Download Consumer Behavior, Consumption, and Consumers` Surplus

Consumer Behavior, Consumption, and Consumers' Surplus
A. The ``law of demand''
1. Why are demand curves downward sloping? This is not an axiom. It can not be proven
using alternative definitions of rationality. Instead it is an empiricl regularity. Both casual
observation and more rigorous statistical studies indicate that people buy more when the price is
less. Some might be tempted to argue that many consumers use price as an indicator of quality,
so that in the ``real world'' the law of demand is wrong: they observe that people buy more when
the price is higher. The problem with this contention is that it mixes up two concepts. The law of
demand simply says that individuals buy more of a specific commodity or service when the price
is less. The observation that people use price as an indicator of quality does not contradict this
contention. The observation that price and quality are positively correlated is perfectly
consistent with rational behavior and suggests that individuals prefer more quality to less.
2. What do economists mean by rational behavior? The assumptions underlying the
notion that the economy consists of ``rational'' agents are summarized on pages 44 - 45 of the
text. However, the most important one is the assumption that individuals prefer more to less.
Implicit in this assumption is the notion that ``human wants are insatiable-that there is no real
income so large that a (household) would not like more.'' But what about garbage or crime?
Individuals surely do not prefer more of these commodities or ``services.'' The notion that
individuals prefer more to less applies to those ``goods'' that increase individual well-being.
Economists would contend that garbage and crime are ``bads.'' For bads rationality dictates that
individuals prefer less to more. The significance of this assumption is that the tools of economic
analysis also can be applied (in reverse) to analyze issues in solid waste management and law
enforcement.1
3. Economists recognize that there exists substantial heterogeneity in the tastes of
individuals and households. This diversity means that household level demand curves also must
exhibit substantial variation. Some households' demand for freshly baked bread may be
extremely sensitive to changes in price, while others' demand is less sensitive. In studies of
household consumption behavior analysts often attempt to account for this variation in tastes by
stratifying households into different groups: gender of household head, number of children, age
of adults in the household, etc. The idea underlying this practice is that within these groupings
the variation in tastes is smaller than the variation in tastes among the groupings. Nevertheless,
a market demand curve is an aggregation of individual and household demand and its shape
reflects this underlying heterogeneity. In some applications studying the ``parameters'' of market
demand is adequate, while in others analysts will want to study demand at a more disaggregated
level.
B. How consumers respond to a changing economic environment
1. Demand depends on:
1. consumer or household tastes-which we hold constant.
2. Prices of product-which we allow to vary when drawing a demand curve.
3. Prices of other products-which we hold constant.
1
Social scientists who have systematically studied ``rationality'' have identified important
deviations from the behavior assumed by economists. Examples include, overconfidence,
misperception of chance (people do not know what random looks like, they see patterns where
none exist), loss aversion (experiments indicate that people feel the pain from a loss more than
the happiness from an equivalent gain), and framing (you alter choices people make by
presenting a problem differently so that people perceive gains and losses differently).
4. Income-which we hold constant.
As shown by Figure 3-1, (see Stigler, G., 1966, chapter three, distributed in class) the downward
sloping demand curve summarizes the relationship between the price of a product and the
amount purchased by the consumer or household. Divisibility does not prose a problem for the
analysis because few goods come in only one size or quality. In addition frequency of purchases
can be altered in response to changes in prices. The element of time can affect judgements about
consumers' price sensitivity (ie. the slope of demand curve.) Usually we expect that over a longer
time period consumers are more price sensitive. This idea is captured in Figure 3-2.
Another ambiguity concerns how we define price. A household's consumption decisions
depend not only the current price for the good, but also on its expectation about future prices.
Avid readers report that they do not buy hard cover editions of best sellers which are relatively
costly, but instead wait for the likely release of the cheaper paper back edition. For nondurable
products that do not store well such as fresh produce or restaurant prepared meals the question
of how to define price is less important when studying consumer demand. However, as the
products become more durable this issue becomes more important.
Even the consumption of goods which are defined in the National Income and Product
Accounts as non-durables, such as clothing, are affected by the way consumers form their price
expectations. In the case of clothing, this non-durable is relatively easy to store. Hence
consumers can buy this good during periods when the price is low. Many consumers prefer to
buy new clothing at the end of the ``season'' when retailers commonly mark down their prices
and then store the new clothing until the following year when the season returns. The ease or
cost that a good can be stored, either by the retailer or the consumer, affects how important the
formation of price expectations is in determining demand.
In general, when the formation of price expectations matters, we expect that the
short-run response of consumers to a price change is larger when they believe that the price
change is temporary. Under this scenario consumers alter the temporal pattern of their
consumption to ``take advantage'' of the temporarily low prices. By contrast, if consumers
believe the price change is permanent they are less likely to dramatically alter their temporal
consumption patterns. An interesting marketing device that retailers use to take advantage of
such behavior by consumers is the ``going out of business sale.'' Some carpet and furniture
dealers have developed a strategy of periodically announcing to the public that ``we are going
out of business, everything must go, no reasonable offer refused, prices may never be lower.''
While long-time residents of a community may not be fooled, the strategy apparently works!
Returning to Figure 3-1, because we assume economic agents prefer more to less, an
increase in income, shifts the demand curve to the right. This shift represents the idea that at
higher incomes, consumers are willing to purchase more goods at any given price. Technically,
this statement is not correct. As shown by Figure 3-3, it is possible to imagine goods for which the
consumption declines at higher incomes. Usually these examples make sense within product
categories, instead of across product categories. Americans when they are young and poor drink
``Bud'' or Miller beer. But as their incomes rise, their consumption of these products declines as
they prefer import or locally brewed beers. Therefore ``Bud'' is an inferior good (no pun
intended) because expenditure on it declines with income.
A similar ambiguity that arose with price also arises with our definition of income. Again
do we mean income this year, or expected future income, or income averaged over several years?
A useful analytical distinction is to treat a consumer's or household's income as consisting of a
permanent component and a transitory component. The permanent component is consumers'
expected income for the year based on their beliefs about future income. The transitory
component measures the ``shock'' or departure from this ``average'' or expected level of income.
Rational consumers should ignore this component of income when making consumption
decisions.2 Generally, we expect consumers' demand to depend on their permanent income not
their actual income. For example, a poor 25 year old graduate student should exhibit different
consumption levels than a poor unemployed 25 year old high school dropout.
2. Interactions Among Markets
Changes in the price of other products also affect the location of the demand curve. The
direction of the shift depends on whether the other products are ``substitutes'' or ``complements.''
Precise definitions of ``substitutes'' or ``complements'' are elusive. A substitute is a product that
can be used as an alternative to the commodity under study; a complement can be used together
with the commodity under study. At one level this definition seems simple enough: natural gas
and electricity are substitutes for heating oil; steak sauce and red wine are complements with
beef. Maxwell House coffee is a very close substitute with other brands of coffee, it is a less close
substitute to coffee sold in bulk, and even less so with other beverages such as tea, coke, and hot
chocolate.
Although these examples seem intuitively clear, other examples demonstrate the
ambiguity. Aluminum is a substitute for wood when choosing siding for your house, but it is not a
substitute with wood in the construction of aircraft or beverage containers. A tractor may be a
substitute for a horse when giving hay rides, but it is not a close substitute for a riding academy.
In practice, identifying substitutes requires a case by case analysis and some judgements about
the nature of consumer preferences.
o define cross elasticity of demand.
Application: Did health concerns change the relative consumption of chicken and beef?(See
discussion in text on pages 73 - 75).
(a) technological innovation in chicken production:
(i)
lowers the cost producers pay to produce chickens. This is represented by a
``leftward'' shift in supply.
(ii) Competition among producers lowers chicken prices to reflect lower costs.
(iii) Consumer purchase more chicken when the price falls
(b) If consumers view chicken and beef as substitutes, then at any given price, demand for
beef declines.
(c) Demand declines for products that are complements with beef: eg. steak sauce, red
wine.
(d) Demand rises for products that are complements with chicken: eg. rosemary, white
wine.
An example in which firms have taken into account consumer substitutes in the
implementation of their business strategies is seen in the retail grocery sector. New and
remodeled stores feature new configurations and departments that help the business segment its
2
However capital constraints in the financial market that prevent consumers from borrowing
against their future expected income would result in consumption being lower following a
``negative'' transitory income shock. Because consumers can always save, we would not expect a
``positive'' transitory income shock to raise consumption.
market and ``compete'' with other non-grocery establishments. In these stores, deli, fast food,
bakery departments are featured in the front of the store. Usually one of these departments sells
freshly brewed premium quality coffee. Why have grocers made these changes? To complete
with 7-11, Dunken Donuts, and restaurants. They locate these services near the entrance with
separate checkout to facilitate consumer convenience. One of the fastest growing services in
retail grocery establishments is home meal replacement (HMR). The purpose of this development
is to the use the store's scale economies to provide consumers with substitute goods to those
provided by restaurants.
Discussion Questions:
1. Is a Cadillac or Lexus cheaper for a professor than for a poor student?
2. During the last 40 years, the price of higher education has increased by more than most other
goods. But the percentage of college age people going to college also has increased. Together
these two observations appear to contract the ``law of demand.''
3. During the 1970s a Presidential Commission on consumer products safety concluded that
there was much more that children's toy manufacturers could do to improve the safety of toys ``at
little or no additional costs.'' Suppose that this conclusion was correct. What does it indicate about
consumers' demand for safety in children's toys? Where must the economy have been on the
demand curve for safety?
4. True, False, or Uncertain: Simultaneous increases in the first class postal rate from $0.32 to
$0.42 and the priority mail rate from $2.90 to $3.00 will leave unaltered the proportion in which
these two types of mail are ``consumed.''
5. How would the convenience associated with purchasing a good or service, affect the demand
curve? Consider Application 4-1 in the text on page 142. One of Walgreens' biggest midwest
competitors is Osco operated by retail giant, American Stores. Some Osco stores are ``stand
alone'' facilities that carry the same products as Walgreens, but most are located in the retailers'
large grocery outlets. Discuss the pros and cons of these differing location strategies on
consumer demand.
6. What is the connection between a consumers' wage rate and the position of their demand
curve for a product? Consider Application 4-2 in the text on pages 152 - 153. Under what
circumstances is the wage rate likely to be an important determinate of demand? (See also
discussion on pages 153 - 154; 159 - 162 in the text.)
C. Substitution and income effects
It is often helpful to decompose consumers' response to a price change into two parts.
When the price of a product declines we expect consumers to purchase more it for two reasons:
First, consumers substitute away from other products (whose relative price has risen) and
purchase more of the commodity whose price declined. This response is known as the
``substitution effect.'' Second, because the price has fallen the consumer is now richer. They can
purchase as much of the commodity as they did before and still have some money (income) left
over. Because they are ``richer'' they should want to buy more of all (normal) goods. The
response is known as the ``income effect.'' Notice that this second response provides an additional
reason why consumption increases for the commodity whose price has fallen. But the income
effect causes the consumption change for the substitute products to be ambiguous. For these
other products the substitution effect is ``negative,'' but the income effect is ``positive.''
As an application consider the consequences of moving from a protected to an open
market in automobiles. One benefit of free trade is that foreign producers discipline domestic
producers pricing practices. Some studies suggest that competition from Japanese auto makers
has reduced prices paid for automobiles in the U.S. by an average of approximately $2,000. One
way to think about this ``income effect'' caused by lower automobile prices is that consumers can
use these savings to consume more goods and services. One option for them is to purchase higher
quality cars. Another option is to purchase more of all other goods and services. This change in
consumption patterns is associated with a rightward shift in demand in other sectors of the
economy.
One consequence of this shift often not acknowledged by critics of freer trade is that the
job loss associated with liberalized trade in the automobile sector is offset by job gains in other
sectors of the economy. Why does employment increase elsewhere? To met the increased demand
by consumers in those sectors of the economy. In fact assertions by political leaders to the
contrary, the expected net job loss or gain associated trade liberalization is zero. (Indeed estimates
that have appeared in the press recently purporting to estimate the impact of NAFTA on
employment in the U.S. are probably nonsense.)
o also consider product entry effects: eg. switching from Pepsi to Coke.
D. Consumers' surplus and Policy Analysis
Every consumer purchase is a ``bargain.'' As indicated earlier in the course, when a
consumer buys a good or service we know that the value placed on that good by the consumer is
equal to or exceeds the price. Otherwise no transaction would occur! For the ``marginal''
consumer this gap is likely to be small so that the price paid is a good approximation of the value
of the product to the consumer. However, many if not most consumers are ``inframarginal''
consumers. For these individuals the gap between the value of the product and the price paid
may be substantial. A useful concept that characterizes this gap is known as consumers' surplus.
It is the difference between the demand for the product-the value placed on the product-and the
price paid.
Why does anyone care about consumers' surplus? First, from the perspective of a business
such knowledge is useful when negotiating with a buyer or if the firm wants to segment its
markets. Second, from the perspective of government policy makers knowledge about consumers
surplus is essential for understanding the ``welfare'' consequences of differently regulatory
interventions in the economy.
Lets begin by considering a policy application: the case of agricultural price supports.
This government policy establishes a minimum and often described ``fair'' price that farmers
receive for their produce. To ensure that there is enough ``demand'' for their product, the
government serves as the buyer of last report. A consequence of this policy is that agricultural
products pile up in government warehouses. How would we analyze the impact of this policy on
the well-being of consumers and other agents in the economy?
Consider the figure discussed in lecture. In the absence of government price supports,
competitive forces ensure that the market price is P0 and the quantity produced and consumed is
Q0. The government sets a price of PM for the agricultural commodity. Consumers respond by
buying less and their consumption falls to QM. Notice that consumers are made unambiguously
worse off from the policy; the lost consumers' surplus is area A + B. This is the amount that
consumers should be willing to pay (eg. political contributions to their Congressmen) to end this
policy.
Farmers are unambiguously better off as a result of this policy. Notice that as a result of
the price support PM their incentives to produce increase. Instead of producing enough to
``meet'' consumer demand, QM , they expand their production to QG. Why? Because at the higher
price, their supply curve indicates that they can make a profit by producing more. The difference
between QG and QM is the amount of the commodity that piles up in government warehouses or
that the government simply has to destroy. The rectangle gives the ``fiscal'' cost to the
government of buying the excess production. In the past governments have avoided the cost of
storing this excess by literally paying farmers not to harvest their crops!
So far this example has established that price supports make consumers worse off and
farmers better off. What about the economy as a whole? It is not hard to imagine that a policy
that causes governments to pay farmers not to harvest crops already in the ground can not be
very efficient. However, from the diagram we can see that consumers simply do not value the
additional output. To generate the additional output, resources are taken from more ``valued''
uses in other sectors of the economy (eg. the farm land could be used to build a shopping mall).
Area C, the gap between supply and demand measures the social cost of diverting resources into
agriculture and producing more output.
Next, consider the case of a price ``ceiling.'' In this instance the government sets a
maximum price for a product. A common example of this practice in industrialized economies is
rent control. Where this practice occurs, land owners are prohibited from relying on market
forces to set their rents. As shown by the diagram, the price ceiling causes landlords to make
fewer rental units available. Because consumers on the ``margin'' value these units at more than
their cost, housing markets with rent controls are usually characterized by shortages and having
to pay a higher fees to real estate brokers to find vacant apartments. Indeed, given the stock of
units available at the controlled price, QR, consumers would be willing to pay, P* for rent. The
implications of this gap is that competition among potential renters causes this difference, P* PR to be spent by consumers in the process of acquiring and retaining a rent controlled
apartment.
Who benefits from this policy? Basically older folks. Area A in the diagram represents the
total (monthly) savings to consumers who live in a rent control apartment. Newer renters do not
benefit because as suggested above they have spent up to A + B to secure an apartment. These
renters are worse off by an amount equal to area B. (Do you understand that if you know the
``slope'' of the demand curve you can estimate this amount?). But there are two other groups that
are worse off. First, those individuals who would have rented (Q0 - QR ) but do not because of the
``higher'' price. They are made worse off by an amount equal to area C. In other words this group
would be willing to pay an amount up to area C to see rent controls ended. Finally, the last
victims of rent control are the landlords. They lose an amount equal to A + D. On balance, it is
easy to see that society pays a high price for this policy in order to provide a benefit to a few
consumers. The concept of consumers' surplus should become clearer after considering some
more examples.
Discussion Questions:
7. The famous Chicago Fire of 1871 is alleged to have destroyed one half of the city's residential
housing and commercial buildings. Surprisingly, the value of the surviving buildings probably
exceeded the value of all existing buildings prior to the fire. Does this outcome demonstrate the
irrationality of the price system, in which values rise despite a great calamity?3
8. Chicago's O'Hare International Airport opened in 1958. Prior to that the land had been used
by Douglas Aircraft to produce and test aircraft for the war effort and for a smaller facility
known as Orchard Park Airport. (Trivia: This is why the official airline destination code for
Chicago is ORD). Chicago has been the leading transportation center in the United States for
3 Several discussion questions in this lecture are from McCloskey, D., The Applied Theory of
Price, 2nd ed., New York: Macmillion Publishing Co., 1986.
more than a century and therefore it is no surprise that in any given year O'Hare Airport is
usually the ``busiest in the world.'' Despite this history, it probably should not surprise us to learn
that homeowners in the area complain about the noise from the airport. They argue that the
noise lowers their property values and that they should be compensated monetarily for this loss.
Evaluate the homeowners' claim.
9. As indicated in the previous lectures, the U.S. has its own anti-competitive agricultural policies.
One example of such a policy is the sugar quota that prevents U.S. producers and consumers
from buying sugar at the world price. Past estimates suggest that as a result of this import quota,
U.S. citizens pay up to 4 times the world price for sugar. A similar example arises in Japan with
rice. There the quota has even been rationalized by government bureaucrats as a way of
protecting the palettes of its citizens and preventing inferior (mostly U.S.) rice from entering the
country. Another more common rationalization of such agricultural policies which also is used in
the U.S. is that they ``protect a way of life.'' Who are the winners and losers in the U.S. and
Japan from the quotas on sugar and rice? How much does society pay to ``protect a way of life?''
10. Consider extending the analysis in the previous question to analyze the effect of the sugar
quotas on the corn syrup industry. Corn syrup is a sweetener that often is used as a substitute
for sugar. How would the sugar quota affect this industry? How does the existence of a
substitute for sugar affect your calculation of the social cost associated with the sugar quota?
How much should a company like Archer Daniels Midland that produces corn syrup be
willing to pay to keep sugar quotas?
Footnote
Social scientists who have systematically studied ``rationality'' have identified important
deviations from the behavior assumed by economists. Examples include, overconfidence,
misperception of chance (people do not know what random looks like, they see patterns where
none exist), loss aversion (experiments indicate that people feel the pain from a loss more than
the happiness from an equivalent gain), and framing (you alter choices people make by
presenting a problem differently so that people perceive gains and losses differently).
2
However capital constraints in the financial market that prevent consumers from borrowing
against their future expected income would result in consumption being lower following a
``negative'' transitory income shock. Because consumers can always save, we would not expect a
``positive'' transitory income shock to raise consumption.
3
Several discussion questions in this lecture are from McCloskey, D., The Applied Theory of
Price, 2nd ed., New York: Macmillion Publishing Co., 1986.