Theory of Demand, Income & Substitution Effects, Consumer Preferences,

1. Go Global !Go Global !
Managerial Economics :Managerial Economics :
Individual & MarketIndividual & Market
DemandDemand
By
Stephen OngStephen Ong
Visiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City University
Visiting Professor, College of Management,Visiting Professor, College of Management,
Shenzhen UniversityShenzhen University
May 2013May 2013

2. AgendaAgenda
1.1. Theory of DemandTheory of Demand
2.2. Income andIncome and
Substitution EffectsSubstitution Effects
3.3. Consumer PreferencesConsumer Preferences

3. Learning ObjectivesLearning Objectives
1.1.To derive the demand curve for an individual consumer.To derive the demand curve for an individual consumer.
2.2. To examine the effect of a price change in more detail.To examine the effect of a price change in more detail.
3.3. To determine the market demand curve from theTo determine the market demand curve from the
aggregation of individual demand curvesaggregation of individual demand curves
4.4. To show how market demand curves can be used toTo show how market demand curves can be used to
measure the benefits that people receive when theymeasure the benefits that people receive when they
consume products, above and beyond the expendituresconsume products, above and beyond the expenditures
they make.they make.
5.5. To describe the effects ofTo describe the effects of network externalitiesnetwork externalities—i.e., what—i.e., what
happens when a person’s demand for a good also dependshappens when a person’s demand for a good also depends
on the demands ofon the demands of otherother people.people.
6.6.To describe some of the methods that economists use toTo describe some of the methods that economists use to
obtain empirical information about demand.obtain empirical information about demand.
7.7.To understand consumer preferences through behaviouralTo understand consumer preferences through behavioural
economics.economics.

4. 11
Theory of DemandTheory of Demand

5. Individual DemandIndividual Demand
Price ChangesPrice Changes
A reduction in the price of
food, with income and the
price of clothing fixed, causes
the consumer to choose a
different market basket.
In panel (a), the baskets that
maximize utility for various
prices of food (point A, $2; B,
$1; D, $0.50) trace out the
price-consumption curve.
Part (b) gives the demand
curve, which relates the price
of food to the quantity
demanded. (Points E, G, and
H correspond to points A, B,
and D, respectively).
EFFECT OF PRICEEFFECT OF PRICE
CHANGESCHANGES

6. Price-consumption curvePrice-consumption curve
Curve tracing the utility-maximizing combinations of two goodsCurve tracing the utility-maximizing combinations of two goods
as the price of one changes.as the price of one changes.
Individual demand curveIndividual demand curve
Curve relating the quantity of a good that a single consumer willCurve relating the quantity of a good that a single consumer will
buy to its price.buy to its price.
The Individual Demand CurveThe Individual Demand Curve
The individual demand curve has two important properties:The individual demand curve has two important properties:
1.1. The level of utility that can be attained changes as weThe level of utility that can be attained changes as we
move along the curve.move along the curve.
2.2. At every point on the demand curve, the consumer isAt every point on the demand curve, the consumer is
maximizing utility by satisfying the condition that themaximizing utility by satisfying the condition that the
marginal rate of substitution (MRS) of food for clothing equalsmarginal rate of substitution (MRS) of food for clothing equals
the ratio of the prices of food and clothing.the ratio of the prices of food and clothing.
Income ChangesIncome Changes
Income-consumption curveIncome-consumption curve
Curve tracing the utility-maximizingCurve tracing the utility-maximizing
combinations of two goods as a consumer’s income changes.combinations of two goods as a consumer’s income changes.

7. EFFECT OFEFFECT OF
INCOME CHANGESINCOME CHANGES
An increase in income, with the
prices of all goods fixed, causes
consumers to alter their choice of
market baskets.
In part (a), the baskets that
maximize consumer satisfaction for
various incomes (point A, $10; B,
$20; D, $30) trace out the income-
consumption curve.
The shift to the right of the demand
curve in response to the increases in
income is shown in part (b). (Points
E, G, and H correspond to points A,
B, and D, respectively.)

8. Normal versus Inferior GoodsNormal versus Inferior Goods
AN INFERIORAN INFERIOR
GOODGOOD
An increase in a
person’s income can
lead to less
consumption of one of
the two goods being
purchased.
Here, hamburger,
though a normal good
between A and B,
becomes an inferior
good when the income-
consumption curve
bends backward
between B and C.

9. Engel CurvesEngel Curves
ENGLE CURVESENGLE CURVES
Engel curves relate the
quantity of a good consumed
to income.
In (a), food is a normal good
and the Engel curve is
upward sloping.
In (b), however, hamburger
is a normal good for income
less than $20 per month
and an inferior good for
income greater than $20 per
month.
Engel curveEngel curve
Curve relating the quantity of a good consumed to income.Curve relating the quantity of a good consumed to income.

10. CONSUMER EXPENDITURES IN THE UNITED STATESCONSUMER EXPENDITURES IN THE UNITED STATES
TABLE 1 ANNUAL U.S. HOUSEHOLD CONSUMER EXPENDITURES
INCOME GROUP (2009 $)
EXPENDITURES
($) ON:
LESS
THAN
$10,0
00
10,000
–19,999
20,000
–29,999
30,000
–39,999
40,000
–49,999
50,000–
69,999
70,000
AND
ABOVE
Entertainment 1,041 1,025 1,504 1,970 2,008 2,611 4,733
Owned Dwelling 1,880 2,083 3,117 4,038 4,847 6,473 12,306
Rented Dwelling 3,172 3,359 3,228 3,296 3,295 2,977 2,098
Health Care 1,222 1,917 2,536 2,684 2,937 3,454 4,393
Food 3,429 3,529 4,415 4,737 5,384 6,420 9,761
Clothing 799 927 1,080 1,225 1,336 1,608 2,850
We can derive Engel curves for groupsWe can derive Engel curves for groups
of consumers. This information isof consumers. This information is
particularly useful if we want to see howparticularly useful if we want to see how
consumer spending varies amongconsumer spending varies among
different income groups.different income groups.

11. Average per-householdAverage per-household
expenditures on rentedexpenditures on rented
dwellings, health care, anddwellings, health care, and
entertainment are plotted asentertainment are plotted as
functions of annual income.functions of annual income.
Health care andHealth care and
entertainment are normalentertainment are normal
goods, as expendituresgoods, as expenditures
increase with income.increase with income.
Rental housing, however,Rental housing, however,
is an inferior good foris an inferior good for
incomes above $30,000.incomes above $30,000.
ENGEL CURVESENGEL CURVES
FOR U.S.FOR U.S.
CONSUMERSCONSUMERS
CONSUMER EXPENDITURES IN THE UNITED STATESCONSUMER EXPENDITURES IN THE UNITED STATES

12. Substitutes and ComplementsSubstitutes and Complements
• Two goods areTwo goods are substitutessubstitutes if an increase in theif an increase in the
price of one leads to an increase in the quantityprice of one leads to an increase in the quantity
demanded of the other.demanded of the other.
• Two goods areTwo goods are complementscomplements if an increase in theif an increase in the
price of one good leads to a decrease in theprice of one good leads to a decrease in the
quantity demanded of the other.quantity demanded of the other.
• Two goods areTwo goods are independentindependent if a change in theif a change in the
price of one good has no effect on the quantityprice of one good has no effect on the quantity
demanded of the other.demanded of the other.
• The fact that goods can be complements orThe fact that goods can be complements or
substitutes suggests that when studying thesubstitutes suggests that when studying the
effects of price changeseffects of price changes in one market, it may bein one market, it may be
important to look at the consequences in relatedimportant to look at the consequences in related

13. 22
Income & SubstitutionIncome & Substitution
EffectsEffects

14. A fall in the price of a good has two effects:A fall in the price of a good has two effects:
1.1. Consumers will tend to buy more of the goodConsumers will tend to buy more of the good
that has become cheaper and less of thosethat has become cheaper and less of those
goods that are now relatively more expensive.goods that are now relatively more expensive.
This response to a change in the relative pricesThis response to a change in the relative prices
of goods is calledof goods is called thethe substitution effectsubstitution effect..
2.2. Because one of the goods is now cheaper,Because one of the goods is now cheaper,
consumers enjoy an increase in real purchasingconsumers enjoy an increase in real purchasing
power.power. The change in demand resulting from thisThe change in demand resulting from this
change in real purchasing power is calledchange in real purchasing power is called thethe
income effect.income effect.
Income and Substitution EffectsIncome and Substitution Effects

15. Substitution EffectSubstitution Effect
Substitution effectSubstitution effect
Change in consumption of a good associated with aChange in consumption of a good associated with a
change in its price, with the level of utility heldchange in its price, with the level of utility held
constant.constant.
Income EffectIncome Effect
Income effectIncome effect
Change in consumption of a good resulting from an increaseChange in consumption of a good resulting from an increase
in purchasing power, with relative prices held constant.in purchasing power, with relative prices held constant.
Total Effect (Total Effect (FF11FF22) = Substitution Effect () = Substitution Effect (FF11EE) + Income Effect () + Income Effect (EFEF22))
The total effect of a change in price is givenThe total effect of a change in price is given
theoretically by the sum of the substitution effect andtheoretically by the sum of the substitution effect and
the income effect:the income effect:

16. INCOME AND SUBSTITUTION EFFECTS:INCOME AND SUBSTITUTION EFFECTS:
NORMAL GOODNORMAL GOOD
A decrease in the price of food has
both an income effect and a
substitution effect.
The consumer is initially at A, on
budget line RS.
When the price of food falls,
consumption increases by F1F2 as the
consumer moves to B.
The substitution effect F1E (associated
with a move from A to D) changes the
relative prices of food and clothing but
keeps real income (satisfaction)
constant.
The income effect EF2 (associated
with a move from D to B) keeps
relative prices constant but increases
purchasing power.
Food is a normal good because the
income effect EF2 is positive.

17. INCOME AND SUBSTITUTION EFFECTS:INCOME AND SUBSTITUTION EFFECTS:
INFERIOR GOODINFERIOR GOOD
The consumer is initially at A on
budget line RS.
With a decrease in the price of
food, the consumer moves to B.
The resulting change in food
purchased can be broken down
into a substitution effect, F1E
(associated with a move from A to
D), and an income effect, EF2
(associated with a move from D to
B).
In this case, food is an inferior
good because the income effect is
negative.
However, because the substitution
effect exceeds the income effect,
the decrease in the price of food
leads to an increase in the quantity
of food demanded.

18. UPWARD-SLOPING DEMANDUPWARD-SLOPING DEMAND
CURVE: THE GIFFEN GOODCURVE: THE GIFFEN GOOD
When food is an inferior good, and
when the income effect is large
enough to dominate the substitution
effect, the demand curve will be
upward-sloping.
The consumer is initially at point A,
but, after the price of food falls,
moves to B and consumes less
food.
Because the income effect F2F1 is
larger than the substitution effect
EF2, the decrease in the price of
food leads to a lower quantity of
food demanded.
A Special Case: The Giffen GoodA Special Case: The Giffen Good
Giffen goodGiffen good
Good whose demand curve slopes upward becauseGood whose demand curve slopes upward because
the (negative) income effect is larger than the substitution effect.the (negative) income effect is larger than the substitution effect.

19. THE EFFECTS OF A GASOLINE TAXTHE EFFECTS OF A GASOLINE TAX
EFFECT OF A GASOLINEEFFECT OF A GASOLINE
TAX WITH A REBATETAX WITH A REBATE
A gasoline tax is imposedA gasoline tax is imposed
when the consumer is initiallywhen the consumer is initially
buying 1200 gallons ofbuying 1200 gallons of
gasoline at pointgasoline at point CC..
After the tax takes effect, theAfter the tax takes effect, the
budget line shifts frombudget line shifts from ABAB toto
ADAD and the consumerand the consumer
maximizes his preferences bymaximizes his preferences by
choosing E, with a gasolinechoosing E, with a gasoline
consumption of 900 gallons.consumption of 900 gallons.
However, when the proceedsHowever, when the proceeds
of the tax are rebated to theof the tax are rebated to the
consumer, his consumptionconsumer, his consumption
increases somewhat, to 913.5increases somewhat, to 913.5
gallons at H.gallons at H.
Despite the rebate program,Despite the rebate program,
the consumer’s gasolinethe consumer’s gasoline
consumption has fallen, asconsumption has fallen, as
has his level of satisfaction.has his level of satisfaction.

20. MMarket demand curvearket demand curve
Curve relating the quantity of a good that all consumers in a marketCurve relating the quantity of a good that all consumers in a market
will buy to its price.will buy to its price.
Market DemandMarket Demand
TABLE 2TABLE 2 DETERMINING THE MARKET DEMAND CURVEDETERMINING THE MARKET DEMAND CURVE
(1)(1)
PRICEPRICE
($)($)
(2)(2)
INDIVIDUAL AINDIVIDUAL A
(UNITS)(UNITS)
(3)(3)
INDIVIDUAL BINDIVIDUAL B
(UNITS)(UNITS)
(4)(4)
INDIVIDUALINDIVIDUAL
CC
(UNITS)(UNITS)
(5)(5)
MARKETMARKET
UNITSUNITS
11 66 1010 1616 3232
22 44 88 1313 2525
33 22 66 1010 1818
44 00 44 77 1111
55 00 22 44 66
From Individual to Market DemandFrom Individual to Market Demand

21. SUMMING TO OBTAIN A MARKETSUMMING TO OBTAIN A MARKET
DEMAND CURVEDEMAND CURVE
The market demand curve is
obtained by summing our
three consumers’ demand
curves DA, DB, and DC.
At each price, the quantity of
coffee demanded by the
market is the sum of the
quantities demanded by
each consumer.
At a price of $4, for example,
the quantity demanded by
the market (11 units) is the
sum of the quantity
demanded by A (no units), B
(4 units), and C (7 units).

22. The aggregation of individual demands intoThe aggregation of individual demands into
market becomes important in practice whenmarket becomes important in practice when
market demands are built up from the demandsmarket demands are built up from the demands
ofof different demographicdifferent demographic groups or fromgroups or from
consumers located inconsumers located in different areasdifferent areas..
Two points should be noted:Two points should be noted:
1.1. The market demand curve will shift to theThe market demand curve will shift to the
right asright as more consumersmore consumers enter the market.enter the market.
2.2. Factors that influence the demandsFactors that influence the demands ofof
many consumers will also affect marketmany consumers will also affect market
demand.demand.

23. THE DEMAND FOR HOUSINGTHE DEMAND FOR HOUSING
There are significant differencesThere are significant differences
in price and income elasticities ofin price and income elasticities of
housing demand among subgroupshousing demand among subgroups
of the population.of the population.
TABLE 4.4
PRICE AND INCOME ELASTICITIES OF THE DEMAND FOR
ROOMS
GROUP PRICE ELASTICITY INCOME ELASTICITY
Single individuals – 0.10 0.21
Married, head of householdMarried, head of household
age less than 30, 1 childage less than 30, 1 child
–– 0.250.25 0.060.06
Married, head age 30–39, 2 or
more children
– 0.15 0.12
Married, head age 50 or older,
1 child
– 0.08 0.19
In recent years, the demand for housing has been partlyIn recent years, the demand for housing has been partly
driven bydriven by speculative demandspeculative demand. Speculative demand is. Speculative demand is
driven not by the direct benefits one obtains from owning adriven not by the direct benefits one obtains from owning a
home but instead by an expectation that the price willhome but instead by an expectation that the price will

24. THE LONG-RUN DEMAND FOR GASOLINETHE LONG-RUN DEMAND FOR GASOLINE
Would higher gasoline pricesWould higher gasoline prices
reduce gasoline consumption?reduce gasoline consumption?
GASOLINE PRICESGASOLINE PRICES
AND PER CAPITAAND PER CAPITA
CONSUMPTION IN 10CONSUMPTION IN 10
COUNTRIESCOUNTRIES
The graph plots per capitaThe graph plots per capita
consumption of gasolineconsumption of gasoline
versus the price per gallonversus the price per gallon
(converted to U.S. dollars)(converted to U.S. dollars)
for 10 countries over thefor 10 countries over the
period 2008 to 2010. Eachperiod 2008 to 2010. Each
circle represents thecircle represents the
population of thepopulation of the
corresponding country.corresponding country.

25. Consumer surplus
Difference between what a consumer is willing to pay for a good and the amount
actually paid.
Consumer SurplusConsumer Surplus
Consumer Surplus and DemandConsumer Surplus and Demand
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:
$6 + $5 + $4 + $3 + $2 + $1
= $21
CONSUMER SURPLUS

26. CONSUMERCONSUMER
SURPLUSSURPLUS
GENERALIZEDGENERALIZED
For the market as a whole,For the market as a whole,
consumer surplus is measuredconsumer surplus is measured
by the area under the demandby the area under the demand
curve and above the linecurve and above the line
representing the purchase pricerepresenting the purchase price
of the good.of the good.
Here, the consumer surplus isHere, the consumer surplus is
given by the yellow-shadedgiven by the yellow-shaded
triangle and is equal to 1/2triangle and is equal to 1/2  ($20($20
− $14)− $14)  6500 = $19,500.6500 = $19,500.
APPLYING CONSUMER SURPLUSAPPLYING CONSUMER SURPLUS
Consumer surplus has important applications in economics. When added over manyConsumer surplus has important applications in economics. When added over many
individuals, it measures the aggregate benefit that consumers obtain from buying goodsindividuals, it measures the aggregate benefit that consumers obtain from buying goods
in a market. When we combine consumer surplus with the aggregate profits thatin a market. When we combine consumer surplus with the aggregate profits that
producers obtain, we can evaluate both theproducers obtain, we can evaluate both the costs and benefitscosts and benefits not only of alternativenot only of alternative
market structures, but of public policies that alter the behaviour of consumers and firmsmarket structures, but of public policies that alter the behaviour of consumers and firms
in those markets.in those markets.

27. THE VALUE OF CLEAN AIRTHE VALUE OF CLEAN AIR
VALUING CLEANER AIRVALUING CLEANER AIR
The yellow-shadedThe yellow-shaded
triangle gives thetriangle gives the
consumer surplusconsumer surplus
generated when airgenerated when air
pollution is reduced by 5pollution is reduced by 5
parts per 100 million ofparts per 100 million of
nitrogen oxide at a costnitrogen oxide at a cost
of $1000 per partof $1000 per part
reduced.reduced.
The surplus is createdThe surplus is created
because mostbecause most
consumers are willing toconsumers are willing to
pay more than $1000 forpay more than $1000 for
each unit reduction ofeach unit reduction of
nitrogen oxide.nitrogen oxide.
Although there is no actual market for cleanAlthough there is no actual market for clean
air, people do pay more for houses where theair, people do pay more for houses where the
air is clean than for comparable houses inair is clean than for comparable houses in
areas with dirtier air.areas with dirtier air.

28. NNetwork externalityetwork externality
When each individual’s demand depends onWhen each individual’s demand depends on
the purchases of other individuals.the purchases of other individuals.
Network ExternalitiesNetwork Externalities
Positive Network Externalities
AA positivepositive network externality existsnetwork externality exists if the quantity of aif the quantity of a
good demanded by a typical consumer increases ingood demanded by a typical consumer increases in
response to the growth in purchases of other consumersresponse to the growth in purchases of other consumers. If. If
the quantity demanded decreases, there is athe quantity demanded decreases, there is a negativenegative
network externality.network externality.
BBandwagon effectandwagon effect
Positive network externality in which a consumerPositive network externality in which a consumer
wishes to possess a good in part because otherswishes to possess a good in part because others
do.do.

29. POSITIVEPOSITIVE
NETWORKNETWORK
EXTERNALITYEXTERNALITY
With a positive networkWith a positive network
externality, the quantityexternality, the quantity
of a good that anof a good that an
individual demandsindividual demands
grows in response togrows in response to
the growth ofthe growth of
purchases by otherpurchases by other
individuals.individuals.
Here, as the price ofHere, as the price of
the product falls fromthe product falls from
$30 to $20, the$30 to $20, the
bandwagon effectbandwagon effect
causes the demandcauses the demand
for the good to shiftfor the good to shift
to the right, fromto the right, from DD4040
toto DD8080..

30. NEGATIVE NETWORKNEGATIVE NETWORK
EXTERNALITY: SNOB EFFECTEXTERNALITY: SNOB EFFECT
Negative Network ExternalitiesNegative Network Externalities
SSnob effectnob effect
Negative network externality in which a consumer wishes to own anNegative network externality in which a consumer wishes to own an
exclusive or unique good.exclusive or unique good.
The snob effect is a negativeThe snob effect is a negative
network externality in whichnetwork externality in which
the quantity of a good thatthe quantity of a good that
an individual demands fallsan individual demands falls
in response to the growth ofin response to the growth of
purchases by otherpurchases by other
individuals.individuals.
Here, as the price falls fromHere, as the price falls from
$30,000 to $15,000 and more$30,000 to $15,000 and more
people buy the good, thepeople buy the good, the
snob effect causes thesnob effect causes the
demand for the good to shiftdemand for the good to shift
to the left, fromto the left, from DD22 toto DD66..

31. FACEBOOKFACEBOOK
TABLE 4.3 FACEBOOK USERS
YEAR FACEBOOK USERS
(MILLIONS)
HOURS PER USER
PER MONTH
2004 1
2005 5.5
2006 12 <1
2007 50 2
2008 100 3
2009 350 5.5
2010 500 7
Network externalities have been crucialNetwork externalities have been crucial
drivers for many modern technologies overdrivers for many modern technologies over
many years.many years.
By early 2011, with over 600 million users, FacebookBy early 2011, with over 600 million users, Facebook
became the world’s second most visited website (afterbecame the world’s second most visited website (after
Google). A strong positive network externality wasGoogle). A strong positive network externality was
central to Facebook’s success.central to Facebook’s success.

32. THE DEMAND FOR READY-TO-EATTHE DEMAND FOR READY-TO-EAT
CEREALCEREAL
The acquisition of Shredded Wheat cereals of NabiscoThe acquisition of Shredded Wheat cereals of Nabisco
by Post Cereals raised the question of whether Postby Post Cereals raised the question of whether Post
would raise the price of Grape Nuts, or the price ofwould raise the price of Grape Nuts, or the price of
Nabisco’s Shredded Wheat Spoon Size.Nabisco’s Shredded Wheat Spoon Size.
One important issue was whether the two brands wereOne important issue was whether the two brands were
close substitutes for one another. If so, it would be moreclose substitutes for one another. If so, it would be more
profitable for Post to increase the price of Grape Nutsprofitable for Post to increase the price of Grape Nuts
after rather than before the acquisition because the lostafter rather than before the acquisition because the lost
sales from consumers who switched away from Grape Nuts wouldsales from consumers who switched away from Grape Nuts would
be recovered to the extent that they switched to the substitutebe recovered to the extent that they switched to the substitute
product.product.
The substitutability of Grape Nuts and Shredded Wheat can beThe substitutability of Grape Nuts and Shredded Wheat can be
measured by the cross-price elasticity of demand for Grape Nutsmeasured by the cross-price elasticity of demand for Grape Nuts
with respect to the price of Shredded Wheat.with respect to the price of Shredded Wheat.
The demand for Grape Nuts is elastic, with a priceThe demand for Grape Nuts is elastic, with a price
elasticity of about −2. Income elasticity is 0.62. theelasticity of about −2. Income elasticity is 0.62. the
cross-price elasticity is 0.14. The two cereals are notcross-price elasticity is 0.14. The two cereals are not

33. Interview and Experimental ApproachesInterview and Experimental Approaches
to Demand Determinationto Demand Determination
Another way to obtain information about demand is through interviews.Another way to obtain information about demand is through interviews.
This approach, however, may not succeed when people lack informationThis approach, however, may not succeed when people lack information
or interest or even want to mislead the interviewer.or interest or even want to mislead the interviewer.
In direct marketing experiments, actual sales offers are posed toIn direct marketing experiments, actual sales offers are posed to
potential customers. An airline, for example, might offer a reduced pricepotential customers. An airline, for example, might offer a reduced price
on certain flights for six months, partly to learn how the price changeon certain flights for six months, partly to learn how the price change
affects demand for flights and partly to learn how competitors willaffects demand for flights and partly to learn how competitors will
respond. Alternatively, a cereal company might test market a new brand,respond. Alternatively, a cereal company might test market a new brand,
with some potential customers being given coupons ranging in valuewith some potential customers being given coupons ranging in value
from 25 cents to $1 per box. The response to the coupon offer tells thefrom 25 cents to $1 per box. The response to the coupon offer tells the
company the shape of the underlying demand curve.company the shape of the underlying demand curve.
Direct experiments are real, not hypothetical, but even so, problemsDirect experiments are real, not hypothetical, but even so, problems
remain. The wrong experiment can beremain. The wrong experiment can be costlycostly, and the firm cannot be, and the firm cannot be
entirely sure that these increases resulted from the experimentalentirely sure that these increases resulted from the experimental
change; other factors probably changed at the same time. Moreover, thechange; other factors probably changed at the same time. Moreover, the
response to experiments—which consumers often recognizeresponse to experiments—which consumers often recognize as short-as short-
livedlived—may differ from the response to permanent changes. Finally, a—may differ from the response to permanent changes. Finally, a
firm can afford to try only afirm can afford to try only a limitedlimited number of experiments.number of experiments.

34. 33
Consumer PreferencesConsumer Preferences

35. An increase in the price of a good based not on theAn increase in the price of a good based not on the
fundamentals of demand or value, but instead on a belieffundamentals of demand or value, but instead on a belief
that the price will keep going up.that the price will keep going up.
Bubbles are often the result of irrational behaviour. PeopleBubbles are often the result of irrational behaviour. People
stop thinking straight.stop thinking straight.
During 1995 to 2000, many investors (perhapsDuring 1995 to 2000, many investors (perhaps
“speculators” is a better word) bought the stocks of“speculators” is a better word) bought the stocks of
Internet companies at very high prices, prices thatInternet companies at very high prices, prices that
were increasingly difficult to justify based onwere increasingly difficult to justify based on
fundamentals. The result was the Internet bubble.fundamentals. The result was the Internet bubble.
The United States experienced a prolonged housing priceThe United States experienced a prolonged housing price
bubble that burst in 2008, causing financial losses to largebubble that burst in 2008, causing financial losses to large
banks. By the end of 2008, the United States was in its worstbanks. By the end of 2008, the United States was in its worst
recession since the Great Depression of the 1930s. Therecession since the Great Depression of the 1930s. The
housing price bubble, far from harmless, was partly to blamehousing price bubble, far from harmless, was partly to blame
for this.for this.
BubblesBubbles

36. THE HOUSING PRICE BUBBLE (I)THE HOUSING PRICE BUBBLE (I)
S&P/CASE-SHILLERS&P/CASE-SHILLER
HOUSING PRICE INDEXHOUSING PRICE INDEX
The Index shows theThe Index shows the
average home priceaverage home price
in the United States atin the United States at
the national level.the national level.
Note the increase inNote the increase in
the index from 1998the index from 1998
to 2007, and then theto 2007, and then the
sharp decline.sharp decline.
During that 8-year period from 1998 to 2006,During that 8-year period from 1998 to 2006,
many people bought into the myth that housingmany people bought into the myth that housing
was a sure-fire investment, and that prices couldwas a sure-fire investment, and that prices could
only keep going up. Many banks also bought intoonly keep going up. Many banks also bought into
this myth. The demand for housing increasedthis myth. The demand for housing increased
sharply, with some people buying four or fivesharply, with some people buying four or five
houses. This speculative demand served to pushhouses. This speculative demand served to push
prices up further. By 2010, housing prices hadprices up further. By 2010, housing prices had
fallen over 28% from their 2007 peak.fallen over 28% from their 2007 peak.

37. Informational CascadesInformational Cascades
The bubble that results from an informational cascade canThe bubble that results from an informational cascade can
in fact be rational in the sense that there is a basis forin fact be rational in the sense that there is a basis for
believing that investing in the bubble will yield a positivebelieving that investing in the bubble will yield a positive
return.return.
The reason is that if investors early in the chainThe reason is that if investors early in the chain
indeed obtained positive information and basedindeed obtained positive information and based
their decisions on that information,their decisions on that information, the expectedthe expected
gain to an investor down the chain will begain to an investor down the chain will be
positive.positive.
However, the risk involved will be considerable,However, the risk involved will be considerable,
and it is likely that at least some investors willand it is likely that at least some investors will
underestimate that risk.underestimate that risk.
Informational cascadesInformational cascades
An assessment (e.g., of an investmentAn assessment (e.g., of an investment
opportunity) based in part on the actions ofopportunity) based in part on the actions of
others, which in turn were based on theothers, which in turn were based on the
actions of others.actions of others.

38. THE HOUSING PRICE BUBBLE (II)THE HOUSING PRICE BUBBLE (II)
Was it rational to buy real estate in Miami in 2006?Was it rational to buy real estate in Miami in 2006?
Rational or not, investors should have known thatRational or not, investors should have known that
considerable risk was involved in buying real estateconsiderable risk was involved in buying real estate
there (or elsewhere in Florida, Arizona, Nevada,there (or elsewhere in Florida, Arizona, Nevada,
and California). Looking back, we now know thatand California). Looking back, we now know that
many of these investors lost their shirts (not tomany of these investors lost their shirts (not to
mention their homes).mention their homes).
S&P/CASE-SHILLER HOUSINGS&P/CASE-SHILLER HOUSING
PRICE INDEX FOR FIVE CITIESPRICE INDEX FOR FIVE CITIES
The Index shows the average homeThe Index shows the average home
price for each of five cities (inprice for each of five cities (in
nominal terms).nominal terms). For some cities, theFor some cities, the
housing bubble was much worsehousing bubble was much worse
than for others. Los Angeles, Miami,than for others. Los Angeles, Miami,
and Las Vegas experienced some ofand Las Vegas experienced some of
the sharpest increases in homethe sharpest increases in home
prices, and then starting in 2007,prices, and then starting in 2007,
prices plummeted.prices plummeted. Cleveland, on theCleveland, on the
other hand, largely avoided theother hand, largely avoided the
bubble, with home prices increasing,bubble, with home prices increasing,
and then falling, only moderately.and then falling, only moderately.

39. Recall that the basic theory of consumer demand is based on threeRecall that the basic theory of consumer demand is based on three
assumptions:assumptions:
(1)(1) consumers haveconsumers have clear preferencesclear preferences for some goodsfor some goods
over others;over others;
(2)(2) consumers faceconsumers face budget constraintsbudget constraints; and; and
(3)(3) given their preferences, limited incomes, and the pricesgiven their preferences, limited incomes, and the prices
of different goods, consumers choose to buyof different goods, consumers choose to buy
combinations of goods thatcombinations of goods that maximize their satisfactionmaximize their satisfaction..
These assumptions, however, are not always realistic.These assumptions, however, are not always realistic.
Perhaps our understanding of consumer demand (as well as thePerhaps our understanding of consumer demand (as well as the
decisions of firms) would be improved if we incorporated more realisticdecisions of firms) would be improved if we incorporated more realistic
and detailed assumptions regarding human behaviour.and detailed assumptions regarding human behaviour.
This has been the objective of the newly flourishing field ofThis has been the objective of the newly flourishing field of
behavioural economicsbehavioural economics..
Behavioural EconomicsBehavioural Economics

40. Here are some examples of consumer behaviour that cannot beHere are some examples of consumer behaviour that cannot be
easily explained with theeasily explained with the basic utility-maximizing assumptionsbasic utility-maximizing assumptions::
• There has just been a big snowstorm, so you stop at theThere has just been a big snowstorm, so you stop at the
hardware store to buy a snow shovel. You had expected tohardware store to buy a snow shovel. You had expected to
pay $20 for the shovel—the price that the store normallypay $20 for the shovel—the price that the store normally
charges. However, you find that the store has suddenlycharges. However, you find that the store has suddenly
raised the price to $40. Although you would expect a priceraised the price to $40. Although you would expect a price
increase because of the storm, you feel that a doubling ofincrease because of the storm, you feel that a doubling of
the price is unfair and that the store is trying to takethe price is unfair and that the store is trying to take
advantage of you. Out of spite, you do not buy the shovel.advantage of you. Out of spite, you do not buy the shovel.
• Tired of being snowed in at home you decide to take aTired of being snowed in at home you decide to take a
vacation in the country. On the way, you stop at a highwayvacation in the country. On the way, you stop at a highway
restaurant for lunch. Even though you are unlikely to returnrestaurant for lunch. Even though you are unlikely to return
to that restaurant, you believe that it is fair and appropriateto that restaurant, you believe that it is fair and appropriate
to leave a 15-percent tip in appreciation of the good serviceto leave a 15-percent tip in appreciation of the good service
that you received.that you received.
• You buy this textbook from an Internet bookseller becauseYou buy this textbook from an Internet bookseller because
the price is lower than the price at your local bookstore.the price is lower than the price at your local bookstore.
However, you ignore the shipping cost when comparingHowever, you ignore the shipping cost when comparing
prices.prices.

41. Reference Points and Consumer PreferencesReference Points and Consumer Preferences
Reference pointReference point
The point from which an individual makes a consumption decision.The point from which an individual makes a consumption decision.
Tendency of individuals to value an item more when theyTendency of individuals to value an item more when they
own it than when they do not.own it than when they do not.
Tendency for individuals to prefer avoiding losses overTendency for individuals to prefer avoiding losses over
acquiring gains.acquiring gains.
Tendency to rely on the context in which a choice isTendency to rely on the context in which a choice is
described when making a decision.described when making a decision.
ENDOWMENT EFFECTENDOWMENT EFFECT
LOSS AVERSIONLOSS AVERSION
FRAMINGFRAMING

42. SELLING A HOUSESELLING A HOUSE
Homeowners can get a good idea of what the house will sell for byHomeowners can get a good idea of what the house will sell for by
looking at the selling prices of comparable houses, or by talking withlooking at the selling prices of comparable houses, or by talking with
a realtor. Often, however, the owners will set an asking price that isa realtor. Often, however, the owners will set an asking price that is
well above any realistic expectation of what the house can actuallywell above any realistic expectation of what the house can actually
sell for.sell for.
As a result, the house may stay on the market for many monthsAs a result, the house may stay on the market for many months
before the owners grudgingly lower the price. During that time thebefore the owners grudgingly lower the price. During that time the
owners have to continue to maintain the house and pay for taxes,owners have to continue to maintain the house and pay for taxes,
utilities, and insurance. This seems irrational. Why not set an askingutilities, and insurance. This seems irrational. Why not set an asking
price closer to what the market will bear?price closer to what the market will bear?
TheThe endowment effectendowment effect is at work here. The homeowners view theiris at work here. The homeowners view their
house as special; their ownership has given them what they think ishouse as special; their ownership has given them what they think is
a special appreciation of its value—a value that may go beyond anya special appreciation of its value—a value that may go beyond any
price that the market will bear.price that the market will bear.
If housing prices have been falling,If housing prices have been falling, loss aversionloss aversion could also be atcould also be at
work. Selling the house turns a paper loss, which may not seem real,work. Selling the house turns a paper loss, which may not seem real,
into a loss that is real. Averting that reality may explain theinto a loss that is real. Averting that reality may explain the
reluctance of home owners to take that final step of selling theirreluctance of home owners to take that final step of selling their
home. It is not surprising, therefore, to find that houses tend to stayhome. It is not surprising, therefore, to find that houses tend to stay
on the market longer during economic downturns than in upturns.on the market longer during economic downturns than in upturns.

43. FairnessFairnessDEMAND FORDEMAND FOR
SNOW SHOVELSSNOW SHOVELS
Demand curveDemand curve DD11 applies duringapplies during
normal weather. Stores havenormal weather. Stores have
been charging $20 and sellbeen charging $20 and sell QQ11
shovels per month.shovels per month.
When a snowstorm hits, theWhen a snowstorm hits, the
demand curve shifts to the right.demand curve shifts to the right.
Had the price remained $20, theHad the price remained $20, the
quantity demanded would havequantity demanded would have
increased toincreased to QQ22..
But the new demand curve (But the new demand curve (DD22))
does not extend up as far as thedoes not extend up as far as the
old one. Consumers view anold one. Consumers view an
increase in price to, say, $25 asincrease in price to, say, $25 as
fair, but an increase much abovefair, but an increase much above
that as unfair gouging.that as unfair gouging.
The new demand curve is veryThe new demand curve is very
elastic at prices above $25, andelastic at prices above $25, and
no shovels can be sold at a priceno shovels can be sold at a price
much above $30.much above $30.

44. Tendency to rely heavily on one or two pieces of informationTendency to rely heavily on one or two pieces of information
when making a decision.when making a decision.
Rules of Thumb and Biases in Decision MakingRules of Thumb and Biases in Decision Making
RULES OF THUMBRULES OF THUMB
A common way to economize on the effort involved inA common way to economize on the effort involved in
making decisions ismaking decisions is to ignore seeminglyto ignore seemingly
unimportant pieces of information.unimportant pieces of information.
For example, a recent study has shown that shipping costsFor example, a recent study has shown that shipping costs
are typically ignored by many consumers when deciding toare typically ignored by many consumers when deciding to
buy things online. Their decisions are biased because theybuy things online. Their decisions are biased because they
view the price of goods to be lower than they really are.view the price of goods to be lower than they really are.
Frequently, rules of thumb help toFrequently, rules of thumb help to save time and effort andsave time and effort and
result in only small biasesresult in only small biases. Thus, they should not be. Thus, they should not be
dismissed outright.dismissed outright.
ANCHORINGANCHORING

45. THE LAW OF SMALL NUMBERSTHE LAW OF SMALL NUMBERS
Research has shown that investors in the stock market areResearch has shown that investors in the stock market are
often subject to a small-numbers bias, believing that highoften subject to a small-numbers bias, believing that high
returns over the past few years are likely to be followed byreturns over the past few years are likely to be followed by
more high returns over the next few years—therebymore high returns over the next few years—thereby
contributing to the kind of “herd behaviour”.contributing to the kind of “herd behaviour”.
Similarly when people assess the likelihood that housingSimilarly when people assess the likelihood that housing
prices will rise based on several years of data, the resultingprices will rise based on several years of data, the resulting
misperceptions can result in housing price bubbles.misperceptions can result in housing price bubbles.
Forming subjective probabilities is not always an easy taskForming subjective probabilities is not always an easy task
and people are generally prone to several biases in theand people are generally prone to several biases in the
process.process.
Likewise, when a probability for a particular event is very,Likewise, when a probability for a particular event is very,
very small, many people simply ignore that possibility invery small, many people simply ignore that possibility in
their decision making.their decision making.
Tendency to overstate the probability that a certain eventTendency to overstate the probability that a certain event
will occur when faced with relatively little information.will occur when faced with relatively little information.

46. Summing UpSumming Up
Where does this leave us? Should we dispense with theWhere does this leave us? Should we dispense with the
traditional consumer theory? Not at all. In fact, the basictraditional consumer theory? Not at all. In fact, the basic
theory that we learned up to now works quite well in manytheory that we learned up to now works quite well in many
situations. It helps us to understand and evaluate thesituations. It helps us to understand and evaluate the
characteristics of consumer demand and to predict thecharacteristics of consumer demand and to predict the
impact on demand of changes in prices or incomes.impact on demand of changes in prices or incomes.
The developing field of behavioural economics tries toThe developing field of behavioural economics tries to
explain and to elaborate on those situations that are notexplain and to elaborate on those situations that are not
well explained by the basic consumer model.well explained by the basic consumer model.
If you continue to study economics, you will notice manyIf you continue to study economics, you will notice many
cases in which economic models are not a perfect reflectioncases in which economic models are not a perfect reflection
of reality. Economists have to carefully decide, on a case-of reality. Economists have to carefully decide, on a case-
by-case basis, what features of the real world to includeby-case basis, what features of the real world to include
and what simplifying assumptions to make so that modelsand what simplifying assumptions to make so that models
are neither too complicated to study nor too simple to beare neither too complicated to study nor too simple to be
useful.useful.

47. NEW YORK CITY TAXICAB DRIVERSNEW YORK CITY TAXICAB DRIVERS
Most cab drivers rent their taxicabs for a fixed dailyMost cab drivers rent their taxicabs for a fixed daily
fee from a company that owns a fleet of cars. Theyfee from a company that owns a fleet of cars. They
can then choose to drive the cab as little or as muchcan then choose to drive the cab as little or as much
as they want during a 12-hour period. As with manyas they want during a 12-hour period. As with many
services, business is highly variable from day to day,services, business is highly variable from day to day,
depending on the weather, subway breakdowns,depending on the weather, subway breakdowns,
holidays, and so on.holidays, and so on.
An interesting study analyzed actual taxicab trip records and found thatAn interesting study analyzed actual taxicab trip records and found that
most drivers drive more hours on slow days and fewer hours on busymost drivers drive more hours on slow days and fewer hours on busy
days. In other words, there is a negative relationship between thedays. In other words, there is a negative relationship between the
effective hourly wage and the number of hours worked each day; theeffective hourly wage and the number of hours worked each day; the
higher the wage, the sooner the cabdrivers quit for the day.higher the wage, the sooner the cabdrivers quit for the day.
Behavioural economics can explain this result. AnBehavioural economics can explain this result. An income targetincome target
provides a simple decision rule for drivers because they need only keepprovides a simple decision rule for drivers because they need only keep
a record of their fares for the day. A daily target also helps drivers witha record of their fares for the day. A daily target also helps drivers with
potential self-control problems.potential self-control problems.

48. Casestudy : Procter & GambleCasestudy : Procter & Gamble
1.1. Read and prepare theRead and prepare the
Casestudy on P&G forCasestudy on P&G for
discussion and presentationdiscussion and presentation
next week.next week.
2.2. Identify and evaluate theIdentify and evaluate the
challenges facing P&G’schallenges facing P&G’s
consumer businesses byconsumer businesses by
conducting Externalconducting External
Environment analysisEnvironment analysis
(PESTEL);and Industry(PESTEL);and Industry
(5+1 Forces) analysis.(5+1 Forces) analysis.

49. ConclusionConclusion
““Bubbles are often the result ofBubbles are often the result of
irrational behaviour. … ‘irrational behaviour. … ‘Yes, I willYes, I will
sell before the price drops. I’ll justsell before the price drops. I’ll just
know.know.’… .”’… .” Robert Pindyck, MITRobert Pindyck, MIT

50. Core ReadingCore Reading
• Keat, Paul G. and Young, Philip KY (2009)
Managerial Economics, 6th
edition, Pearson
• Samuelson, William F. and Marks, Stephen G.
(2010) Managerial Economics, 6th
edition, John
Wiley
• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)
Microeconomics, 8th
edition, Pearson
• Samuelson, P.A. and Nordhaus, W. D.Samuelson, P.A. and Nordhaus, W. D.
(2010)(2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19thth
EditionEdition
• Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy –“Competitive Strategy –
Techniques for Analyzing Industries and Competitors”Techniques for Analyzing Industries and Competitors”
Free PressFree Press

51. Questions?Questions?