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MEM Lecture 7

Biresh Sahoo, Ph.DProfessor , XIM, Bhubaneswar

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Application: Welfare effects of changes inhousing prices

Consider the following two scenarios:1. A builder has purchased a house for Rs.20,00000.

The very next day, the prices of all houses, includingthe one the builder just bought, double.

2. The builder has purchased a house for Rs.20,00000.The very next day, the prices of all houses, includingthe one the builder just bought, fall by half.

In each case, how does the price change affect thebuilders welfare? (Can the builder be better offbefore the price change or after?) Assume that m =

Rs.40,000009/2/2014 2

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20,00000

40,00000

60,00000

1 21.5H2 Qty. of housing (x)

Other goods (y)

u 0

u 1

0

O 2

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A

B

B2B1

Scenario I

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1 2 3

40,00000

20,00000

30,00000

H3

O3

B1

B2

A

B

u 0

u 1

Scenario II

0

Qty. of housing (x)

Other goods (y)

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Application of demand analysis While at a discount shoe store, a customer asked a clerk, I see

that your shoes are buy one, get one free - limit one free pair percustomer. Will you sell me one pair for half -price? The clerkanswered, I cant do that. When the customer started to leavethe store, the clerk hastily offered, However, I am authorized togive you a 40 percent discount on any pair in the store.

Assuming the consumer has $200 to spend on shoes (X) or allother goods (Y), and that shoes cost $100 per pair, answer thefollowing questions:a) Illustrate the consumers opportunity set under the buy

one, get one free deal and under a 40 percent discount. b) Why was the 40 percent discount offered only after the

consumer rejected the buy one, get one free deal andstarted to leave the store?

c) Why was the clerk willing to offer a buy one, get one free

deal, but unwilling to sell a pair of shoes for half-price?2 September 2014 5

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o1 2 3 4

100

200

Pairs ofshoes (x)

Income on othergoods (y)

ICB

A

D

J

N

F

H M K

G

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Application of demand analysis

A common marketing tactic among many liquorstores is to offer their clientele quantity (or volume)discounts. For instance, the second-leading brand of

wine exported from Chile sells in the US for $8 perbottle if the consumer purchases up to eight bottles.The price of each additional bottle is only $4. If aconsumer has $100 to divide between purchasing thisbrand of wine and other goods, graphically illustratehow this marketing tactic affects the consumersbudget set if the price of other goods $1. Will aconsumer ever purchase exactly eight bottles of wine?Explain.

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4 8 12 16

17

1020

30405060

708090

100

12.5

36

Bottles ofWine

OtherGoods

0

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4 8 12 16

17

1020

30405060

708090

100

12.5

36

Bottles ofWine

OtherGoods

0

uo

u1

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4 8 12 16

17

1020

30405060

708090

100

12.5

36

Bottles ofWine

OtherGoods

0

uo u1

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Market demand: How to arrive at?Summing individual demand curves to derive market demand forsandwiches

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0 2 4 6

P r i c e

2

4

6

d Y

(a) You

0 2 4

2

4

6

d B

(b) Brian

0 2

2

4

6

d C

(c) Chris

0 2 6 12

2

4

6

d Y +d B+d C =D

(d) Market demandfor sandwiches

Sandwiches per month

Market demand curve is the horizontal sum of individual demand curves

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Determinants of demand

IncomePrices of substitutes

Prices of complements AdvertisingPopulation

Consumer expectations

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Change in quantity demandedPrice of pizza (p)

Pizzas (x)

D0

4 7

10

6

A

A to B: Increase in quantity demanded ( x)

B

0

p

x

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Price of pizza (p)

Pizzas (x)

D0

D1

6

7

D0 to D1: Increase in demand ( x)

Change in demand

12 0

x

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Application: Consumer surplus (CS)

The value consumers get from a good but do nothave to pay for it.

That is, the amount a buyer is willing to pay for agood minus the amount the same buyer actuallypays for it.

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An illustrative example:Imagine that you have a digital camera, and because now you badly

need money, you decide to sell it. One way to do so is to holdan auction. Assume that four persons show up for your auction.

Buyer Willingness to Pay JohnPaulGeorgePeter

Rs.1000Rs. 800Rs. 700Rs. 500

To sell your camera, you begin bidding at a low price, say Rs.100.Because all four buyers are willing to pay much more, the price

rises quickly. The bidding stops when John bids Rs.800 (orslightly more). Note that camera will go to that buyer who valuesit most highly.

Johns CS = Rs.1000 Rs.800 = Rs.200

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Example continued

Therefore, price rises until two buyers are left. In this case,John and Paul bid Rs.700 (or slightly higher). At this price,both John and Paul each receive CS of Rs.300 and Rs.100.

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Now consider a somewhat different example. Supposethat you have two identical cameras to sell. Again, youauction them off to the four possible buyers.

To keep things simple, we assume that both cameras areto be sold for the same price and that no buyer isinterested in buying more than one camera.

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Using DD curve to measure CSPrice Buyers Quantity

1000 < p800 < p < 1000700 < p < 800500 < p < 700

p < 500

None John John, Paul John, Paul, George John, Paul, George, Peter

01234

1 2 3 4

1000

500

800700

0

P r i c e

Camera

Johns CS = 500

Pauls CS = 300

Georges CS = 200

Peters CS = 0

DemandcurveTotal CS = 1000

CS: Discrete

demand curve

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CS: Continuous DD curve

Price (p)

Quantity (x)

D

10

8

6

4

2

1 2 3 4 5

Total willingness to pay for 4

units = Rs.24CS = 16

Actual amount paid for 4

units = Rs.8

0

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Learning and applying CS

Assume that Johns dd. curve for court time is: p = 50 - (1/4)x,where x is measured in hours per year. What is the maximumannual membership fees John would be willing to pay for the

right to buy court time for Rs.25/hr?

Court time (hr/yr)

Price(Rs./hr)

50

25

100 2000

A

CB

CS = (1/2)*100*25= Rs.1250

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Why do some tennis clubs have an annual membershipcharge in addition to their hourly court fees?

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