MEM Lecture 7

Biresh Sahoo, Ph.D

Professor, XIM, Bhubaneswar
Application: Welfare effects of changes in
housing 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, including
the 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, including
the one the builder just bought, fall by half.

In each case, how does the price change affect the
builders welfare? (Can the builder be better off
before the price change or after?) Assume that m =
Rs.40,00000
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20,00000
40,00000
60,00000
1 2 1.5
H
2
Qty. of housing (x)
Other goods (y)
u
0
u
1
0
O
2
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A
B
B
2
B
1
Scenario I
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1
2 3
40,00000
20,00000
30,00000
H
3
O
3
B
1
B
2
A
B
u
0
u
1
Scenario II
0
Qty. of housing (x)
Other goods (y)
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 per
customer. Will you sell me one pair for half-price? The clerk
answered, I cant do that. When the customer started to leave
the store, the clerk hastily offered, However, I am authorized to
give you a 40 percent discount on any pair in the store.
Assuming the consumer has $200 to spend on shoes (X) or all
other goods (Y), and that shoes cost $100 per pair, answer the
following 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 and
started 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?

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2 September 2014 6
o
1 2 3
4
100
200
Pairs of
shoes (x)
Income on other
goods (y)
IC
B
A
D
J
N
F
H
M
K
G
Application of demand analysis
A common marketing tactic among many liquor
stores 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 per
bottle if the consumer purchases up to eight bottles.
The price of each additional bottle is only $4. If a
consumer has $100 to divide between purchasing this
brand of wine and other goods, graphically illustrate
how this marketing tactic affects the consumers
budget set if the price of other goods $1. Will a
consumer ever purchase exactly eight bottles of wine?
Explain.
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2 September 2014 8
4 8
12
16
17
10
20
30
40
50
60
70
80
90
100
12.5
36
Bottles of
Wine
Other
Goods
0
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4 8
12
16
17
10
20
30
40
50
60
70
80
90
100
12.5
36
Bottles of
Wine
Other
Goods
0
u
o
u
1
2 September 2014 10
4 8
12
16
17
10
20
30
40
50
60
70
80
90
100
12.5
36
Bottles of
Wine
Other
Goods
0
u
o
u
1
Market demand: How to arrive at?
Summing individual demand curves to derive market demand for
sandwiches
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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 demand
for sandwiches
Sandwiches per month
Market demand curve is the horizontal sum of individual demand curves
Determinants of demand
Income
Prices of substitutes
Prices of complements
Advertising
Population
Consumer expectations

Change in quantity demanded
Price of pizza (p)
Pizzas (x)
D
0

4 7
10
6
A
A to B: Increase in quantity demanded (x)
B
0
p
x
Price of pizza (p)
Pizzas (x)
D
0

D
1

6
7
D
0
to D
1
: 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 not
have to pay for it.
That is, the amount a buyer is willing to pay for a
good minus the amount the same buyer actually
pays for it.
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 hold
an auction. Assume that four persons show up for your auction.
Buyer Willingness to Pay
John
Paul
George
Peter
Rs.1000
Rs. 800
Rs. 700
Rs. 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 (or
slightly more). Note that camera will go to that buyer who values
it 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. Suppose
that you have two identical cameras to sell. Again, you
auction them off to the four possible buyers.
To keep things simple, we assume that both cameras are
to be sold for the same price and that no buyer is
interested in buying more than one camera.
Using DD curve to measure CS
Price Buyers Quantity
1000 < p
800 < p < 1000
700 < p < 800
500 < p < 700
p < 500
None
John
John, Paul
John, Paul, George
John, Paul, George, Peter
0
1
2
3
4
1 2 3 4
1000
500
800
700
0
P
r
i
c
e

Camera
Johns CS = 500
Pauls CS = 300
Georges CS = 200
Peters CS = 0
Demand
curve
Total 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.24
CS = 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 maximum
annual 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
100 200 0
A
C
B
CS = (1/2)*100*25
= Rs.1250
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Why do some tennis clubs have an annual membership
charge in addition to their hourly court fees?
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