DEMAND TABLE 4.4 Price and Income Elasticities of the Demand for Rooms Group Price Elasticity Income Elasticity Single individuals Married, head of household age less than 30, 1 child Married, head age 30 39, or more children Married, head age 50 or older, 1 child

25 4.4 CONSUMER SURPLUS consumer surplus Difference between what a consumer is willing to pay for a good and the amount actually paid. Consumer Surplus and Demand Figure 4.13 Consumer Surplus Consumer surplus is the total benefit from the consumption of a product, less the total cost of purchasing it. Here, the consumer surplus associated with six concert tickets (purchased at $14 per ticket) is given by the yellow-shaded area.

26 4.4 CONSUMER SURPLUS Consumer Surplus and Demand Figure 14.4 Consumer Surplus Generalized 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.

27 4.5 NETWORK EXTERNALITIES network externality Situation in which each individual s demand depends on the purchases of other individuals. A positive network externality exists if the quantity of a good demanded by a typical consumer increases in response to the growth in purchases of other consumers. If the quantity demanded decreases, there is a negative network externality. The Bandwagon Effect bandwagon effect Positive network externality in which a consumer wishes to possess a good in part because others do.

28 4.5 NETWORK EXTERNALITIES The Bandwagon Effect Figure 4.16 Positive Network Externality: Bandwagon Effect A bandwagon effect is a positive network externality in which the quantity of a good that an individual demands grows in response to the growth of purchases by other individuals. Here, as the price of the product falls from $30 to $20, the bandwagon effect causes the demand for the good to shift to the right, from D 40 to D 80.

29 4.5 NETWORK EXTERNALITIES The Snob Effect snob effect Negative network externality in which a consumer wishes to own an exclusive or unique good. Figure 4.17 Negative Network Externality: Snob Effect The snob effect is a negative network externality in which the quantity of a good that an individual demands falls in response to the growth of purchases by other individuals. Here, as the price falls from $30,000 to $15,000 and more people buy the good, the snob effect causes the demand for the good to shift to the left, from D 2 to D 6.

30 *4.6 EMPIRICAL ESTIMATION OF DEMAND The Statistical Approach to Demand Estimation TABLE 4.5 Demand Data Year Quantity (Q) Price (P) Income (I)

31 *4.6 EMPIRICAL ESTIMATION OF DEMAND The Statistical Approach to Demand Estimation Figure 4.18 Estimating Demand Price and quantity data can be used to determine the form of a demand relationship. But the same data could describe a single demand curve D or three demand curves d 1, d 2, and d 3 that shift over time. This linear demand curve would be described algebraically as (4.2)

32 *4.6 EMPIRICAL ESTIMATION OF DEMAND The Form of the Demand Relationship Because the demand relationships discussed above are straight lines, the effect of a change in price on quantity demanded is constant. However, the price elasticity of demand varies with the price level. For the demand equation Q = a bp, the price elasticity E P is (4.3) There is no reason to expect elasticities of demand to be constant. Nevertheless, we often find it useful to work with the isoelastic demand curve, in which the price elasticity and the income elasticity are constant. When written in its log-linear form, the isoelastic demand curve appears as follows: log( Q) a b log( P) c log( I) (4.4)

33 *4.6 EMPIRICAL ESTIMATION OF DEMAND The acquisition of Shredded Wheat cereals of Nabisco by Post Cereals raised the question of whether Post would raise the price of Grape Nuts, or the price of Nabisco s Shredded Wheat Spoon Size. One important issue was whether the two brands were close substitutes for one another. If so, it would be more profitable for Post to increase the price of Grape Nuts after rather than before the acquisition. The substitutability of Grape Nuts and Shredded Wheat can be measured by the cross-price elasticity of demand for Grape Nuts with respect to the price of Shredded Wheat. One estimated isoelastic demand equation appeared in the following log-linear form: The demand for Grape Nuts is elastic (at current prices), with a price elasticity of about 2. Income elasticity is The cross-price elasticity is The two cereals are not very close substitutes.

34 Thank You