Chapter 5

Consumers and
Incentives

5 Consumers and Incentives

Chapter Outline
5.1 The Buyers Problem
5.2 Putting It All Together
5.3 From the Buyers Problem to the Demand
Curve
5.4 Consumer Surplus
5.5 Demand Elasticities

5 Consumers and Incentives

Key Ideas
1. The buyers problem has three parts: what
you like, prices, and your budget.
2. An optimizing buyer makes decisions at the
margin.
3. An individuals demand curve reflects an
ability and willingness to pay for a good or
service.

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 variables
responsiveness to changes in another variable.

What would it take a smoker to quit smoking?

Education about the health costs?

Money?
Family pressure?
Actual health scare?
Something else?

The point is that consumers make choices based on incentives, and

incentives can be of many different kinds, depending on the
individual.

5 Consumers and Incentives

Why does the demand curve

have a negative slope?

A downward sloping demand curve means

that for each additional unit to be sold, the
price needs to fall.
So we need to look at what happens at the
marginal level.

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? Are they
not worried that you might take more than one?

The Buyers Problem

The Buyers Problem:

1. What do you like?
2. How much does it
cost?
3. How much money
do you have?

The Buyers Problem

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

The Buyers Problem

Prices of Goods and Services

How much does it cost?

We also assume two characteristics of prices:
1. Prices are fixedno negotiation
2. We can buy as much as we want of something
without driving the price up (an individual
buyer unable to effect the demand curve)

The Buyers 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
2. That even though we use a straight line to
represent purchase choices, we only purchase
whole units (just to simplify things)

Imagine going on a shopping spree of buying

jeans and sweaters.
Each pair of jeans cost $50, each sweater
costs $25.
You have $300 in your pocket.

The Buyers 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

The budget line is the graphical

representation of the budget constraint:
50j+25s=300
What do the various point on the graph
represent?
The X axis intersection point?
The Y axis intersection point?
Any point on the line?
Any point inside of the triangle?
Any point outside of the triangle?

The Buyers Problem

How Much Money You Have to Spend: The Budget Set

Why does the budget line have

a negative slope?

The negative slope arises due to scarcity,

given that you have fixed budget, you have to
give up sweaters in order to get more pairs of
jeans.
No matter how large your budget is, this
trade-off is always there given a fixed budget.

The Buyers Problem

How Much Money You Have to Spend: The Budget Set

What does the slope represent?

The slope measure the per unit opportunity

cost of a good.
For the good in horizontal axis, the
opportunity cost is given by the slope.
For the good in vertical axis, the opportunity
cost is the inverse of the slope.

We can also do it using prices.

If you want to calculate the opportunity cost
of getting one additional unit of good 1, in
terms of the number of units that you have to
give of good 2,
(Price of good 1/price of good 2)=opportunity
cost of good 1 in terms of good 2