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Readings. Readings. Baye 6 th edition or 7 th edition, Chapter 4. Overview. Overview. Overview. Consumer Optimum. Consumer Optimum. Consumer Optimum. Overview

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Readings

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  1. Readings • Readings • Baye 6th edition or 7th edition, Chapter 4 BA 445 Lesson A.6 Manipulating Others

  2. Overview • Overview BA 445 Lesson A.6 Manipulating Others

  3. Overview BA 445 Lesson A.6 Manipulating Others

  4. Consumer Optimum • Consumer Optimum BA 445 Lesson A.6 Manipulating Others

  5. Consumer Optimum Overview Consumer Optimum is when a consumer makes a rational choice (maximizes happiness) subject to a budget constraint on money or time. — So, customers optimize purchases and workers optimize leisure and work. BA 445 Lesson A.6 Manipulating Others

  6. Consumer Optimum Budget Line Y = 6 – (3/4)X Y Consider definitions for a simple budget constraint. Apples cost $3 each, oranges $4 each, and consumer income is $24. • Budget Set is the triangular set of consumption bundles of apples and oranges that are affordable: • 3X + 4Y 24 • Budget Line is the line of bundles that exhaust income: • 3X + 4Y = 24 • Or, Y = 6 – (3/4)X • Market Rate of Substitution is the slope of the budget line: -3/4 6 Budget Set 8 X BA 445 Lesson A.6 Manipulating Others

  7. Consumer Optimum Budget Line Y = M/PY – (PX/PY)X Y More generally, consider any two goods selling at positive prices Px and Py, and consumer income M. • Budget Set is the triangular set of consumption bundles of goods X and Y that are affordable: • PxX + PyYM • Budget Line is the line of bundles that exhaust income: • PxX + PyY = M • Or, Y = M/PY – (PX/PY)X • Market Rate of Substitution is the slope of the budget line: -Px / Py M/PY Budget Set M/PX X BA 445 Lesson A.6 Manipulating Others

  8. Consumer Optimum M1/PY M2/PY M2/PX M1/PX M0/PY M0/PX0 M0/PX1 Y M0/PY Graph changes in budget lines as parameters change: • Changes in Income: • Increases lead to a parallel, outward shift in the budget line (M1 > M0). • Decreases lead to a parallel, inward shift (M2 < M0). • Changes in Price: • Decreases in the price of good X rotates the budget line counter-clockwise (PX0 > PX1). • Increases in the price of good X rotates the budget line clockwise (not shown). X M0/PX Y X BA 445 Lesson A.6 Manipulating Others

  9. Consumer Optimum Consumer Optimum Y Consumer Optimum is when a consumer makes a rational choice (maximizes happiness) subject to a budget constraint. • Consumer optimum occurs where the slope of the indifference curve equals the slope of the budget line. • The Consumer would be happier with more consumption than the optimum, but that is unaffordable (it violates the budget constraint). Happier M/PY Happy Sad M/PX X BA 445 Lesson A.6 Manipulating Others

  10. Consumer Optimum M1/PY Y1 M0/PY Y0 M0/PX X0 X1 M1/PX • Normal Goods have increased consumption caused by an income increase. • Examples include steak, cars… • The movement from A to B is caused by an income increase. • Since the consumption of both goods increases, both goods are normal. Y B A X 0 BA 445 Lesson A.6 Manipulating Others

  11. Consumer Optimum M1/Y M0/Y Y0 M0/PX X0 M1/PX • Inferior Goods have decreased consumption caused by an income increase. • Examples include hot dogs, economy cars, … • The movement from A to B is caused by an income increase. • Since the consumption of good X decreases and good Y increases, good X is inferior and good Y is normal. Y B A X 0 BA 445 Lesson A.6 Manipulating Others

  12. Gross Substitutes and Complements • Gross Substitutes and Complements BA 445 Lesson A.6 Manipulating Others

  13. Gross Substitutes and Complements Overview Gross Substitutes and Complements combine substitution and income effects of a price increase for one good on the demand for another good. — So, they explain the affect of higher-priced housing on cars. BA 445 Lesson A.6 Manipulating Others

  14. Gross Substitutes and Complements Definitions for the effects of a price change • Gross Substitutes • An increase in the price of good X leads to an increase in the consumption of good Y. • Examples: • Coke and Pepsi. • Verizon Wireless or AT&T. • Beer and wine. • Gross Complements • An increase in the price of good X leads to a decrease in the consumption of good Y. • Examples: • DVD and DVD players. • Computer CPUs and monitors. • Beer and pretzels. BA 445 Lesson A.6 Manipulating Others

  15. Gross Substitutes and Complements Y2 II Y1 I X1 X2 M/PX2 Graphing Gross Substitute Goods When the price of good X falls (PX1 > PX2) and the consumption of Y falls, then X and Y are gross substitute goods. Wine (Y) M/PY1 A B 0 M/PX1 Beer (X) BA 445 Lesson A.6 Manipulating Others

  16. Gross Substitutes and Complements Y2 II Y1 I X1 X2 M/PX2 Graphing Gross Complement Goods When the price of good X falls (PX1 > PX2) and the consumption of Y rises, then X and Y are gross complement goods. Pretzels (Y) M/PY1 B A 0 M/PX1 Beer (X) BA 445 Lesson A.6 Manipulating Others

  17. Gross Substitutes and Complements Decomposition into Substitution and Income Effects • An increase in the price of Good X causes both a substitution effect and an income effect. • The substitution effect concerns finding the cheapest way to meet your needs (happiness, nutrition, …). Goods are • substitutes if an increase in price of X increases demand for Y • complements if an increase in price of X decreases demand for Y • The income effect concerns adjusting consumption to what you can afford. An increase in the price of Good X first causes a decrease in purchasing power. That is a decrease in your ability to purchase any good. • If Good Y is normal, then an increase in the price of Good X first causes a decrease in purchasing power, which then decreases demand for Y. • If Good Y is inferior, then an increase in the price of Good X first causes a decrease in purchasing power, which then increases demand for Y. BA 445 Lesson A.6 Manipulating Others

  18. Gross Substitutes and Complements Why not use the simplified definition of Substitutes and Complements? • Recall the simplified definition from an Introduction to Microeconomics is Good X and Good Y are • substitutesif an increase in price of X increases demand for Y • complementsif an increase in price of X decreases demand for Y • There are examples when that definition makes sense: • Apples and oranges: An increase in price of apples increases demand for oranges since consumers switch from one fruit to the cheaper fruit. • Sometimes that definition makes no sense: • Pepperdine and oranges: An increase in tuition at Pepperdine decreases demand for oranges since consumers can no longer afford fruit. Would you say Pepperdine and oranges are complements? • Pepperdine and Raman noodles: An increase in tuition at Pepperdine increases demand for noodles since consumers can no longer afford other food. Would you say Pepperdine and noodles are substitutes? BA 445 Lesson A.6 Manipulating Others

  19. Gross Substitutes and Complements • The Gross definition always makes sense • Example: Apples and oranges. An increase in price of apples increases demand for oranges in the substitution effect since consumers switch from one fruit to the cheaper fruit. But the increase in the price of apples causes only a small income effect. So the substitution effect dominates. Apples and oranges are substitutes and gross substitutes. BA 445 Lesson A.6 Manipulating Others

  20. Gross Substitutes and Complements • The Gross definition always makes sense • Example: Pepperdine and oranges. • An increase in tuition at Pepperdine causes only a small substitution effect on oranges since the two goods do not substitute or complement each other (not like Pepperdine and books, or Pepperdine and computers). • An increase in tuition at Pepperdine causes a large decrease in purchasing power. That is a decrease in your ability to purchase any good, including oranges. • So increase in tuition at Pepperdine decreases demand for oranges. Call the Pepperdine and oranges gross complements since the demand decrease for the second good is the combination of both the substitution effect and the income effect. BA 445 Lesson A.6 Manipulating Others

  21. Gross Substitutes and Complements • The Gross definition always makes sense • Example: Pepperdine and Raman noodles. • An increase in tuition at Pepperdine causes only a small substitution effect on Raman noodles since the two goods do not substitute or complement each other (not like Pepperdine and books, or Pepperdine and computers). • An increase in tuition at Pepperdine causes a large decrease in purchasing power. That is a decrease in your ability to purchase any good and the need to buy cheaper goods, like Raman noodles. • So increase in tuition at Pepperdine increases demand for Raman noodles. Call the Pepperdine and Raman noodles gross substitutes since the demand increase for the second good is the combination of both the substitution effect and the income effect. BA 445 Lesson A.6 Manipulating Others

  22. Gross Substitutes and Complements • The Gross definition always makes sense • Example: SoCal housing and cars: • An increase in SoCal housing causes only a small substitution effect on cars since the two goods do not substitute or complement each other (not like SoCal housing and furniture, or SoCal housing and Arizona housing). • An increase in price for SoCal housing causes a large decrease in purchasing power. That is a decrease in your ability to purchase any good, including cars. • So increase in price for SoCal housing decreases demand for cars. Call the SoCal housing and cars gross complements since the demand decrease for the second good is the combination of both the substitution effect and the income effect. BA 445 Lesson A.6 Manipulating Others

  23. Buy 1 Get 1 Free • Buy 1 Get 1 Free BA 445 Lesson A.6 Manipulating Others

  24. Buy 1 Get 1 Free OverviewBuy 1 Get 1 Free deals indirectly affect consumer optimum choices by manipulating their budget sets. — So, firms can manipulate customers to buy more. BA 445 Lesson A.6 Manipulating Others

  25. Buy 1 Get 1 Free • Why does Little Caesars Pizza offer two pizzas for the price of one? For example, buy one pizza for $10, get one pizza free. • Might some consumers be attracted by the idea of free pizza and buy more pizza on impulse? (An impulse buy is an unplanned decision to buy a product or service, made just before the purchase.) • Have you ever enjoyed making a carefree impulse buy? • Or, do you always satisfy economic assumptions and consider how a deal affects your budget set? • Is “buy one pizza for $10 get one pizza free” the same as buying pizza for $5 each? BA 445 Lesson A.6 Manipulating Others

  26. Buy 1 Get 1 Free All other goods 30 A I 1 2 0 3 4 Pizzas (in continuous units) • Buy one, get one free analysis: This deal can get customers to buy more pizza than cutting price in half. Consider budget lines and choices when Pizzas cost $10, all other goods cost $1 each, customer income is $30, and sample indifference curves I (sad) and II (happy). • With no deal (Pizza cost remains $10), • Budget line connects (3,0) and (0,30) • With buy one, get one free (Pizza cost $10) • Budget line segments connect (0,30), (1,20), (2,20), and (4,0) • Consumption A, with 2 Pizzas • Happiness level I. • With half price (Pizza cost $5), • Budget line has connects (6,0) and (0,30). • Consumption bundle B, with 1 pizza. • Happiness level II. B II 20 BA 445 Lesson A.6 Manipulating Others

  27. Quantity Discounts • Quantity Discounts BA 445 Lesson A.6 Manipulating Others

  28. Quantity Discounts OverviewQuantity Discounts manipulate customers’ budget sets. — So, firms can manipulate customers to spend more while receiving less quantity. BA 445 Lesson A.6 Manipulating Others

  29. Quantity Discounts • We considered buy one get one free, and showed how consumers can choose to consume more but be less happy than if price were reduced. • Buy X get Y free can likewise cause consumers to consume more but be less happy. Consider a frequent-flyer program of buy 8 flights get 1 flight free. BA 445 Lesson A.6 Manipulating Others

  30. Quantity Discounts • Buy one get the rest at half price can be even more effective for producers. When compared with reducing the price by half for all units, “buy one get the rest at half price” can cause consumers to • Consume less of the good • Spend more on the good BA 445 Lesson A.6 Manipulating Others

  31. Quantity Discounts All other goods 30 A I 1 0 3 4 Pizzas (in continuous units) • Buy one, get rest at half price analysis: This deal can get customers to spend more on less pizza than cutting the price for all units.Consider Pizza cost $10, all other goods cost $1 each, customer income is $30, and sample indifference curves I (sad) and II (happy). • With no deal (Pizza cost $10), • Budget line connects (0,30) and (3,0) • With buy one, get rest at half (Pizza cost $10 for first, then $5 for rest) • Budget line segments connect (0,30), (1,20), and (5,0) • Consumption A, with 2 Pizzas • Consumer spends $15 • With half price (Pizza cost $5 for each), • Budget line has intercepts (0,30) and (6,0). • Consumption bundle B, with 2.5 pizzas. • Consumer spends $12.5 B 20 II 2 BA 445 Lesson A.6 Manipulating Others

  32. Overtime Wages • Overtime Wages BA 445 Lesson A.6 Manipulating Others

  33. Overtime Wages OverviewOvertime Wages manipulate workers’ budget sets. — So, firms can manipulate workers to receive less income while working more hours. BA 445 Lesson A.6 Manipulating Others

  34. Overtime Wages • Buy one get the rest at half price or buy X get the rest at half price can be adapted to employees as overtime wages. The program is to offer work 8 hours a day at the normal wage rate and work hours beyond 8 at double the normal wage. The results of those overtime wages are similar to buy one get the rest at half price. When compared with doubling the wage for all hours worked, “work 8 hours at the normal wage and work the rest at double wages” can cause employees to • Work more hours • Receive less income BA 445 Lesson A.6 Manipulating Others

  35. Overtime Wages All goods other than leisure 480 A I 11 13 16 0 24 Leisure hours (in continuous units) • Overtime wage analysis: Employees have 24 hours per day to divide between leisure and work. Employees consume leisure and “all other goods”. Consider normal wage $10, all other goods cost $1 each, and sample indifference curves I (sad) and II (happy). • With no deal (wages $10), • Budget line connects (0,240) and (24,0) • Work 8, work rest at double wage (wages $10 for first 8 hours, then $20 for rest) • Budget line segments connect (0,400), (16,80), and (24,0) • Consumption A, with leisure 11 and work 13 • Consumer earns $180 = $10x8 + $20x5 • With double wage (wages $20), • Budget line has intercepts (0,480) and (24,0) • Consumption B, with leisure 13 and work 11 • Consumer earns $220 = $20x11 400 240 B II 80 BA 445 Lesson A.6 Manipulating Others

  36. Review Questions • Review Questions • You should try to answer some of the review questions (see the online syllabus) before the next class. • You will not turn in your answers, but students may request to discuss their answers to begin the next class. • Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exams. BA 445 Lesson A.6 Manipulating Others

  37. BA 445 Managerial Economics End of Lesson A.6 BA 445 Lesson A.6 Manipulating Others

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