web appendix a - cengage

WA-1

CONSUMER CHOICE USINGINDIFFERENCE CURVE ANALYSIS

INTRODUCTION

Consumers make some choices that are deliberate and others that are spontaneous.Economics examines the purposeful, goal-seeking choice behavior, while cognitivepsychology and marketing examine the spontaneous choice behavior. Householdsare hypothesized to choose housing, automobile, vacation and other major expen-ditures so as to maximize their satisfaction from a given set of preferences whenfaced with scarce resources. Consumer modeling in managerial economics then

WEB APPENDIX A

� MANAGERIAL CHALLENGEDirect-Mail Discount Coupon from Chevrolet Dealership1

Repeat purchase customers are the key to success inthe auto dealership business. Once a prospectivebuyer has been sold on the dealership’s pricingmethod, its commitment to customer satisfaction,and its service department reliability, repeatedlyselling that customer a second, third, or fourth carwhen it’s time for replacement requires many fewerresources than selling the first. And households tendto purchase more expensive cars in the later stagesof their life cycle. “Customers for life” has thereforebecome a mantra for dealership marketing plans.Some dealers make extraordinary commitmentssuch as free roadside service should a car boughtfrom and maintained by the dealership break downon the highway. Sewell Cadillac in Dallas makessuch an offer anywhere in the state of Texas.Prospective customers figure out that these promiseswould not be profitable unless Sewell really does in-tend to secure their repeat purchases over manydecades. This extraordinary commitment conveys ahostage to customers who then rely on Sewell to de-liver consistently high-quality cars and service inorder to win their business again and again.

Flow Chevrolet has a substantial database on allpast and prospective customers who have shoppedat their “Chevy Store.” In July the Flow sales man-ager is sometimes told to run a promotion on Chevy

Malibus, Chevrolet’s midsized sedan. To whom inthe dealership’s database should the manager send adirect-mail coupon for a 20 percent discount on theprice of Flow Malibus: the community college stu-dent who recently shopped for a Flow subcompact,the Chevy Geo; the young German immigrant cou-ple who own a three-year-old Chevy Malibu; theFrench immigrant couple who recently shopped atthe Flow Buick dealership for a midsized sedan; orthe loyal 40-year-old Flow customer who onceowned a Malibu and recently bought a third full-sized Chevrolet sedan? And should the discountcoupon be dated to expire in two or three days orlast two or three weeks? Remember the objectiveis to reduce the excess inventory of Malibus byincreasing demand with the least advertising andpromotion cost. In this appendix the analysis of sub-stitution and income effects resulting from a pricechange will help you answer such questions. In gen-eral, the closer and more numerous the substitutes,the longer the availability of the discount offer, andthe larger the percentage of the budget spent on theproduct, the larger the total demand effect of a pricechange.

1 Based on Carl Sewell Customers for Life (New York: Simonand Schuster, Inc., 1990).

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consists of analyzing and predicting expenditure choices in response to changes inthe household budget constraint (i.e., in prices and disposable incomes), taking pref-erences as predetermined. Social psychology, sociology, and marketing address theorigin of these tastes or preferences, the formation of loyalties to particular products,and the incidence of taste change.

Consumption modeling assists businesses in planning sales campaigns, pricingpolicies, and production capacity. The analysis usually focuses on the individualhousehold rather than group behaviors. The exceptions are notable, however. Forexample, think about the network effects on your own consumption decisions ofhaving friends and colleagues adopt the same hobby or join the same chat room.Such network effects may form the basis for an analysis of predicted demand for anew Internet Web site.

OPTIMIZATION AND CONSUMER UTILITY

Why choose well? Households try to optimize and attain the highest satisfactionavailable in their consumption decisions not because they are driven by economiccalculations, but simply because of scarcity. Few if any consumers have access tomore resources than they know how to spend. Instead, most households face budgetconstraints that limit their consumption decisions. Constraints imply trade-offs;more of one thing implies less of another. And these household budget constraintsare effective because scarcity is omnipresent. “There’s no such thing as a free lunch.”Clean air is scarce, desirable housing is scarce, Internet access is scarce, time itself isscarce. As a result, consumers seek to allocate their limited purchasing power not infrivolous or random expenditures but rather in the careful pursuit of the maximumsatisfaction attainable given their budget.

To optimize really means no more than carefully examining these trade-offs andtaking all actions in which the marginal benefit exceeds the marginal cost. If therental of a larger apartment and a smaller lease car payment each month increasethe household’s satisfaction when the family size grows, we expect such householdsto economize on auto leasing and find a bigger place to live. To do otherwise wouldbe to “satisfice” at a level of household utility less than is attainable. Satisficing canbe attractive when the transaction costs of adjustment overwhelm any possiblegains. For example, the family in question may own their car and find it difficult,expensive, and time consuming to resell. Or they may have a long-term housing con-tract that contains massive penalty clauses for breaking the lease earlier than agreed.In general, however, with typically low transaction costs, satisficing is less attractive,by definition, than optimizing.

Maximizing household utility subject to a budget constraint is an all-encompassinggoal; it addresses nonmaterial as well as material objectives and other-centered aswell as self-centered motives. In choosing to spend on more housing versus more autotransportation, consumers reflect the nonmaterial, psychological effects of a pur-chase as well as the tangible benefits that material goods and services provide. Housingpurchases are more often motivated by the design aesthetics or by the sense of com-munity in the neighborhood than by the physical shelter provided or the reducedcommute time to work. Similarly, utility-maximizing consumers can be motivated byother-centered rather than self-centered motives. A family may, for example, choosemore expensive lead-free paint even though they have no children or grandchildrenwho might ingest the toxic paint chips. Finally microeconomics usually takes the

WA-2 WEB APPENDIX A Consumer Choice Using Indifference Curve Analysis

Household Budget Constraint

The summation of con-sumer expenditures lessthan or equal to dispos-able money income.


view that “there’s no explaining preferences” (i.e., seemingly bizarre preferences arejust as likely to be exhibited as more common, routine preferences). Why some peo-ple like Limburger cheese and pink Cadillacs is simply beyond the scope of an eco-nomic analysis. Consequently, microeconomics takes consumer preferences as givenand instead focuses analytical attention on the behavioral effects of a change in theconstraints.

REVEALED PREFERENCE ANALYSIS OF CONSUMER BEHAVIOR

Constraints separate unattainable from attainable choices. In the consumer choiceproblem, the budget constraint of disposable income defines the household’s oppor-tunity set. Initially, we address the consumer choice problem of allocating a sub-budget between two desirable goods: dining out and larger apartments. Later, wewill generalize the analysis to the household’s complete budget and all other goods.In Figure WA.1, the household has $600 per week to spend on dining out plus theirapartment rental. Restaurant meals are priced at $30 each and apartments rent for$60 per 100 square feet per week. A specialist in consumption could dine out essen-tially three meals a day (i.e., 20 per week) and live on the streets, consuming zerohousing space. This choice bundle (0h, 20f ) exhausts the $600 sub-budget at the farNW corner solution (point A) in the opportunity set. Similarly, the household could

WEB APPENDIX A Consumer Choice Using Indifference Curve Analysis WA-3

Figure WA.1 Consumption Choices with an Increase in Money Income

Quantity of apartment housing (sq. ft./week)

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specialize in the consumption of housing with a 1,000-square-foot three-bedroomapartment but always dine in (i.e., 1,000h, 0f ) at choice bundle B. A more typicallydiversified consumer might select the choice bundle C with 700 square feet of hous-ing and six restaurant meals (700h, 6f ). The entire shaded area ABO identifies all theattainable combinations of apartment space and restaurant meals in the household’sopportunity set. Any choice bundle within this area can be purchased with the $600sub-budget.

The microeconomist’s mode of reasoning can now be illustrated in its simplestform. Suppose a household’s disposable income available for expenditure on restau-rant meals and apartment rent rose by 20 percent from $600 to $720. The economicanalyst would then theorize about how this change in the constraint would affect thehousehold’s opportunity set. In this case, because the maximum quantity of eachgood available to a specialist in consumption would increase by an identical 20 per-cent (i.e., from 20 to 24 meals and from 1,000 to 1,200 square feet), the budget con-straint AB shifts out in a parallel fashion to A�B�. In short, the opportunity set hasexpanded symmetrically in all directions. The economic analyst would then make aprediction about the resulting change in consumer behavior. For example, if bothdining out and apartment space were income-superior goods whose household de-mand increased with rising income, then the analyst would predict that the diversifiedconsumer selecting choice bundle C before the income increase would now purchasemore of both goods (perhaps selecting choice bundle C�, C�, or C��). If one of thegoods (e.g., the apartment) were deemed income-inferior, the household would bepredicted to reduce its apartment housing (perhaps to zero), move out, and seek an-other housing alternative, say a condominium. Finally, by observing the household’schange in behavior and by attempting to hold constant other factors, the economicanalyst would seek to test the predictions of the theory.

THE HOUSEHOLD BUDGET CONSTRAINT

As we have seen, the corner solutions A and B preferred by specialists in consumptionexhaust the household’s money income sub-budget for dining out and apartmentrent, represented henceforth as M. In addition, the budget constraint is exhausted byall those choice bundles between A and B in Figure WA.1. Writing this locus ofpoints as the sum of the household expenditures on each product, setting the resultless than or equal to M,

[WA.1]

and rearranging, we obtain the equation for the line segment between A and B:

[WA.2]

where M�Pf is the y-intercept and (Ph�Pf) is the slope of the budget constraint.Assuming that restaurant meals and apartment space are income-superior goods, forwhich more is preferred to less, we can predict that a household will proceed fromany interior choice bundle such as D to the northeast (say to C) where more of bothgoods is available. In general, remembering that the household has other sub-budgetsfor auto transportation, clothes, utilities, insurance, and maybe even savings, we pre-dict that the consumer will exhaust this sub-budget and choose combinations ofhousing and food (h, f) on the constraint AB. Although all the choice bundles in theshaded area are attainable, border solutions such as C—where the household buys(700h, 6f) and expends $420 on apartment rent and the remaining $180 on restaurant

Qf � M�Pf � (Ph�Pf)Qh

M � PfQf � PhQh



meals—are more likely than interior choice bundles such as D that do not exhaustthe sub-budget.

In some Hindu cultures, small is beautiful. That is, the self-discipline of consum-ing less provides an aesthetic benefit to compensate for the self-denial associatedwith remaining at D rather than moving on to purchase and consume C. In these cir-cumstances, the prediction that households will exhaust their sub-budgets mayprove incorrect. In Western cultures, however, such predictions have tested well (i.e.,apparently the self-discipline of consuming less is not pleasing enough), leading tothe development of a powerful tool known as revealed preference analysis.

THE WEAK AXIOM OF REVEALED PREFERENCE

In Figure WA.2, the price of apartment rent has declined from $60 per 100 squarefeet per week to $45 per 100 square feet per week. Normally this change would in-crease the household’s ability to fund possible expenditures on all other goods (i.e.,the household’s purchasing power). However, in this case, suppose a luxury condo-minium and apartment complex that lowered its rental price $15 per 100 square feetper week also raised the community association dues for the health club, tenniscourts, and pool by $105 per week. If the landlord requires that all tenants purchasethe complete package of housing and ancillary services, the increased lump sum feewill offset the decreased price per unit. Indeed, for the typically diversified household


Figure WA.2 The Weak Axiom of Revealed Preferences

Quantity of apartment housing (sq. ft./week)

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0 800700 1000 1333

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consuming bundle C, the stated increase in the association fees would be just enoughto offset the per-unit price cut exactly because ($15�100 sq. ft.) � 700 � $105. Onthe surface, one might think that requiring the same total expenditure per week—namely, $105 for association fees plus 700 � $45�100 sq. ft. � $315 for rent—would not affect the housing consumption choices of a household who previouslyspent the same total $420 per month for the 700-square-foot apartment. However,a change in consumer behavior under these circumstances is precisely the insight ofthe weak axiom of revealed preference. In particular, if the price of one good relativeto another declines and purchasing power remains unchanged, the unambiguousprediction is that the household will increase its consumption of housing.

The decline in relative prices as apartment rent declines by $15 is illustrated byrotating the original budget constraint AB to AE where (in the absence of any othercharges required by the landlord) a specialist in consumption would be able to con-sume a 1,333-square-foot apartment. However, the landlord’s new lump sum feeslower this intermediate, provisional budget constraint by $105 at all levels of con-sumption. That is, subtracting the $105 lump sum fee from each point on AE yields thenew actual budget constraint facing the household, the line FG. To lower the budgetconstraint in Figure WA.2 by an amount equal to $105 requires that we calculate thenumber of restaurant meals (the units on the vertical axis) associated with this amountof money income that is no longer available for expenditures on meals and apartmentspace. The new actual budget constraint FG is $105�$30 � 3.5 meals below AE.

Note that the consumer’s opportunity set has expanded in an asymmetrical way.Theorizing about the change in the constraints and the resulting change of theconsumer’s opportunity set from ABO to FGO leads to the following prediction.Because the household earlier revealed that choice bundle C was preferred to all thealternatives along line segment AB, and because every choice bundle along the newconstraint from F to C is interior to (contains less of both goods than) some point onAC, we can conclude that a household facing budget constraint FG will not selectany of the choices along the line segment FC. In contrast, each of the choice bundlesalong the new constraint between C and G contains more of both goods than somepreviously rejected choice bundle along CB. Together these two arguments implythat under the stated circumstances, the consumer will never decrease and may wellincrease his or her consumption of apartment housing.

In sum, according to the weak axiom of revealed preference, when relative pricedeclines and purchasing power remains unchanged, the household will substitute to-ward the good whose price has fallen. In Figure WA.2, the household’s demand forlarger apartments would increase, perhaps to a choice such as 800 square feet at D.That is, within the same apartment/condominium complex, we might expect anincrease in demand for larger apartments and a decrease in demand for smallerapartments. In addition, with no change in the sub-budget for housing and restau-rant meals, this reallocation would therefore imply fewer meals out. In a typicalhousehold’s budget allocation of their entire disposable income, the money for alarger apartment might well come from spending less on something else. All we canbe sure of is that demand for housing space will increase.

RELATIVE PRICES AS RATES OF EXCHANGE IN THE MARKETPLACE

A useful distinction arises at this point between absolute prices and relative prices.An absolute price conveys the monetary value required to purchase a product orservice (e.g., $60 per 100 sq. ft. per week). Relative prices, on the other hand, are a


Weak Axiom of Revealed Preference

A principle of demandanalysis involving rela-tive price changes withno change in purchasingpower.


rate of exchange in the marketplace between two products or services. For example,initially, the household choosing how to allocate its $600 sub-budget between diningout and a larger apartment found that two restaurant meals exchanged for 100additional square feet of apartment space per week:

Two f (food) to one h (housing) is the relative price of housing in the initial consumerchoice problem. After the absolute price of housing declines to $45, the relative priceof housing would be 1.5f�1h.

A natural question that arises is whether absolute prices and absolute pricechanges or relative prices and relative price changes are more important in deter-mining consumer choice.

To address this question, try to resolve the following paradox.

COUPLES WITH AND WITHOUT CHILDREN GO OUT FOR THE EVENING

Consider two couples, one with children and the other without, who are choosingbetween two types of entertainment outings: dinner theaters and movies. The couplewithout children faces a movie absolute price of $8 and a dinner theater absoluteprice of $24. The couple with children must pay a babysitter $12, so they face anabsolute price for the movie outing of $20 and a dinner theater absolute price of$36. What if you observed that the couple with children, going out for the evening,chose dinner theaters more often than the couple without children when that coupledecided to go out for the evening. On the surface, such choice behavior wouldappear quite surprising since the couple with children faces the higher ($36) absoluteprice for dinner theater outings. How can we resolve this paradox? Think about therelative prices! The couple with children face a relative price of dinner theaters of($36 per dinner theater)�($20 per movie) � 1.8 movies per dinner theater. In con-trast, the couple without children must forego $24�$8 � 3 movies in order topurchase a night at the dinner theater. It is the second couple (the couple withoutchildren) that faces the higher price, specifically, a higher relative price of dinner the-atres. For that reason, the couple without children substitute away from the dinnertheater purchase and goes instead to the movies.

It is relative prices (not absolute prices) that determine the household’s allocation ofa sub-budget between competing products and services.

UTILITY ANALYSIS OF THE CONSUMER CHOICE PROBLEM

As we have seen, revealed preference analysis allows us to make a prediction aboutconsumer demand when relative prices decline and purchasing power remains un-changed. Revealed preference analysis can be easily implemented because it onlynecessitates knowing the households’ money income and its consumption choices at

Pf �2 restaurant meals

100 sq. ft. per week

Ph �$60 per 100 sq. ft. per week

$30 per restaurant meal


EXAMPLE


various prices. However, often when per-unit prices decline, no offsetting increase inlump sum fees occurs. Instead, typically, both prices and purchasing power changeconcurrently. To analyze the effect on consumer choice of this more complex changein both prices and household purchasing power requires that we learn more aboutthe utility implications of consumer choice.

Every choice bundle throughout the commodity space in Figure WA.3 generates apotentially different level of the utility function U(h, f ), which indexes the amount ofsatisfaction received by the consuming household from a particular quantity ofrestaurant meals (f ) and apartment space (h). In general, choice bundles fartherto the northeast generate higher utility, and more of both goods usually raises totalutility. Thus U(J) exceeds U(C), and U(K) exceeds U(J). The consumer thereforeprefers K to J to C based on their respective utilities. But what about a choice bun-dle such as L in comparison to C, or alternatively, N in comparison to C; whichwould be preferred? To answer this question the commodity space is divided by a


Figure WA.3 Indifference Curves Demarcate More Preferred and Less Preferred Choice Bundles

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U12(h, f )

Preferencedirections


line of demarcation between all those choice bundles more preferred than C and allthose less preferred than C. L is preferred to C but N is not. Instead, choice bundleN appears to offer utility just equal to that of C.

ASSUMPTIONS OF THE PREFERENCE RANKINGS AND CHARACTERISTICSHAPES OF INDIFFERENCE CURVES

The utility constant curve through C and N is referred to as an indifference curve be-cause the consumer is indifferent among all choice bundles yielding the same level ofU(h, f ). For example, U12 is achievable with either choice bundle C or N, and theconsumer is therefore indifferent between them. Several assumptions of the prefer-ence ranking ability of households set the characteristic shape of these indifferencecurves. First, we assume that households can determine pairwise rankings. In otherwords, if the underlying components of choice bundles are known, we assumehouseholds can determine which combination is preferred. Second, we assume thatmore is preferred to less for economic “goods,” and less is preferred to more for eco-nomic “bads” (e.g., garbage, pollution, etc.). Third, we assume households are logi-cally consistent and therefore that their preference ranking relations are transitiveand additive. That is, if the consumer tells us she prefers choice bundle J to C andalso that she prefers K to J, we assume that she also prefers K to C. However, L � Cmay well be preferred over K because L � C offers the consumption indicated bychoice bundle R, which is (1,200h, 15f ). Finally, we assume that marginal utilitydiminishes eventually as the consumption of a good increases. Even hours spentdriving a borrowed Porsche eventually wane in their enjoyment. Note that this lastassumption implies that we will treat fads and addictive goods as exceptions.

Given these assumptions, indifference curves such as U12 and U13 will never in-tersect. An intersection would violate the transitivity property of the preferenceranking. That is, in Panel (a) in Figure WA.4, consider what is inconsistent with ourassumptions about consumer behavior. A consumer cannot be indifferent betweentwo choice bundles S and T at the same time they tell us that S is preferred to Ubecause T and U generate equal utility. Similarly, indifference curves will alwayshave a negative slope with economic goods. A positively sloped indifference curvewould deny that more of both goods is preferred to less. Finally, indifference curveswill be concave from above (convex from the perspective of the origin) because ofdiminishing marginal utility. As we move down to the right along U12 replacingrestaurant meals with more apartment square footage, the additional floor spacebecomes less and less useful. Initially, we’re offering to add a second bedroom, aseparate dining area, or a walk-in closet but eventually we’re adding a formal livingroom, a sewing room, and a third bedroom (i.e., incremental space that few apart-ment residents really value). Consequently, as you ask such a household how muchadditional square footage is needed to compensate for reducing the meals out perweek from 12 to 11, the answer is a modest additional 50 square feet as illustratedalong U12 in Figure WA.4. Fifty square feet has great incremental utility whenyou’re living in a 200-square-foot efficiency apartment. However, after several moreof these substitutions have taken place, when one asks how much square footageis needed to compensate for reducing meals out from seven to six, the answer maybe 200 square feet. This increasing floor space requirement to be compensated fora unit reduction in restaurant meals implies a concave shape for the consumerindifference curves.




Figure WA.4 Violations of Properties of Indifference Curves

Apartment housing space (sq. ft./week)

Panel (b) Less Is Preferred to More with Economic Bads

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Garbage removalpollution abatement

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Panel (a) Violation of Assumption of Consumer Transitivity



Figure WA.4 Violations of Properties of Indifference Curves (continued)

Quantity of dressy right shoes

Panel (c) Perfect Complements

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Panel (d) Perfect Substitutes

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NOTABLE EXCEPTIONS

Several unusual cases assist in understanding typical indifference curves. Considerwhat happens in Panel (b) of Figure WA.4 when a household is choosing betweenrestaurant meals and an economic bad such as garbage or ambient air pollution (say,radon). Note the positive slope of the indifference curve. However, from the per-spective of the new origin to the right in the southeast corner, normal indifferencecurves are present because reading upward and left, the household is choosing be-tween two economic goods (i.e., more restaurant meals and more pollution abate-ment or garbage removal). To take another exceptional case, hours of access to apersonal computer and the software to run the programs you desire are perfect com-plements. The two economic goods are consumed only together, never separately.Consequently, without any substitution between them, the goods’ indifference“curves” are, in fact, indifference right-angles. A transparent illustration of this ideaoccurs with right and left pairs of women’s dress shoes. In Panel (c), note that utilityincreases along the 45 degree line only when both members of the additional paircan be located in one’s closet. Your finding more nonmatching right shoes, and theability to move from choice bundle W to V results in no additional choices of any value.Consequently, utility remains constant at level U5. Only by finding the matching leftshoe can utility rise to U6. Finally, consider the opposite case of a choice between twobrands of number #2 pencils, which are perfect substitutes. In this instance, the in-difference curves lose their curvature and are straight lines. In Panel (d), no satisfactionor use value changes as one proceeds downward to the right along U4 replacing onebrand of pencils with another. Because the incremental utility gain from anotherBrand A #2 pencil just equals the incremental utility loss from one less Brand B #2pencil no matter how far rightward we go, constant (not diminishing) marginal utilityis present. In general, the more commodity-like a product or service such as bath soap,engine oil, or video rentals, the flatter the indifference curves between the competingproducts. In the extreme, perfect substitutes approach the case in Panel (d).

INTERNET WEB SURFING PROVES ADDICTIVE: SALES OF RECREATIONAL SPORTS EQUIPMENT SUFFER

Outdoor sports equipment has always been seasonal merchandise. Except forChristmas gifts, few households purchase baseball gloves, tennis racquets, or evenfrisbees until the weather improves, and kids begin to play outdoors. This spring,however, Wilson Sporting Goods Co. experienced a substantial decline in sales of allrecreational sports equipment. Either baseball is no longer the national pastime, ten-nis has lost its appeal, or children just are not heading outside to play as much asthey once did. Schedules are tighter, less free time may be available, but another ex-planation looms. Personal computers connected to the Internet have now penetratedinto nearly 75 percent of American households, and Web surfing may be addictive.

Given the choice between hours spent watching TV or hours spent playing tennis,most consumers would diversify in consumption and do some of each. Diversificationreflects the law of diminishing marginal utility. No matter how much you like to playtennis, a three-hour match is exceptional, and no one likes to stay out on the courtsfor the fourth hour. Similarly, viewers have favorite and less-preferred shows on TV.Until it becomes much easier for individual households to record and reprogramthe broadcast of sitcoms and soap operas to meet their own schedules, eventually


EXAMPLE


diminishing marginal utility will characterize hours spent in front of “the tube.” ButWeb surfing is different. The network of Web links continues to grow; the more Websites you explore, the larger the variety of Web surfing experiences made available.Some Web surfers find this “choice” to be addictive. In Figure WA.5, the indifferencecurves between hours playing tennis and hours Web surfing are convex from above.More of both goods generates higher utility (i.e., the indifference curves are nega-tively sloped), but additional hours spent Web surfing generate increasing marginalutility. That effect on consumers might not be literally true for dozens of hours perday, but there are time budget constraints for recreation. Within the relevant range ofone to five hours, Web surfing does generate increasing marginal utility. This excep-tional property implies that moving downward to the right along U9 in Figure WA.5,the consumer requires fewer hours of Web surfing to compensate for additional ten-nis hours sacrificed (i.e., a convex from above shape of the indifference curves).

In such circumstances, a normally diversified consumer becomes myopic. Facingthe budget constraint XZ, the consumer maximizes utility by selecting a corner so-lution on the horizontal axis—namely, choice bundle Z. All-or-nothing decisions areextremely rare in economic decision making. However, when one good is addictive,not surprisingly the consumer in Figure WA.5 will select Web surfing to the exclusionof tennis. The real problem with addictive drugs is related; heroin addicts will selectheroin to the exclusion of all else. Most heroin addicts therefore die of malnutrition-related disease; they feed their habit before feeding themselves.


Figure WA.5 A Corner Solution for Addictive Goods

Quantity of web surfing (hours/day)

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CONSUMER EQUILIBRIUM

To characterize an equilibrium consumption decision once consumers have had suf-ficient time to consider all the alternatives and optimize their choices, consider thefollowing analysis. As we have seen, the overall level of consumer satisfaction or util-ity can be expressed as a preference ordering represented by the index number on anindifference curve. Moreover, for any given level of utility, the consumer’s tastescan be represented as the desired rate of exchange between the two goods repre-sented by the slope along a given indifference curve. For example, at choice bundleAA in Figure WA.6, the household has exhausted its $600 sub-budget for dining outand apartment space by consuming 14 restaurant meals and 300 square feet ofapartment space. At this point the marginal utility of an additional meal relative tothe marginal utility of an additional 100 square feet of space is 1�4 to 1. That is,after already eating all one’s lunches and dinners at a restaurant every week, begin-ning to eat out at breakfast too has a small additional utility whereas additionalsquare footage has great marginal utility when you’re residing in a 15' � 20' (i.e.,300 sq. ft.) efficiency apartment. Consequently, at choice bundle AA, the consumerwould give up four additional meals to occupy another 100 square feet of floor space(i.e., the desired rate of exchange is 4:1, the slope of the indifference curve).

In the marketplace, however, the consumer can alter personal consumptionchoices by sacrificing only two restaurant meals for an additional 100 square feet ofapartment space. That is, the actual rate of exchange in the marketplace is only 2:1.Recognizing this divergence, the consumer takes advantage of the opportunity to


Figure WA.6 Consumer Equilibrium

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reallocate the $600 sub-budget (i.e., 10 � $30 � $300 to restaurant meals and5 � $60 � $300 to apartment space). At the new choice bundle BB, the consumer issaid to be in equilibrium because the desired rate of exchange (the slope along theindifference curve) and the actual rate of exchange (the slope along the budgetconstraint) are equated:2

[WA.3]

After rearranging Equation WA.3 to emphasize the marginal nature of all equilib-rium conditions, the marginal use value per dollar of housing MUh�Ph just equals themarginal use value per dollar of food MUf�Pf. Otherwise, if this marginal conditiondid not hold, the consumer should reallocate his or her expenditures to secure stillhigher total utility.

GRAPHICAL DETERMINATION OF THE DEMAND CURVE

Consumer demand can be derived graphically based on indifference curves and bud-get line. Consider a consumer whose indifference curves and budget line are shownin Figure WA.7. Assume the consumer has $350 to spend on products F and E. Theinitial price of E is $5 per movie and the initial price of F is $10 per restaurant meal.Under these conditions, the consumer could acquire 70 movies or 35 meals or anyother combination thereof (illustrated by the lower budget line). Three indifferencecurves are plotted, U1, U2, and U3. Given the income constraint of $350 and the ini-tial prices of F ($10) and E ($5), the consumer would choose combination X oncurve U1. At this point the consumer would acquire 16 units of F. Hence at a priceof $10 per unit, the consumer would demand 16 meals. This point is now plotted onthe lower panel of Figure WA.7 as point X�.

If the price of F declines to $5, a new budget line is defined, which intersects theQF axis at 70 units. The new optimum occurs at point Y with 35 units of F being de-manded at a price of $5. This point is plotted on the lower panel at Y�.

Finally, at a price of $3.50 for a unit of F, a new optimum point occurs at Z with64 units of F being demanded. By plotting in the lower panel of Figure WA.7 thethree prices and associated quantities demanded, the familiar demand curve, DF, forfood is derived and is illustrated by the curve that connects points X�, Y�, and Z�.

INCOME AND SUBSTITUTION EFFECTS ILLUSTRATED

Indifference curve analysis can also be used to illustrate the income and substitutioneffects of a price decline. Consider the case of a consumer who consumes food andentertainment with an initial budget constraint given in Figure WA.8 as XV. Theconsumer will buy Q1 units of F and Q4 units of E, as indicated at Point 1.

If the price of food declines such that the new budget line becomes XV�, Point 2represents the new optimum for the consumer. This point falls on the higher of thetwo indifference curves, U2, plotted on the figure. Given the new lower price forfood, the consumer demands Q2 units of F.

Next, we construct a new, artificial budget line, ZW, which is parallel to XV� andtangent to the original indifference curve U1. From the original optimal combination

(MUh�MUf) � (Ph�Pf)


2 Algebraically, Equation WA.3 is obtained by taking the maximum quantity of meals on the y-axis availablewith a $600 budget and dividing by the maximum quantity available of floor space on the x-axis:($600/Pf )/($600/Ph) � (Ph/Pf).



Figure WA.7 Deriving the Demand Curve

Qua

ntit

y of

ent

erta

inm

ent

(mov

ies)

QE

Pric

e of

F (

$/m

eal)

X

Y

Z

70

0

16 35 64

16 35 64 70 100

9

8

7

6

5

4

3

2

1

3.5

Quantity of food (meals) QF


X�10

U1 U2 U3

Y�

Z�

DF

0


of food and entertainment, Point 1, to the artificial optimum, Point 3, “real” incomeof the consumer has remained the same in the sense that the consumer experiencesthe same utility at Point 1 and Point 3. The change in quantity demanded for F fromQ1 to Q3 may be thought of as representing the “pure” substitution effect of food forentertainment resulting from the price reduction for food. In contrast, the increasedconsumption of food measured from Points Q3 to Q2 may be thought of as the “pure”income effect, because the only difference between ZW and XV� is the level of incomethat each reflects. In summary, a decline in price for food results in the consumer de-manding Q3 � Q1 more units of food because of the substitution effect, and Q2 � Q3more units of food because of the income effect for an income-superior good.

INFERIOR GOODS

To define income-inferior goods, one can now simply ask the question, “Whatchoice equilibrium response arises when money income increases; does consumptionincrease or decline?” For the Chevy Geo, the answer is apparent. Fairly quickly asmoney income rises, the representative American household prefers to reduce itsconsumption of subcompacts such as the GEO and replace them with larger, more


Figure WA.8 Income and Substitution Effects for Income-Superior Goods

Qua

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(mov

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QE

Substitution effect Income effect

Quantity of food(meals) QF

V�WVQ2Q3Q10

Q4

Z

X

U1

U2

2

1

3


powerful cars. Hence, an inferior good is one whose consumption declines eventu-ally as income rises. Steaks, on the other hand, are likely to have increased demandas income rises. Note, however, that the income superiority or inferiority character-istic is not inherent to the product or service. What is a superior good in one econ-omy or at one stage of a life cycle (e.g., while you’re a student) might not be superiorat a different income range in another economy or at a different stage of your lifecycle as your income builds. Many consumers in developing nations see the sub-compacts such as the Chevy Geo as a desirable, income-superior item on which toexpend their modest money incomes. The Chevy Geo proves to be income superioruntil disposable money income reaches approximately $35,000; after that, ChevyGeos are income-inferior.

ALGEBRIAC DETERMINATION OF THE OPTIMAL COMBINATION

The determination of the optimal combination of goods F and E that maximizes a con-sumer’s utility subject to a budget constraint can also be obtained algebraically usingLagrangian multiplier techniques. The objective is to maximize utility, represented by

[WA.4]

subject to the budget constraint, represented by

[WA.5]

We begin by forming the Lagrangian function

[WA.6]

Differentiating Equation WA.6 with respect to QF, QE, and and setting the deriva-tives equal to 0 yields

[WA.7]

[WA.8]

[WA.9]

Recognizing that and we substitute these quanti-ties into Equations WA.7 and WA.8 to give

[WA.10]

and

[WA.11]

Setting Equation WA.10 equal to Equation WA.11 yields the optimality condition:

MUF

PF�

MUE

PE

�MUE

PE

MUE � PE

�MUF

PF

MUF � PF

f�QE � MUE,f�QF � MUF

U

� �PFQF � PEQE � M � 0

U

QE�

f

QE� PE � 0

U

QF�

f

QF� PF � 0

U � f(QF, QE) � (PFQF � PEQE � M)

M � PFQF � PEQE

U � f(QF, QE)



DEMAND CURVES AND DETERMINANTSOF THE PRICE ELASTICITY OF DEMAND

The analysis in Figure WA.9 begins with the weak axiom of revealed preference. Ifthe price of apartment space declines from $60 per 100 square feet per month to$30, the maximum quantity of housing available to a household with a $600 budgetarises from Qmax (1,000 sq. ft.) to (2,000 sq. ft.). This total effect of price changeon the consumer’s opportunity set and subsequent choice behavior can be decom-posed into two separate subcomponents: a substitution effect and an income effect.We now isolate each of these in turn.

Controlling real income so that the purchasing power of the household remainsthe same, the consumer would substitute toward the apartment space (whose pricehas declined 50 percent) and away from all other goods. For example, consistentwith the weak axiom of revealed preference, if the consumer remains just able to buychoice bundle GG but faces a reduced price of housing, the consumer would select850 square feet at choice bundle FF rather than 600 square feet at the original choicebundle. This �250 square feet change in demand is the magnitude of the substitu-tion effect resulting from the price change.

As we saw earlier, the weak axiom of revealed preference asserts that such a sub-stitution would make the consumer better off (in this case, raising utility from U6 toU10). What is new is the attention to magnitudes. Had the price change lasted a longtime and the apartments in question been generic with many close substitutes, the50 percent price reduction might well have induced more potential demanders toswitch and might well have induced the representative household to substitute awayfrom still more alternative activities. The substitution effect would then have beeneven larger than �250 square feet (perhaps �400). Conversely, had the price reduc-tion been only temporary and had the apartment complex been unique with fewclose substitutes, most potential demanders interested in such a complex would al-ready have taken advantage of the opportunity. And the representative householdwould likely have already made full use of the unique space. In that case, the pricereduction would likely have triggered a smaller substitution effect on floor spacedemand (perhaps only �50 square feet).

The particular magnitude of the �250 square feet substitution effect in Figure WA.9identifies one of the two subcomponents of the total effect of the price change. Be-cause price elasticity measures the percentage change in quantity demanded for anygiven percentage change in price, the magnitude of the substitution effect determinesin part how elastic demand will be; the larger the substitution effect, the more priceresponsive and therefore the more elastic the demand.

The other subcomponent of the total effect of the price change is the income effect.As purchasing power rises from the level of budget constraint associated with choicebundles GG and FF to the budget constraint , the quantity demanded mayrise further to 930 square feet at HH� or even 1,200 square feet at HH. The effectthat actually occurs reflects the magnitude of the consumer’s income effect, whichdepends on several factors.

First and most obviously, the more income superior the apartments in question,the larger the income effect of a price reduction. A 50 percent price reduction forcondominiums at a tennis, golf, and swimming club community has a larger incomeeffect for middle class target households than a 50 percent price reduction on un-adorned efficiency apartments along a busy street. In addition, however, the per-centage of its total budget that a household spends on housing matters. If a newly

MQ�max

Q�max




Figure WA.9 Magnitudes of Income and Substitution Effects Determinethe Price Elasticity of Demand

Qmax Q�max

All

othe

r go

ods

($)

M

600 8500

+250 +80 +350

930 1,000 1,200 2,000

U6

Apartment space (sq. ft./month)

Pric

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/100

sq.

ft.

)

6000

$30

$60

930

D�

D

1,200

GG

U10

FF

HH�

HH


married couple in their early twenties spends 40 percent of their budget on housing,the effect on their purchasing power of a 50 percent price reduction will be muchlarger than the effect of the same 50 percent price reduction on the purchasingpower of a retired couple with the same income who only spends 25 percent of theirbudget on housing.

And, just as with substitution effects, the larger the magnitude of the income effect,the larger the total response of quantity demanded to a price change (at least for nor-mal, income superior goods). Consequently, one might expect the younger couple tohave a more price elastic demand for housing. That is, the larger �350 income effectin Figure WA.9 when added to the �250 substitution effect makes for a more priceelastic demand D, whereas the smaller income effect �80 when added to the same�250 substitution effect makes for a less price elastic demand D�. In sum, the newlymarried couple doubles their quantity demanded from 600 square feet to 1,200square feet in response to the 50 percent price reduction, while the retired coupleincreases their quantity demanded from 600 to only 930 square feet. Calculating thearc price elasticities, we have for the young couple,

and for the retired couple,

Once again, the larger income and substitution effects for the newly married coupleresults in a more price elastic demand.

GERMAN–AMERICAN COUPLES EXHIBIT ELASTIC AUTO DEMAND

The determinants of elasticity prove important in choosing a customer subpopulationat whom to target price promotions. For example, consider the cultural differencesthat affect the allocation of expenditure decisions in the Managerial Challenge.Americans spend about 30 percent of their disposable income on housing, 20 percenton autos, and 10 percent on food. The French spend 30 percent on food, 20 percent on housing, and 15 percent on autos. The typical German household mayspend as much as 30 percent of their disposable income on autos, 20 percent onhousing, and 10 percent on food. Using your newly acquired analytical tools relatingincome and substitution effects to price elasticity, go back to the application at the be-ginning of this appendix. Identify two reasons why a 20 percent direct-mail discountcoupon on midsized Chevrolet Malibu automobiles from Flow Motors to a youngGerman immigrant couple who already own a three-year-old Malibu will be more ef-fective in stimulating demand than the same discount offered to the French immigrantcouple who recently shopped at the Flow Buick dealership for a midsized sedan.

NEW PRODUCT PRICING

What’s a cell phone worth? When cell phones first began replacing two-way mobileradios in 1983, one of the hardest questions for Motorola to answer was what priceelasticity of demand would characterize the new product. Clearly, no close substitutes

εp �(930 � 600)�765($30 � $60)�$45

� �0.65

εp �(1,200 � 600)�900($30 � $60)�$45

� �1.0


EXAMPLE


existed. Returning to the mobile phone installed in one’s car or truck to check inwith the office or stopping to regularly call the office from a pay phone imposed sub-stantial inconvenience relative to a small light cell phone carried in one’s coat pocket.Consumers would presumably pay substantially higher prices for the convenience ofthe new technology. But how much higher and what sensitivity would the new de-mand exhibit to price promotions? These difficult questions require careful analysiswhen an extensive history of product sales and price data are present. They are evenharder to answer with new products, not yet introduced.

One approach to estimating the value of a new product is to conduct market-ing research experiments that benchmark the product against other similartechnologies. Thus, when digital technology made pagers a practical extension ofcell phones in 1992, it was possible to ask cell phone users what extra amountper month they would pay to have access to a pager. Similarly, buyers of Chee-rios, a ready-to-eat cereal, can be surveyed about their willingness to pay extrafor Apple Cinnamon Cheerios. Often, however, the technological leaps associ-ated with new product introductions make these comparisons infeasible. In1972, few engineers could assess their willingness to pay for pocket calculatorsrelative to slide rules. In 1981, few secretaries could assess their improved effi-ciency with electronic word processors rather than manual typewriters. Someother method was required to identify the extra quality and value contributed bythe new products.

One approach involves identifying a buyer’s indifference curve. In a so-called re-vealed preference experiment, a household agrees to keep a diary of their food andentertainment consumption over an extended time period. Various coupon and sub-sidy schemes change the effective price of items the household buys regularly. If aconsumption experimenter lowers the price of food and raises the price of entertain-ment such that the household now can select between (F1, E1) or any other combi-nation allowed by the new flatter budget line in Figure WA.10, and if the householdresponds that they still prefer (F1, E1), the new shaded area of consumption choiceshas been identified as less preferred.

Conducting the same experiment in reverse (i.e., with increased food prices andlower entertainment prices along the steepest budget constraint in Figure WA.10),we identify another shaded set of consumption bundles less preferred than (F1, E1).Continuing in this fashion until the household switches to a new subsidized foodcombination such as (F2, E2) or a new subsidized entertainment combination like(F3, E3) reveals the shape and location of the household’s indifference curve. Thesetechniques are important in pricing new products and in measuring the cost of livingbefore and after new product introductions.

MEASURING THE VALUE OF CELLULAR PHONES3

Motorola’s introduction of the cellular phone clearly raised the quality of telecom-munications services. The difficult question was what value to place on thisenhanced convenience for “staying in touch.” Public as well as private managers


3 Based on “It Overstates Inflation,” BusinessWeek (June 9, 1997), pp. 68–69; “Costing a Packet,” TheEconomist (May 6, 1996), p. 75; and J. Hausman, “Cellular Telephones: New Products and the CPI,” NBERWorking Paper, no. 5982 (March 1997).

EXAMPLE


are interested in such a question because quality enhancements offered by newproducts such as cellular phones, open-heart surgery, and central air conditioningall lower the cost of living. Official cost-of-living indices for medical services, hous-ing, and telecommunications determine everything from hospital cost reimburse-ments to wage indexation agreements in union bargaining, and therefore becomeembedded in the underlying rate of inflation. Estimating correctly the value of thesequality improvements from a new product became a serious issue in boardrooms,on Wall Street, and in congressional debates about social security cost-of-livingadjustments.

To calculate the value of a new product consumed at PNP in the quantity QNP (onthe horizontal axis), consider the following procedure with a representative house-hold or business that chooses between two-way-radio mobile phones and cellularphones. Raise the price of the new cellular phone service until the last most valuableuse is discouraged and quantity demanded falls to zero. Figure WA.11 illustrates thisidea as a steepening of the initial budget constraint whose x-intercept is M�PNP untilthe preferred quantity declines from QNP to zero at Point 2�. Identify the price thatis high enough to accomplish the collapse of all new product sales as Pmax, the “vir-tual price” beyond which no one would purchase the new cellular phone product.Then, maintaining relative prices at this Pmax level (namely, Pmax�Pradio), calculate thepurchasing power required to leave the household as well off as they were with QNP

at Point 1� on U1. After the money income of the household (M) is subtracted out,the value of the enhanced quality attributable to the new product is equal to the ad-ditional dollars required to restore utility to the level U1 associated with current salesof the new product.


Figure WA.10 Using Budget Lines to Reveal the Consumer’s Preference

F1

E1

M/PF

M/PE

(F3, E3)

(F2, E2)

M = PF QF + PE QE


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(mov

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QE


Graphically, in Figure WA.11, hold utility constant at U1 while raising cellularphone prices to Pmax as indicated by the shape of the budget constraint from M toM/Pmax. Along U1 the tangency at Point 3� identifies M � VNP as the amount of pur-chasing power required. Subtracting M from the y-intercept of the budget constrainttangent at 3� leaves VNP. Therefore, VNP is the additional value attributable to thenew cellular phone product.

Revealed preference techniques for identifying the household’s indifference curvedata and knowledge of the budget constraints in question make estimates of VNP forcell phones obtainable for both Motorola’s pricing analysts and the cost-of-livinganalysts in the Bureau of Labor Statistics.


Figure WA.11 The Value of a New Product

O

M

M/Pmax QNP M/PNP

M + VNP

U1

Quantity of new product (cellular phones) QNP

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1

3

2



SUMMARY• Scarcity implies trade-offs, and consumers carefully

examine trade-offs in order to maximize their satisfac-tion from spending budgets that are constrained.

• Economics analyzes changes in budget constraints andtheorizes about subsequent consumer choices based ongiven preferences.

• If the price of one good relative to another declines,and if purchasing power remains unchanged, thenquantity demanded will increase. This implication isreferred to as the weak axiom of revealed preference.

• Relative prices (not absolute prices) determine the al-location of household budget between competingproduct expenditures.

• Indifference curves separate the choice bundles a con-sumer prefers from those less preferred.

• These assumptions can be made about consumers:they are capable of pairwise ranking hypothetical con-sumption bundles; they prefer more to less for eco-nomic goods and the reverse for economic bads(garbage, pollution); they are logically consistent; andthey experience eventually declining marginal utility asconsumption of a good increases.

• Indifference curves never intersect, always have negativeslope for economic goods, and are concave from above.

• Perfect complements in consumption generate indiffer-ence right angles.

• To reach consumer equilibrium, households set theratio of prices for two goods equal to the ratio of theirmarginal utilities. These ratios are the slopes of thehousehold’s budget constraint and the relevant indif-ference curve at the point of tangency.

• Demand curves can be derived from indifference curveanalysis, and the price elasticity of demand is traceableto the magnitude of the income and substitution effectsin the indifference curve analysis.

• The income inferiority of a good or service depends onthe income level context, especially the target market’smedian income, the economy being described, and thestage of the consumer’s life cycle.

• The sensitivity of demand to a price discount dependson the percentage of the budget the target householdspends on the good, as well as the number and close-ness of substitutes and the time period allowed for ad-justment of consumption.

• Revealed preference experiments can be used to ana-lyze the optimal price at which to introduce newproducts.

• The value to the target consumer of the enhanced qual-ity from introducing a new technology or product canbe estimated by measuring the income effect in an in-difference curve analysis.

1. A recent employee has been assigned out of town for several weeks as a consultant forAnderson Consulting (AC), a management consulting company. AC pays a travel ex-pense supplement of $1,350 per month for local auto and housing expenses during out-of-town assignments. The supplemental income is available only as reimbursement forthese two types of purchases. The price for apartment space is $25 per 50 square feetper week, and the price for auto rentals is $150 per week. What is the actual rate of ex-change between autos and housing space? Construct a diagram illustrating the choicesin the consultant’s opportunity set. If the job site were in a remote location separatedfrom all the apartments and no ride-sharing or public transportation is available, whatconsumption choices in the opportunity set would be excluded from consideration?

2. If the consultant in Exercise 1 could walk to work but chose instead to consume threeweeks of auto transportation and rented a 450-square-foot apartment, what can onepredict about the likelihood of increasing apartment space consumption when a $150per month increase in the supplemental budget for these living expenses occurs? Whatcharacteristic of the apartments in question is pivotal to this prediction? What charac-teristic of auto rental consumption is pivotal to this prediction? Why?

3. If the consultant in Exercise 2, who initially consumed three weeks of auto rentals anda 450-square-foot apartment, experienced a $50 per week increase in the price of rental

Exercises


cars at the same time the $150 supplemental living expense was granted, what can onepredict then about the consumption of auto rentals? Apartment space? Why?

4. Ms. Jones consumes three products, A, B, and C. She decided that her last purchase ofA gave her 8 units of satisfaction, her last purchase of B gave her 10 units of satisfac-tion, and her last purchase of C gave her 5 units of satisfaction. The prices of A, B, andC are $4, $5, and $3 per unit, respectively. As a rational consumer, should Ms. Jonespurchase a different mix of A, B, and C?

5. Charitable motives can explain why one household sacrifices part of its own consump-tion to give greater consumption to a less fortunate household. Illustrate this conceptwith indifference curves between more consumption for the donor on the x-axis, for therecipient on the y-axis, and budget choices below the 45 degree line. Now, suppose thatabove the 45 degree line envy sets in for the donor household. What shape will the in-difference curves of the donor take above the 45 degree line? (Remember more charityin this region is a source of disutility for the donor.) What choice bundle is implied bythe these preferences if the recipient should ever happen to acquire more consumptionthan the donor?

6. Most gift givers assume that Christmas gift recipients prefer presents rather than cash.In order for this assumption to be true, the time and effort of the gift giver in selectinga present must have value to the recipients. Using indifference curve analysis, show why.

7. Which of the following is more likely to have a negatively sloped income-consumptioncurve for an upper middle income American household: steak dinners, designer jeans,efficiency apartments, personal computers, all housing? Why? What would be the effectof looking at the same question in an upper high income household?

8. In the following pairs, which products are likely to have the flattest and which thesharpest indifference curves for an individual’s consumption: Kroger Jolt cola andCoca-Cola’s Surge, Netscape and Yahoo! Internet search engines, tennis balls and ten-nis racquets, skis and ski boot bindings, chocolate milk mix and milk? Why?

9. Identify four reasons why the demand for Gatorade is likely to be less price elastic thanthe demand for two-bedroom generic apartments. Relate your answers to the conceptsof income and substitution effects.

10. Using income and substitution effects, explain several reasons why table salt has one ofthe lowest measured price elasticities of market demand—namely, �0.1.

11. In targeting a price promotion for the Chevy Impala to households in neighborhoodswith known income levels, what factors should be considered in deciding which neigh-borhoods to place on the list for a direct-mail promotion? Why?

12. Analyze the effect of a price reduction on a product that has become increasingly a com-modity, such as 35 mm photographic film. Is demand more or less price elastic than ear-lier when Kodak film had a unique brand image? What has changed about the incomeand substitution effects from the price reduction?

13. Explain why inferior goods have less elastic demand than income superior goods, allother things being the same.


Elective health care and child care can be purchased with either taxable wage incomeor tax-exempt payroll deductions. Some companies offer such health and child carepayroll deductions, and others do not. Because the employees with health and childcare accounts pay for these services in pretax dollars, the net price is lower than ifthe employee purchased the same services on the open market.

Consider the household consumption choice between elective health care (e.g.,sun-sensor eyeglasses or cosmetic surgery) and all other goods. Analyze the effect on

CASE

EXERCISES


demand of exempting the amount spent on such purchases from income taxes. Usingrevealed preference analysis, show why households would prefer tax-free electivehealth care accounts that substantially reduce their take-home pay but retain suffi-cient purchasing power to replicate the household’s consumption prior to the taxexemption. Investigate whether your school or business has such accounts.

VALUE-IN-USE OF DVDS

Discuss alternative methods of estimating the value of DVDs. What establishedproducts would you ask consumers to compare to DVDs? What advantages wouldmarketing researchers focus on as the sources of new product value for a DVD overearlier products? Sketch how a revealed preference experiment and indifferencecurve analysis could be used to estimate the value of a DVD.



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