Go Global !Go Global !Managerial Economics :Managerial Economics :Individual & Market Individual & Market DemandDemand

By

Stephen OngStephen OngVisiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City UniversityVisiting Professor, College of Management, Visiting Professor, College of Management,

Shenzhen UniversityShenzhen UniversityMay 2013May 2013

AgendaAgenda

1.1. Theory of DemandTheory of Demand

2.2. Income and Income and Substitution EffectsSubstitution Effects

3.3. Consumer PreferencesConsumer Preferences

Learning ObjectivesLearning Objectives1.1.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 the To determine the market demand curve from the aggregation of individual demand curves aggregation of individual demand curves

4.4. To show how market demand curves can be used to To show how market demand curves can be used to measure the benefits that people receive when they measure the benefits that people receive when they consume products, above and beyond the expenditures consume products, above and beyond the expenditures they make.they make.

5.5. To describe the effects of To describe the effects of network externalitiesnetwork externalities—i.e., what —i.e., what happens when a person’s demand for a good also depends happens when a person’s demand for a good also depends on the demands of on the demands of otherother people. people.

6.6.To describe some of the methods that economists use to To 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 behavioural To understand consumer preferences through behavioural economics.economics.

11Theory of DemandTheory of Demand

Individual DemandIndividual DemandPrice 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 PRICE EFFECT OF PRICE CHANGESCHANGES

Price-consumption curve Price-consumption curve Curve tracing the utility-maximizing combinations of two goods Curve tracing the utility-maximizing combinations of two goods as the price of one changes.as the price of one changes.

Individual demand curve Individual demand curve Curve relating the quantity of a good that a single consumer will Curve 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 we The 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 is At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the maximizing utility by satisfying the condition that the marginal rate of substitution (MRS) of food for clothing marginal rate of substitution (MRS) of food for clothing equals the ratio of the prices of food and clothing.equals the ratio of the prices of food and clothing.

Income ChangesIncome ChangesIncome-consumption curve Income-consumption curve Curve tracing the utility-maximizingCurve tracing the utility-maximizingcombinations of two goods as a consumer’s income changes.combinations of two goods as a consumer’s income changes.

EFFECT OF EFFECT OF INCOME CHANGESINCOME CHANGESAn 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.)

Normal versus Inferior GoodsNormal versus Inferior GoodsAN INFERIOR AN INFERIOR

GOODGOODAn 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.

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 curve Engel curve Curve relating the quantity of a good consumed to income.Curve relating the quantity of a good consumed to income.

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 ANDABOVE

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 groups We can derive Engel curves for groups of consumers. This information is of consumers. This information is particularly useful if we want to see how particularly useful if we want to see how consumer spending varies among consumer spending varies among different income groups.different income groups.

Average per-household Average per-household expenditures on rented expenditures on rented dwellings, health care, and dwellings, health care, and entertainment are plotted as entertainment are plotted as functions of annual income.functions of annual income.

Health care and Health care and entertainment are normal entertainment are normal goods, as expenditures goods, as expenditures increase with income.increase with income.

Rental housing, however, Rental housing, however, is an inferior good for is an inferior good for incomes above $30,000.incomes above $30,000.

ENGEL CURVES ENGEL CURVES FOR U.S. FOR U.S. CONSUMERSCONSUMERS

CONSUMER EXPENDITURES IN THE UNITED STATESCONSUMER EXPENDITURES IN THE UNITED STATES

Substitutes and ComplementsSubstitutes and Complements

• Two goods are Two goods are substitutessubstitutes if an increase in the if an increase in the price of one leads to an increase in the quantity price of one leads to an increase in the quantity demanded of the other.demanded of the other.

• Two goods are Two goods are complementscomplements if an increase in the if an increase in the price of one good leads to a decrease in the price of one good leads to a decrease in the quantity demanded of the other.quantity demanded of the other.

• Two goods are Two goods are independentindependent if a change in the if a change in the price of one good has no effect on the quantity price of one good has no effect on the quantity demanded of the other.demanded of the other.

• The fact that goods can be complements or The fact that goods can be complements or substitutes suggests that when studying the substitutes suggests that when studying the effects of price changes effects of price changes in one market, it may be in one market, it may be important to look at the consequences in related important to look at the consequences in related markets.markets.

22Income & Substitution Income & Substitution

EffectsEffects

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 good Consumers will tend to buy more of the good that has become cheaper and less of those that 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 prices This response to a change in the relative prices

of goods is called of goods is called the the 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 purchasing consumers enjoy an increase in real purchasing power. power. The change in demand resulting from this The change in demand resulting from this

change in real purchasing power is called change in real purchasing power is called the the income effect.income effect.

Income and Substitution EffectsIncome and Substitution Effects

Substitution EffectSubstitution Effect

Substitution effect Substitution effect Change in consumption of a good associated with a Change in consumption of a good associated with a change in its price, with the level of utility held change in its price, with the level of utility held constant.constant.

Income EffectIncome EffectIncome effect Income effect Change in consumption of a good resulting from an increase Change 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 given The total effect of a change in price is given theoretically by the sum of the substitution effect and theoretically by the sum of the substitution effect and the income effect:the income effect:

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.

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.

UPWARD-SLOPING DEMAND UPWARD-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 GoodGiffen good Giffen good Good whose demand curve slopes upward becauseGood whose demand curve slopes upward becausethe (negative) income effect is larger than the substitution effect.the (negative) income effect is larger than the substitution effect.

THE EFFECTS OF A GASOLINE TAXTHE EFFECTS OF A GASOLINE TAXEFFECT OF A GASOLINE EFFECT OF A GASOLINE TAX WITH A REBATETAX WITH A REBATE

A gasoline tax is imposed A gasoline tax is imposed when the consumer is initially when the consumer is initially buying 1200 gallons of buying 1200 gallons of gasoline at point gasoline at point CC. .

After the tax takes effect, the After the tax takes effect, the budget line shifts from budget line shifts from ABAB to to ADAD and the consumer and the consumer maximizes his preferences by maximizes his preferences by choosing E, with a gasoline choosing E, with a gasoline consumption of 900 gallons. consumption of 900 gallons.

However, when the proceeds However, when the proceeds of the tax are rebated to the of the tax are rebated to the consumer, his consumption consumer, his consumption increases somewhat, to 913.5 increases somewhat, to 913.5 gallons at H. gallons at H.

Despite the rebate program, Despite the rebate program, the consumer’s gasoline the consumer’s gasoline consumption has fallen, as consumption has fallen, as has his level of satisfaction.has his level of satisfaction.

MMarket demand curvearket demand curveCurve relating the quantity of a good that all consumers in a market Curve 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)INDIVIDUAL INDIVIDUAL

CC

(UNITS)(UNITS)

(5)(5)MARKET MARKET

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

SUMMING TO OBTAIN A MARKET SUMMING 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).

The aggregation of individual demands into The aggregation of individual demands into market becomes important in practice when market becomes important in practice when market demands are built up from the demands market demands are built up from the demands of of different demographic different demographic groups or from groups or from consumers located in consumers located in different areasdifferent areas..

Two points should be noted:Two points should be noted:

1.1. The market demand curve will shift to the The market demand curve will shift to the right as right as more consumers more consumers enter the market.enter the market.

2.2. Factors that influence the demands Factors that influence the demands of of many consumers will also affect market many consumers will also affect market demand.demand.

THE DEMAND FOR HOUSINGTHE DEMAND FOR HOUSINGThere are significant There are significant differences in price and differences in price and income elasticities of housing income elasticities of housing demand among subgroups of demand among subgroups of the population.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 household Married, 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 partly In recent years, the demand for housing has been partly driven by driven by speculative demandspeculative demand. Speculative demand is . Speculative demand is driven not by the direct benefits one obtains from owning a driven not by the direct benefits one obtains from owning a home but instead by an expectation that the price will home but instead by an expectation that the price will increase.increase.

THE LONG-RUN DEMAND FOR GASOLINETHE LONG-RUN DEMAND FOR GASOLINE

Would higher gasoline Would higher gasoline prices reduce gasoline prices reduce gasoline consumption? consumption?

GASOLINE PRICES GASOLINE PRICES AND PER CAPITA AND PER CAPITA CONSUMPTION IN 10 CONSUMPTION IN 10 COUNTRIESCOUNTRIESThe graph plots per capita The graph plots per capita consumption of gasoline consumption of gasoline versus the price per gallon versus the price per gallon (converted to U.S. dollars) (converted to U.S. dollars) for 10 countries over the for 10 countries over the period 2008 to 2010. Each period 2008 to 2010. Each circle represents the circle represents the population of the population of the corresponding country.corresponding country.

Consumer surplusDifference 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

CONSUMER CONSUMER SURPLUS SURPLUS GENERALIZEDGENERALIZED

For the market as a whole, For the market as a whole, consumer surplus is measured consumer surplus is measured by the area under the demand by the area under the demand curve and above the line curve and above the line representing the purchase price representing the purchase price of the good. of the good.

Here, the consumer surplus is Here, the consumer surplus is given by the yellow-shaded given by the yellow-shaded triangle and is equal to 1/2 triangle and is equal to 1/2 ($20 − $14) ($20 − $14) 6500 = $19,500. 6500 = $19,500.

APPLYING CONSUMER SURPLUSAPPLYING CONSUMER SURPLUS

Consumer surplus has important applications in economics. When added over many Consumer surplus has important applications in economics. When added over many individuals, it measures the aggregate benefit that consumers obtain from buying goods individuals, it measures the aggregate benefit that consumers obtain from buying goods in a market. When we combine consumer surplus with the aggregate profits that in a market. When we combine consumer surplus with the aggregate profits that producers obtain, we can evaluate both the producers obtain, we can evaluate both the costs and benefits costs and benefits not only of alternative not only of alternative market structures, but of public policies that alter the behaviour of consumers and firms market structures, but of public policies that alter the behaviour of consumers and firms in those markets.in those markets.

THE VALUE OF CLEAN AIRTHE VALUE OF CLEAN AIR

VALUING CLEANER AIRVALUING CLEANER AIR

The yellow-shaded The yellow-shaded triangle gives the triangle gives the consumer surplus consumer surplus generated when air generated when air pollution is reduced by 5 pollution is reduced by 5 parts per 100 million of parts per 100 million of nitrogen oxide at a cost nitrogen oxide at a cost of $1000 per part of $1000 per part reduced. reduced.

The surplus is created The surplus is created because most because most consumers are willing to consumers are willing to pay more than $1000 for pay more than $1000 for each unit reduction of each unit reduction of nitrogen oxide.nitrogen oxide.

Although there is no actual market for Although there is no actual market for clean air, people do pay more for houses clean air, people do pay more for houses where the air is clean than for where the air is clean than for comparable houses in areas with dirtier comparable houses in areas with dirtier air.air.

NNetwork externalityetwork externalityWhen each individual’s demand depends on When each individual’s demand depends on the purchases of other individuals.the purchases of other individuals.

Network ExternalitiesNetwork Externalities

Positive Network Externalities

A A positivepositive network externality exists network externality exists if the quantity of a if the quantity of a good demanded by a typical consumer increases in good 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 a the quantity demanded decreases, there is a negative negative network externality.network externality.

BBandwagon effectandwagon effectPositive network externality in which a consumer Positive network externality in which a consumer wishes to possess a good in part because others wishes to possess a good in part because others do.do.

POSITIVE POSITIVE NETWORK NETWORK EXTERNALITYEXTERNALITYWith a positive network With a positive network externality, the quantity externality, the quantity of a good that an of a good that an individual demands individual demands grows in response to grows in response to the growth of the growth of purchases by other purchases by other individuals. individuals.

Here, as the price of Here, as the price of the product falls from the product falls from $30 to $20, the $30 to $20, the bandwagon effect bandwagon effect causes the demand causes the demand for the good to shift for the good to shift to the right, from to the right, from DD4040

to to DD8080..

NEGATIVE NETWORK NEGATIVE NETWORK EXTERNALITY: SNOB EFFECTEXTERNALITY: SNOB EFFECT

Negative Network ExternalitiesNegative Network ExternalitiesSSnob effectnob effectNegative network externality in which a consumer wishes to own an Negative network externality in which a consumer wishes to own an

exclusive or unique good.exclusive or unique good.

The snob effect is a negative The snob effect is a negative network externality in which network externality in which the quantity of a good that the quantity of a good that an individual demands falls an individual demands falls in response to the growth of in response to the growth of purchases by other purchases by other individuals.individuals.

Here, as the price falls from Here, as the price falls from $30,000 to $15,000 and more $30,000 to $15,000 and more people buy the good, the people buy the good, the snob effect causes the snob effect causes the demand for the good to shift demand for the good to shift to the left, from to the left, from DD22 to to DD66..

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 crucial Network externalities have been crucial drivers for many modern technologies drivers for many modern technologies over many years.over many years.

By early 2011, with over 600 million users, By early 2011, with over 600 million users, Facebook became the world’s second most Facebook became the world’s second most visited website (after Google). A strong positive visited website (after Google). A strong positive network externality was central to Facebook’s network externality was central to Facebook’s success.success.

THE DEMAND FOR READY-TO-EAT THE DEMAND FOR READY-TO-EAT CEREALCEREALThe acquisition of Shredded Wheat cereals of NabiscoThe acquisition of Shredded Wheat cereals of Nabiscoby Post Cereals raised the question of whether Postby Post Cereals raised the question of whether Postwould raise the price of Grape Nuts, or the price ofwould raise the price of Grape Nuts, or the price ofNabisco’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 wereclose substitutes for one another. If so, it would be moreclose substitutes for one another. If so, it would be moreprofitable for Post to increase the price of Grape Nuts profitable 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 lostsales from consumers who switched away from Grape Nuts sales from consumers who switched away from Grape Nuts would be recovered to the extent that they switched to the would be recovered to the extent that they switched to the substitute product.substitute product.

The substitutability of Grape Nuts and Shredded Wheat can The substitutability of Grape Nuts and Shredded Wheat can be measured by the cross-price elasticity of demand for be measured by the cross-price elasticity of demand for Grape Nuts with respect to the price of Shredded Wheat. Grape Nuts with respect to the price of Shredded Wheat.

The demand for Grape Nuts is elastic, with a The demand for Grape Nuts is elastic, with a price elasticity of about −2. Income elasticity is price elasticity of about −2. Income elasticity is 0.62. the cross-price elasticity is 0.14. The two 0.62. the cross-price elasticity is 0.14. The two cereals are not very close substitutes.cereals are not very close substitutes.

Interview and Experimental Approaches Interview 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 information This 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 to In direct marketing experiments, actual sales offers are posed to potential customers. An airline, for example, might offer a reduced price potential customers. An airline, for example, might offer a reduced price on certain flights for six months, partly to learn how the price change on certain flights for six months, partly to learn how the price change affects demand for flights and partly to learn how competitors will affects 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 value with some potential customers being given coupons ranging in value from 25 cents to $1 per box. The response to the coupon offer tells the from 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, problems Direct experiments are real, not hypothetical, but even so, problems remain. The wrong experiment can be remain. The wrong experiment can be costlycostly, and the firm cannot be , and the firm cannot be entirely sure that these increases resulted from the experimental entirely sure that these increases resulted from the experimental change; other factors probably changed at the same time. Moreover, the change; other factors probably changed at the same time. Moreover, the response to experiments—which consumers often recognize response 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 a firm can afford to try only a limitedlimited number of experiments. number of experiments.

33Consumer PreferencesConsumer Preferences

An increase in the price of a good based not on the An increase in the price of a good based not on the fundamentals of demand or value, but instead on a belief fundamentals 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. People Bubbles are often the result of irrational behaviour. People stop thinking straight.stop thinking straight.

During 1995 to 2000, many investors (perhaps During 1995 to 2000, many investors (perhaps “speculators” is a better word) bought the stocks “speculators” is a better word) bought the stocks of Internet companies at very high prices, prices of Internet companies at very high prices, prices that were increasingly difficult to justify based on that were 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 price The United States experienced a prolonged housing price bubble that burst in 2008, causing financial losses to large bubble that burst in 2008, causing financial losses to large banks. By the end of 2008, the United States was in its worst banks. By the end of 2008, the United States was in its worst recession since the Great Depression of the 1930s. The recession since the Great Depression of the 1930s. The housing price bubble, far from harmless, was partly to blame housing price bubble, far from harmless, was partly to blame for this.for this.

BubblesBubbles

THE HOUSING PRICE BUBBLE (I)THE HOUSING PRICE BUBBLE (I)

S&P/CASE-SHILLER S&P/CASE-SHILLER HOUSING PRICE INDEXHOUSING PRICE INDEX

The Index shows the The Index shows the average home price average home price in the United States at in the United States at the national level. the national level. Note the increase in Note the increase in the index from 1998 the index from 1998 to 2007, and then the to 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 housing many people bought into the myth that housing was a sure-fire investment, and that prices could was a sure-fire investment, and that prices could only keep going up. Many banks also bought into only keep going up. Many banks also bought into this myth. The demand for housing increased this myth. The demand for housing increased sharply, with some people buying four or five sharply, with some people buying four or five houses. This speculative demand served to push houses. This speculative demand served to push prices up further. By 2010, housing prices had prices up further. By 2010, housing prices had fallen over 28% from their 2007 peak.fallen over 28% from their 2007 peak.

Informational CascadesInformational Cascades

The bubble that results from an informational cascade can The bubble that results from an informational cascade can in fact be rational in the sense that there is a basis for in fact be rational in the sense that there is a basis for believing that investing in the bubble will yield a positive believing that investing in the bubble will yield a positive return. return.

The reason is that if investors early in the chain The reason is that if investors early in the chain indeed obtained positive information and based indeed obtained positive information and based their decisions on that information, their decisions on that information, the expected the expected gain to an investor down the chain will be gain 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 will and it is likely that at least some investors will underestimate that risk.underestimate that risk.

Informational cascadesInformational cascadesAn assessment (e.g., of an investment An assessment (e.g., of an investment opportunity) based in part on the actions of opportunity) based in part on the actions of others, which in turn were based on the others, which in turn were based on the actions of others.actions of others.

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 that Rational or not, investors should have known that considerable risk was involved in buying real considerable risk was involved in buying real estate there (or elsewhere in Florida, Arizona, estate there (or elsewhere in Florida, Arizona, Nevada, and California). Looking back, we now Nevada, and California). Looking back, we now know that many of these investors lost their shirts know that many of these investors lost their shirts (not to mention their homes).(not to mention their homes).

S&P/CASE-SHILLER HOUSING S&P/CASE-SHILLER HOUSING PRICE INDEX FOR FIVE CITIESPRICE INDEX FOR FIVE CITIES

The Index shows the average home The Index shows the average home price for each of five cities (in price for each of five cities (in nominal terms). nominal terms). For some cities, the For some cities, the housing bubble was much worse housing bubble was much worse than for others. Los Angeles, Miami, than for others. Los Angeles, Miami, and Las Vegas experienced some of and Las Vegas experienced some of the sharpest increases in home the sharpest increases in home prices, and then starting in 2007, prices, and then starting in 2007, prices plummeted.prices plummeted. Cleveland, on the Cleveland, on the other hand, largely avoided the other hand, largely avoided the bubble, with home prices increasing, bubble, with home prices increasing, and then falling, only moderately.and then falling, only moderately.

Recall that the basic theory of consumer demand is based on three Recall that the basic theory of consumer demand is based on three assumptions: assumptions:

(1)(1) consumers have consumers have clear preferences clear preferences for some goods for some goods over others; over others;

(2)(2) consumers face consumers face budget constraintsbudget constraints; and ; and

(3)(3) given their preferences, limited incomes, and the prices given their preferences, limited incomes, and the prices of different goods, consumers choose to buy of different goods, consumers choose to buy combinations of goods that combinations 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 the Perhaps our understanding of consumer demand (as well as the decisions of firms) would be improved if we incorporated more realistic decisions 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

Here are some examples of consumer behaviour that cannot beHere are some examples of consumer behaviour that cannot beeasily explained with the easily explained with the basic utility-maximizing assumptionsbasic utility-maximizing assumptions::

• There has just been a big snowstorm, so you stop at the There has just been a big snowstorm, so you stop at the hardware store to buy a snow shovel. You had expected to hardware store to buy a snow shovel. You had expected to pay $20 for the shovel—the price that the store normally pay $20 for the shovel—the price that the store normally charges. However, you find that the store has suddenly charges. However, you find that the store has suddenly raised the price to $40. Although you would expect a price raised the price to $40. Although you would expect a price increase because of the storm, you feel that a doubling of increase because of the storm, you feel that a doubling of the price is unfair and that the store is trying to take the 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 a Tired of being snowed in at home you decide to take a vacation in the country. On the way, you stop at a highway vacation in the country. On the way, you stop at a highway restaurant for lunch. Even though you are unlikely to return restaurant for lunch. Even though you are unlikely to return to that restaurant, you believe that it is fair and appropriate to that restaurant, you believe that it is fair and appropriate to leave a 15-percent tip in appreciation of the good service to 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 because You 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 comparing However, you ignore the shipping cost when comparing prices.prices.

Reference Points and Consumer PreferencesReference Points and Consumer Preferences

Reference point Reference 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 they Tendency 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 over Tendency for individuals to prefer avoiding losses over acquiring gains.acquiring gains.

Tendency to rely on the context in which a choice is Tendency 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

SELLING A HOUSESELLING A HOUSEHomeowners can get a good idea of what the house will sell for by Homeowners can get a good idea of what the house will sell for by looking at the selling prices of comparable houses, or by talking with looking at the selling prices of comparable houses, or by talking with a realtor. Often, however, the owners will set an asking price that is a realtor. Often, however, the owners will set an asking price that is well above any realistic expectation of what the house can actually well 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 months As a result, the house may stay on the market for many months before the owners grudgingly lower the price. During that time the before 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 asking utilities, 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?

The The endowment effect endowment effect is at work here. The homeowners view their is at work here. The homeowners view their house as special; their ownership has given them what they think is house as special; their ownership has given them what they think is a special appreciation of its value—a value that may go beyond any a 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 aversion loss aversion could also be at could 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 the into a loss that is real. Averting that reality may explain the reluctance of home owners to take that final step of selling their reluctance of home owners to take that final step of selling their home. It is not surprising, therefore, to find that houses tend to stay home. 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.

FairnessFairnessDEMAND FOR DEMAND FOR SNOW SHOVELSSNOW SHOVELS

Demand curve Demand curve DD11 applies during applies during normal weather. Stores have normal weather. Stores have been charging $20 and sell been charging $20 and sell QQ11 shovels per month.shovels per month.When a snowstorm hits, the When a snowstorm hits, the demand curve shifts to the demand curve shifts to the right. right. Had the price remained $20, the Had the price remained $20, the quantity demanded would have quantity demanded would have increased to increased to QQ22. . But the new demand curve (But the new demand curve (DD22) ) does not extend up as far as the does not extend up as far as the old one. Consumers view an old one. Consumers view an increase in price to, say, $25 as increase in price to, say, $25 as fair, but an increase much fair, but an increase much above that as unfair gouging.above that as unfair gouging.The new demand curve is very The new demand curve is very elastic at prices above $25, and elastic at prices above $25, and no shovels can be sold at a price no shovels can be sold at a price much above $30.much above $30.

Tendency to rely heavily on one or two pieces of information Tendency 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 THUMBA common way to economize on the effort involved in A common way to economize on the effort involved in making decisions is making decisions is to ignore seemingly to ignore seemingly unimportant pieces of information.unimportant pieces of information.

For example, a recent study has shown that shipping costs For example, a recent study has shown that shipping costs are typically ignored by many consumers when deciding to are typically ignored by many consumers when deciding to buy things online. Their decisions are biased because they buy 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 to Frequently, rules of thumb help to save time and effort save time and effort and result in only small biasesand result in only small biases. Thus, they should not be . Thus, they should not be dismissed outright.dismissed outright.

ANCHORINGANCHORING

THE LAW OF SMALL NUMBERSTHE LAW OF SMALL NUMBERS

Research has shown that investors in the stock market are Research has shown that investors in the stock market are often subject to a small-numbers bias, believing that high often subject to a small-numbers bias, believing that high returns over the past few years are likely to be followed by returns over the past few years are likely to be followed by more high returns over the next few years—thereby more 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 housing Similarly when people assess the likelihood that housing prices will rise based on several years of data, the resulting prices 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 task Forming subjective probabilities is not always an easy task and people are generally prone to several biases in the and 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 in very small, many people simply ignore that possibility in their decision making.their decision making.

Tendency to overstate the probability that a certain event Tendency to overstate the probability that a certain event will occur when faced with relatively little information.will occur when faced with relatively little information.

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

NEW YORK CITY TAXICAB DRIVERSNEW YORK CITY TAXICAB DRIVERSMost cab drivers rent their taxicabs for a fixed dailyMost cab drivers rent their taxicabs for a fixed dailyfee from a company that owns a fleet of cars. Theyfee from a company that owns a fleet of cars. Theycan then choose to drive the cab as little or as muchcan then choose to drive the cab as little or as muchas they want during a 12-hour period. As with manyas they want during a 12-hour period. As with manyservices, 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 that An interesting study analyzed actual taxicab trip records and found that most drivers drive more hours on slow days and fewer hours on busy most drivers drive more hours on slow days and fewer hours on busy days. In other words, there is a negative relationship between the days. In other words, there is a negative relationship between the effective hourly wage and the number of hours worked each day; the effective 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. An Behavioural economics can explain this result. An income target income target provides a simple decision rule for drivers because they need only keep provides 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 with a record of their fares for the day. A daily target also helps drivers with potential self-control problems.potential self-control problems.

Casestudy : Procter & GambleCasestudy : Procter & Gamble

1.1. Read and prepare the Read and prepare the Casestudy on P&G for Casestudy on P&G for discussion and discussion and presentation next week. presentation next week.

2.2. Identify and evaluate the Identify and evaluate the challenges facing P&G’s challenges facing P&G’s consumer businesses by consumer businesses by conducting External conducting External Environment analysis Environment analysis (PESTEL);and Industry (PESTEL);and Industry (5+1 Forces) analysis.(5+1 Forces) analysis.

ConclusionConclusion

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

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

Questions?Questions?