The consumption decision

Miller UN1105
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?

2
The Consumer’s Problem:

1. What do you like?

2. How much do things cost?

3. How much money do you have?

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What do you like?

We assume everyone has two things in common:

1. We all want the “biggest bang for our buck”
(that is, optimization)
2. What we actually buy reflects our tastes and
preferences (revealed preference)

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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 (no market power)

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How much money do you have?
We assume (for the moment):

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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The two-good choice problem
Only two goods to choose between: in our
example these will be sweaters and jeans

Jeans cost $50 each and sweaters cost $25 each

You have $300 to spend

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Budget lines and sets

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The buyer’s problem: benefits
Sweaters $25 Jeans $50
Quantity Total Marginal Marginal 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 Blank Blank
1 100 100 4 160 160 3.2
2 185 85 3.4 310 150 3
3 260 75 3 410 100 2
4 325 65 2.6 490 80 1.6
5 385 60 2.4 520 30 0.6
6 425 50 2 530 10 0.2
7 480 45 1.8 533 3 0.06
8 520 40 1.6 535 2 0.04

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The buyer’s problem: $300 available
Sweaters $25 Jeans $50
Quantity Total Marginal Marginal 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 Blank Blank
1 100 100 4 160 160 3.2
2 185 85 3.4 310 150 3
3 260 75 3 410 100 2
4 325 65 2.6 490 80 1.6
5 385 60 2.4 520 30 0.6
6 425 50 2 530 10 0.2
7 480 45 1.8 533 3 0.06
8 520 40 1.6 535 2 0.04

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 Consumer Equilibrium Condition:

MBs = MBj
Ps Pj

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

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What happens if price of sweaters
increases to $50?

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What happens if income (amount of
cash) increases?

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 Sweaters $25 Jeans $50/$75
Quantity Total
Benefits
Marginal
Benefits
Marginal
Benefits per
Total
Benefits
Marginal
Benefits
Marginal
Benefits per
Marginal
Benefits per
Dollar Spent Dollar Spent Dollar Spent
(A) (B) = (C) (D) = =
(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

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A demand curve for jeans

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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?

16
Consumer surplus
The difference between what a buyer is willing

to pay for a good and what the buyer actually

pays.

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Recall: a demand curve for jeans

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Calculating consumer surplus

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Market-wide consumer surplus

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Market-wide consumer surplus when
prices change

21
 Why are last-minute
airplane tickets so
expensive?

Why are last-minute

Broadway show tickets so
cheap?

22
Suppose you play in a band. You play at a bar that
gives you the whole cover charge. Your band is
talking about changing the cover charge to try to
make more money.

Should you increase it or decrease it?

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Pricing decisions for McDonald’s:

How do hamburger sales and revenues

respond to price changes?

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Elasticity
A measure of how sensitive one variable is to

changes in another

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Price elasticity of demand
How much does quantity demanded change
when the good’s price changes?

The percentage change in quantity demanded

due to a percentage change in price:

Price elasticity of demand (𝜀𝐷 ) =

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
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Calculating price elasticity of
demand
If you have two points on a demand curve
you can calculate the elasticity between the
two points: called an arc elasticity
%Δ𝑄
𝜀𝐷 =
%Δ𝑃
𝑄2 − 𝑄1 Δ𝑄
%Δ𝑄 = =
(𝑄1 + 𝑄2 )/2 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑄
𝑃2 −𝑃1 Δ𝑃
%Δ𝑃 = =
(𝑃1 +𝑃2 )/2 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑃
An alternate expression for elasticity:
rearrange the equations above:

%Δ𝑄 Δ𝑄/𝑄𝑎𝑣𝑔
𝜀𝐷 = =
%Δ𝑃 Δ𝑃/𝑃𝑎𝑣𝑔

Δ𝑄 𝑃𝑎𝑣𝑔
=
Δ𝑃 𝑄𝑎𝑣𝑔

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An example of calculating price
elasticity of demand
For jeans, recall that at $25 the quantity
demanded was 4, but at $50 the quantity
demanded was 3

Quantity decreased by 25% ((4-3)/4)

Price increased by 100% ((25-50)/25)

εD = -25%/100% = | -0.25 |

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εD > 1 = Elastic

εD < 1 = Inelastic

εD = 1 = Unit Elastic

εD = ∞ = Perfectly Elastic

εD = 0 = Perfectly Inelastic

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Examples of measured price elasticities
Goods Category Price Elasticity
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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Suppose you play in a band. You play at a bar that
gives you the whole cover charge. Your band is
talking about changing the cover charge to try to
make more money.

Should you increase it or decrease it?

32
Some determinants of εD:

• Number and closeness of substitutes

• Budget share spent on the good
• Time horizon available to adjust to price
changes

33
 Why are last-
minute airplane
tickets so
expensive?

Why are last-minute

Broadway show tickets
so cheap?

34
Cross-price elasticity of demand
How much does the quantity demanded of one
good change when the price of another good
changes?
Precisely: the percentage change in demand of
good 1 due to a percentage change in the price of
good 2

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Categories of goods by cross-price
elasticity
Cross-Price
Type of Good or
Elasticity of
Service
Demand

Negative Complement

Zero Independent

Positive Substitute

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Examples of measured cross-price
elasticities
Cross-Price
Goods Elasticity

Meat and Fish 1.6

Clothing and 0.6
Entertainment
Whole Milk and Low-Fat 0.5
Milk
Meat and Potatoes −0.2
Food and Entertainment −0.7
Income elasticity of demand
How much does quantity demanded change
when income changes?

Precisely: the percentage change in demand of a

good due to a percentage change in income
Categories of goods based on the income
elasticity of demand
Income
Elasticity of Type of Good or Service
Demand

Less than 0 Inferior

Less than 1 and

Normal and Necessity
greater than 0

Greater than 1 Normal and Luxury

Examples of measured income
elasticities
Goods Income Elasticity
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