Demand

Summary and Introduction to Demand

In microeconomics, demand refers to the buying behavior of a household. What does this mean? Basically, micro economists want to try to explain three things: 1. Why people buy what they buy 2. How much they're willing to pay 3. How much they want to buy Instead of looking at all consumers in the world, however, they try and model how smaller units function: instead of asking, "How does the American market function?" they ask, "What will one household do?" Each household, or small-scale decision-making unit, is affected by different factors when making choices about what to buy and how much to buy. For instance, if one household lives in Florida and other lives in Michigan, they might have different preferences for clothing, since the climates are so different. Consumer preferences weigh heavily in a household's buying decisions. Another factor that affects such decisions is income: a millionaire and an average citizen will have very different purchasing choices, since they have different budgets to work on. All buyers will try to maximize their utility, that is, make themselves as happy as possible, by spending what money they have in the best way possible. By considering both their preferences and their budget, they ensure that they end up with the best combination of goods possible. Because the household is such a small unit, no household has a significant impact on the market, and so the actions of any single household is its best effort to react to the market price and the goods available. In this unit on demand, we will learn how to work with graphical and mathematical models for demand, we will observe how changes in price or income can affect demand, we will see how consumers make choices under uncertainty, and we will apply that knowledge to calculate the optimal purchases an individual consumer can make, given their income and the prices of goods.

Terms
Aggregate Demand - The combined demand of all buyers in a market. Budget Constraint - The outermost boundary of possible purchase combinations that a person can make, given how much money they have and the price of the goods in consideration. Buyer - Someone who purchases goods and services from a seller for money. Competition - In a market economy, competition occurs between large numbers of buyers and sellers who vie for the opportunity to buy or sell goods and services. The competition among buyers means that prices will never fall very low, and the competition among sellers means that prices will never rise very high. This is only true if there are so

many buyers and sellers that no one individual has a significant impact on the market's equilibrium. Complementary Good - A good is called a complementary good if the demand for the good increases with demand for another good. One extreme example: right shoes are complementary goods for left shoes. Demand - Demand refers to the amount of goods and services that buyers are willing to purchase. Typically, demand decreases with increases in price, this trend can be graphically represented with a demand curve. Demand can be affected by changes in income, changes in price, and changes in relative price. Demand Curve - A demand curve is the graphical representation of the relationship between quantities of goods and services that buyers are willing to purchase and the price of those goods and services. Example:

A Sample Demand Curve Diminishing Returns - Concept that the marginal utility derived from acquiring successive identical goods decreases with increasing quantities of goods. Economics - Economics is the study of the production and distribution of scarce resources, and goods and services. Equilibrium Price - The price of a good or service at which quantity supplied is equal to quantity demanded. Also called the market-clearing price. Equilibrium Quantity - Amount of goods or services sold at the equilibrium price. Because supply is equal to demand at this point, there is no surplus or shortage. Expected Value (EV) - How much a buyer thinks that a good or investment will be worth after a time lapse, based on the probabilities of different possible outcomes. Usually refers to stocks and other uncertain investments. Giffen Good - Theoretical case in which an increase in the price of a good causes an increase in quantity demanded. Firm - Unit of sellers in microeconomics. Because it is seen as one selling unit in microeconomics, a firm will make coordinated efforts to maximize its profit through sales of its goods and services. The combined actions and preferences of all firms in a market will determine the appearance and behavior of the supply curve. Goods and Services - Products or work that are bought and sold. In a market economy, competition among buyers and sellers sets the market equilibrium, determining the price and the quantity sold.

Horizontal addition - The process of adding together all quantities demanded at each price level to find aggregate demand Household - Unit of buyers in microeconomics. Because it is seen as one buying unit in microeconomics, a household will make coordinated efforts to maximize its utility through its choices of goods and services. The combined actions and preferences of all households in a market will determine the appearance and behavior of the demand curve. Income Effect - Income effect describes the effects of changes in prices on consumption. According to the income effect, an increase in price causes a buyer to feel poorer, lowering the quantity demanded, and vice versa. Although the buyer's actual income hasn't changed, the change in price makes the buyer feel as if it has. Indifference Curve - Graphical representation of different combinations of goods and services that give a consumer equal utility or happiness. Inferior Good - A good for which quantity demanded decreases with increases in income. Marginal Utility - Additional utility derived from each additional unit of goods acquired. Market - A large group of buyers and sellers who are buying and selling the same good or service. Market Economy - An economy in which the prices and distribution of goods and services are determined by the interaction of large numbers of buyers and sellers who have no significant individual impact on prices or quantities. Market-clearing Price - The price of a good or service at which quantity supplied is equal to quantity demanded. Also called the equilibrium price. Microeconomics - Subfield of economics which studies how households and firms behave and interact in the market. Normal Good - A normal good is a good for which an increase in income causes an increase in demand, and vice versa. Optimization - To maximize utility by making the most effective use of available resources, whether they be money, goods, or other factors. Resource - A supply of capital that can be used in an economy. Because resources are scarce, however, there is not enough to go around. Risk - Refers to the amount of variation in possible payoffs. A very risky investment will have wide variation in possible payoffs, but might have a higher expected value; a less risky investment will have a more predictable payoff, but a lower expected value. Risk-averse - Refers to a buyer who is unwilling to invest in an investment with wide variation in possible payoffs. Someone who is risk-averse might even refuse to invest in something with a positive expected value if the variation in possible outcomes is too great. Risk-loving - Refers to a buyer who is willing to invest in an investment with wide variation in possible payoffs, in the hopes of getting a large return. In extreme cases, a risk lover might even invest in something with a negative expected value. Risk-neutral - Refers to a buyer who does not care about variation in possible payoffs. A risk-neutral buyer will invest in any investment with a positive expected return, regardless of how risky it is. Scarcity - Goods, services, or resources are scarce if there is not enough for everyone to have as much as they would like.

Seller - Someone who sells goods and services to a buyer for money. Substitute Good - Refers to a good which is to some extent interchangeable with another good, meaning that when the price of one good increases, demand for the other good increases. Substitution Effect - Describes the effects of changes in relative prices on consumption. According to the substitution effect, an increase in price of one good causes a buyer to buy more of the other good, since the first good has become relatively expensive, and vice versa. The buyer substitutes consumption of the second good for consumption of the first. Supply - Supply refers to the amount of goods and services that sellers are willing to sell. Typically, supply increases with increases in price, this trend can be graphically represented with a supply curve. Utility - An approximate measure for levels of "happiness." Wage - Price per unit of time when the good being sold is some form of labor or work (as opposed to a physical product).

Two Approaches to Demand

The Graphical Approach

Economists graphically represent the relationship between product price and quantity demanded with a demand curve. Typically, demand curves are downwards sloping, because as price increases, buyers are less likely to be willing or able to purchase whatever is being sold. Each individual buyer can have their own demand curve, showing how many products they are willing to purchase at any given price, as shown below. This graph shows what Jim's demand curve for graham crackers might be:

Jim's Demand Curve for Graham Crackers To find out how many boxes of graham crackers Jim will buy for a given price, extend a perpendicular line from the price on the y-axis to his demand curve. At the point of intersection, extend a line from the demand curve to the x-axis (perpendicular to the x-

axis). Where it intersects the x-axis (quantity) is how many boxes of graham crackers Jim will buy. For instance, in the graph above, Jim will buy 3 boxes when the price is $2 a box.

Aggregate Demand and Horizontal Addition

Typically, economists don't look at individual demand curves, which can vary from person to person. Instead, they look at aggregate demand, the combined quantities demanded of all potential buyers. To do this, add the quantities which buyers are willing to buy at different prices. For instance, if Jim and Marvin are the only two buyers in the market for graham crackers, we would add how many they are willing to buy at price p=1 and record that as aggregate demand for p=1. Then we would add how many they are willing to buy at price p=2 and record that as aggregate demand for p=2, and so on. This results in the following graph of aggregate demand for graham crackers:

Jim and Marvin's Demand Curves for Graham Crackers

Aggregate Demand Curve for Graham Crackers

This method is called horizontal addition because you look at a price level, and add the separate quantities demanded across that price level, giving you total quantity demanded for that price. There are many factors that can affect demand quantity, including income, prices, and preferences. Let's look at one good to see how this works. How much are you willing to pay for a cold soda? If you recently got a raise at your job, you might not mind buying a pricier soda, even if you don't need it. Your friend who has less money, however, might pick a generic brand, or they might stick with tap water. Below are possible demand curves for you (with your big raise) and your friend (without your big raise). Note that you are willing to buy more soda than your friend is:

2 Demand Curves for Soda What if soda cost a dollar yesterday and costs two dollars today? That might make you think twice about getting the same soda you drank yesterday. Likewise, if it cost two dollars yesterday and a dollar today, you might be more willing to buy the soda than usual. We can see this on the graph on a single demand curve. When the price is a dollar, the quantity demanded is higher than when the price is two dollars. What this means in the real world is that if two companies charge different prices for the same good, the company that charges a lower price will get more customers. (Exceptions to this general rule may occur when there is a real or perceived difference in quality of the goods being sold).

Changes in Demand with Changes in Price We have been looking at how changes in price can affect buyers' decisions: when price increases, demand decreases, and vice versa. However we have been assuming that when the price changes, all else is staying the same; this restriction allows us to use the same demand curve, with changes in demand being represented by movements up and down the same curve. This model of a buyer moving up and down one demand curve is correct if the only thing that is changing is the price of the good. If preferences or income change, however, the demand curve can actually shift. For example, let's say that Conan's initial demand curve for concert tickets looks like curve 1. If Conan gets a new job, with a permanently higher income, however, his demand curve will shift outwards, to curve 2. Why is this? Conan realizes that he has more money, and that, as long as he doesn't lose his new job, he will always have more money. That means that he can buy more of what he likes, and he will have a higher demand curve for all normal goods.

Shifts in Demand

Note that for any price level, Conan's demand is now higher than it was before the demand shift. This can also occur with a change in buyer preferences. If Conan suddenly decides that he wants to collect jazz CDs, and he now likes jazz CDs much more than he did before, his demand curve will shift outwards, reflecting his new appreciation of jazz, and his willingness to pay more for the same CDs, since they have become more valuable in his eyes. Shifts in demand curves are caused by changes in income (which make the goods seem more or less expensive) or changes in preferences (which make the goods seem more or less valuable).

The Algebraic Approach

It is also possible to model demand using equations, known as demand equations or demand functions. While these equations can be very complex, for now we will use simple algebraic equations. We have been showing demand as straight, downwardsloping lines, which can easily be translated into mathematical equations, and vice versa. Just as the graphs provide a visual guide to consumer behavior, demand functions provide a numerical guide to consumer behavior. For example, if Sean's demand curve for Tshirts looks like this:

Figure %: Sean's Demand Curve for T-Shirts The corresponding equation that describes Sean's demand for T-shirts is simply the equation for the line on the graph, or: Q = 25 - 2P If we want to see how much Sean will buy if the price is 10, we plug 10 in for P and solve for Q. In this case, [25 - 2(10)] = 5 T-shirts. When we want to find aggregate demand using the algebraic approach instead of the graphical approach, we just add the demand equations together. So, if we're adding Sean's demand for T-shirts to Noah's demand for T-shirts, it looks like this:

Figure %: Aggregate Demand If price for T-shirts is still equal to 10, we find out that together, Sean and Noah will buy [65 - 5(10)] = 15 T-shirts. One caveat in this method is that you can only add the equations together when both will result in positive demand. For example, if the price of a T-shirt is $13, Sean would supposedly want to buy [25 - 2(13)] = -1 T-shirts. Obviously that is impossible, and Sean will buy 0 T-shirts. But because Sean's demand equation would yield the answer 1, adding the demand equations together would result in a wrong answer. When using this method, always check to make sure that there will be no negative demand for the given price before adding equations together. To find how many T-shirts Sean and Noah would buy in this case, you would only look at Noah's demand, [40 - 3(13)] = 1 T-shirt.

Income and Substitution Effects

Income and Substitution Effects

Changes in price can affect buyers' purchasing decisions; this effect is called the income effect. Increases in price, while they don't affect the amount of your paycheck, make you feel poorer than you were before, and so you buy less. Decreases in price make you feel richer, and so you may feel like buying more. What if we're looking at two goods at once? For instance, a fast food chain sells hamburgers and hot dogs. If the price of hamburgers goes up, but the price of hot dogs stays the same, you might be more inclined to buy a hot dog. This tendency to change your purchase based on changes in relative price is called the substitution effect. When the price of hamburgers goes up, it makes hamburgers relatively expensive and hot dogs relatively cheap, which influences you to buy fewer hamburgers and more hot dogs than you usually would. Likewise, a decrease in hamburger price would cause you to eat more hamburgers and fewer hot dogs, according to the substitution effect. The income effect also affects buying decisions when there are two (or more) goods. When the price of hamburgers goes up, it makes you feel relatively poorer, so your tendency might be to buy fewer of both hamburgers and hot dogs. If you look at the combined results of the income effect and the substitution effect, the total effect is a little unclear. According to the income effect, an increase in the price of

hamburgers decreases consumption of both hamburgers and hot dogs. According to the substitution effect, however, hamburger consumption drops, but hot dog consumption rises. Thus, while it is clear what happens to hamburger consumption, since both effects tend to cause a decrease, we cannot be sure what happens to hot dog consumption, since there is both an increase (substitution effect) and a decrease (income effect).

Table of Income and Substitution Effects While we cannot be absolutely certain about the net result, in general, the substitution effect is stronger than the income effect. That is, when the price of hamburgers goes up, you will most likely eat fewer hamburgers and more hot dogs, since the change in relative prices (substitution effect) affects you more than the perceived change in your income (income effect). Another factor influencing demand is one which marketers and advertisers are always trying to understand and target: buyers' preferences. What do people like? When and how do they like it? Still looking at soda, it makes sense that people drink more soda when it's hot, or when they're eating a meal, or when they've been exercising. In these cases, buyers' preferences have changed: they want the soda more, and are therefore willing to pay more for the same good. Likewise, if it's snowing, fewer people will crave a cold soda, and the price they are willing to pay for a cold soda is lower, although they may be willing to pay a little extra money for a hot coffee.

Normal, Inferior, and Giffen Goods

Are all goods the same? Is more always better? Up to this point, we have been assuming that when we have more money, or feel like we have more money, we will tend to buy more goods. It makes sense: the more money we have, the more we buy. If we have less money, or if the price goes up, however, we tend to buy less. Because this is usually the case, we call such goods normal goods. If you buy more of a good when you have more money, that good is a normal good. If the price of a normal good increases, you buy less.

There are some exceptions, however: not all goods are normal goods. For instance, if an increase in your income causes you to buy less of a good, that good is called an inferior good. For instance, "poor college students" often satisfy themselves with generic soda and cheap ramen. When they get jobs and a steady income, however, they might forego the cheap soda and ramen in favor of Coke and pasta. In this example, the generic soda and cheap ramen are inferior goods. Income and substitution effects change demand differently with different types of goods. For instance, we have been looking at income and substitution effects when a buyer is faced with a choice between two normal goods. An increase in the price of good A will cause a decrease in consumption of A, and an increase in consumption of good B (assuming that the substitution effect is stronger than the income effect). If good A is a normal good, and good B is inferior, however, the results will be different. Why is this true? Consider the case where the price of good A goes up.

Income and Substitution Effects with Normal and Inferior Goods The substitution effect makes B relatively cheaper, so consumption of B will increase, and consumption of A will decrease. The income effect makes the buyer feel poorer, and so consumption of A will decrease, but consumption of B will increase. Remember that consumption of an inferior good varies inversely with income: when you are rich, you buy less, when you are poor, you buy more. If the A is still normal and B is still inferior, and the price of A falls, then the substitution effect will cause higher consumption of A and lower consumption of B, and the income effect will cause higher consumption of A and lower consumption of B. Because the buyer now feels richer, they are less inclined to buy the inferior good.

Income and Substitution Effects with Normal and Inferior Goods Another exception is the case where an increase in price causes an increase in demand. This results in an upward-sloping demand curve, and the good is called a Giffen good. Giffen goods are theoretically possible, but very improbable, since it is unlikely that an increase in price causes increase in demand. One possible justification for a Giffen good is that people associate higher prices with status, luxury, and quality, so that a higher price might increase the perceived value of a good. In reality, however, this effect is outweighed by the overwhelming tendency to prefer lower prices: even if a few people prefer the added cachet of a high-priced luxury good, the general public will prefer lower prices. Another possible case that could cause a Giffen good is the case in which a good is inferior and the income effect outweighs the substitution effect. To illustrate, assume that ACME Cola is an inferior good. When it's price increases, the income effect makes Calvin feel poorer. If the income effect is very strong, and the substitution effect is very weak, then Calvin will buy more ACME Cola, because the consumption of inferior goods increases with decreases in income. This, too, is unlikely, however, because the substitution effect is almost always stronger than the income effect.

Demand Curve for a Giffen Good

Utility

Utility and Indifference Curves

We know how to represent changes in demand as price or income changes on a graph, but how can we show preferences? What makes buyers happy and how can we measure that happiness? Economists use the term utility when referring to the level of happiness or satisfaction that someone experiences from buying (or selling) goods and services: the more utility, the happier the person. Utility is typically represented on a graph in an indifference curve. An indifference curve represents all of the different combinations of two goods that generate the same level of utility. What this means is that each point on an indifference curve represents a combination of goods. All points on one indifference curve give the person the exact same amount of happiness. For instance, if you give Jim a choice between points A and B on this indifference curve, he won't really mind either way, he is indifferent. One shirt and two hats makes him just as happy as two shirts and one hat, which is why both points are on the same indifference curve.

One of Jim's Indifference Curves for Shirts and Hats In general, indifference curves bow in towards the origin, rather than being straight lines or outward-bulging curves. The reason for this is that most people do not like extremes: they would rather have a some shirts and some hats than many hats and no shirts. This changing preference results in the traditional inward-curving indifference curves, and illustrates the effects of diminishing returns. In this example, diminishing returns simply means that the first hat Jim gets makes him happier than the second hat, which makes him happier than the third, and so on. His marginal utility--the extra utility he gets with each hat--decreases with the number of hats he gets. After a while, he has had enough of hats, the extra ones don't make him much happier, and he'd rather get a shirt, and might even trade several hats for one shirt. Generally, at the extremes, people are willing to give up many hats to get a few shirts; as the numbers even out, this swapping ratio decreases, and then when they start moving to the other extreme, they want a lot of shirts in exchange for any hats they might give up.

Another example that illustrates the principle of diminishing returns would be the case in which you give Thom a choice between gold and steak. We all know that a bar of gold is worth more than a steak, so only a fool would choose the steak over the gold, right? Thom knows this. If you ask Thom to choose between a bar of gold and a steak, he will probably choose the gold, and be very excited to have a bar of gold. The marginal utility of that first bar of gold is quite high. An hour later, he will choose another bar of gold, and he will still be happy to get another bar of gold; the marginal utility he gets from the second bar of gold might not be quite as high as the marginal utility from the first bar, but it's still higher than the marginal utility he would get from a steak. This will continue, bar after bar, with the added utility of each bar of gold being a little lower than the last. Eventually, Thom will start to get hungry, and if he gets hungry enough, then he will choose the steak over the gold, as the marginal utility from the steak will be higher than the marginal utility from a bar of gold. Thom still knows the relative values of gold and steak, and he knows that he is choosing something that is worth less, but in his situation, he has so much gold that more gold makes very little difference, but a steak can make a large difference, as he is very hungry. Different indifference curves represent different levels of utility, and in general, more is better: the more goods you have, the happier you are. On the graph, we see this preference for more as an indifference curve that is further away from the origin. Thus, because curve 2 is further out than curve 1, and represents a higher level of utility, any point on curve 2 will be preferable to any point on curve 1, and any point on curve 3 will be preferable to any point on curves 1 or 2.

Indifference Curves A few more important observations about one person's indifference curves: they can never cross. Why is this true? Think about it this way: if curve 2 is supposed to make you happier than curve 1, but curve two crosses curve 1, then that means that at the point of intersection, you are experiencing two different levels of utility, that is, you are both happy and happier at the same time, which makes no sense. Thus, indifference curves never intersect, but move further away from the origin with increased levels of utility.

A Correct Set of Indifference Curves

An Incorrect Set of Indifference Curves The indifference curves we have been considering are for normal goods. How can we tell? Because more of either good increases utility. Starting on curve 1 and moving outwards (increasing the number of hats) or upwards (increasing the number of shirts) lands us on curve 2, representing a higher level of utility. Using different types of goods changes what indifference curves look like. For instance, if one good is a normal good, such as CDs, and the other good is an undesirable good, such as Spam, the indifference curves will look like this, with the second indifference curve being better than the first:

Utility Curves for Normal and Undesirable Goods As you can see, an increase in number of CDs causes an increase in utility, since we end up on a better indifference curve, but an increase in the amount of Spam results in a decrease in utility. What if the consumer doesn't care about one of the goods, meaning that getting more or less of that good doesn't make them happier or unhappier? For instance, replace the Spam with expired baseball tickets. Jim likes getting CDs, but really doesn't care how many expired baseball tickets he gets. This makes his indifference curves look like this:

Indifference Curves for Normal and Neutral Goods Note that increasing or decreasing the number of baseball tickets makes no difference in his indifference curve; only changing the number of CDs moves him to a different indifference curve. Another instance in which indifference curves behave strangely is in the case of complementary goods. Demand for complementary goods is directly related. In other words, buying one good increases the probability you'll buy the other good, those two goods are complementary. Mittens are an extreme example of complementary goods: if you buy a right mitten, it is almost a sure bet that you'll buy a left mitten. This also means

that having extra stray mittens isn't likely to increase your utility. There is virtually no difference in your happiness whether you have one right mitten and one left mitten, or two right mittens and one left mitten. This shows up in the following indifference curves (note that only a simultaneous increase of right and left mittens will result in increased utility).

Indifference Curves for Complementary Goods: Mittens What if the two goods being evaluated are pretty much the same? Such goods are called substitute goods: the buyer considers them to be interchangeable. One example of perfect substitutes (though some might argue otherwise) could be Coke and Pepsi. If you consider them to be the same thing, then you don't mind which one you get. More is still better, but you don't care what combination of the two you get, which means that when you have a lot of Pepsi, you would not be willing to trade three cans of Pepsi for one can of Coke, eliminating the inward bend of the indifference curves. This results in indifference curves like this:

Indifference Curves for Substitute Goods: Cola

Utility Optimization
While it is impossible to know exactly what goes on inside a buyer's head while they are making a decision, we can assume that a normal person will choose whichever combination will make them as happy as possible, given their choices and their budget. On the graph, this means that they will choose whichever combination lands them on the highest indifference curve possible. We can see this optimization if we draw in the consumer's budget constraint on the same graph as the consumer's indifference curves. To draw a budget constraint, a line that shows the maximum amount of goods a buyer can purchase with their available funds, you need to know two things: 1) how much money they have, and 2) the prices of the two goods being considered. Once you have both pieces of information, it is simply a matter of finding out the maximum amount of the first good you can buy, without buying any of the second, then finding the maximum amount of the second good you can buy, without buying any of the first. Mark these points on the graph and connect them. To illustrate, suppose Tina has $100. She is deciding how many bottles of wine and how many wine glasses she wants to buy. If wine costs $20 a bottle and glasses cost $5 each, then the most wine she can buy is ($100/$20)=5 bottles. Likewise, she can buy at most ($100/$5)=20 wine glasses. Her budget constraint would look like the darker line, while the filled area includes all of her possible buying decisions, given the amount of money she has. Anything not included in the colored area is out of her budget:

Tina's Budget Constraint If we know her indifference curves, we can draw her budget constraint in with them on the same graph. After that, it is simply a matter of finding the outermost indifference curve that is tangent to (just barely touches) her budget constraint, and use this tangent point as her optimal combination of wine and glasses. In this case, it is the second indifference curve that optimizes her utility given her budget.

Optimizing Tina's Purchasing Decision It looks like Tina will buy about 12 wine glasses and 2 bottles of wine. Even though the optimal amount is a little more than 2 bottles, she has to buy either 2 bottles or 3 bottles, and 2 is all she can afford. (When doing such problems, never round up, since that will land you outside of the budget constraints). Why does it have to be the indifference curve that is tangent to her budget constraint? If it were an indifference curve that crosses her budget constraint, such as the first indifference curve, then we can see that the two points of intersection don't make her as happy as the single tangent point in the previous graph. By picking the outermost curve that still touches her budget constraint, we have maximized her utility. We can't pick a curve any further out, such as the third indifference curve, since she can't afford to buy more than $100 worth of wine and glasses. Obviously, budget constraints change with changes in income or price. For instance, if Tina now has $125 instead of $100, her new budget constraint will be a parallel shift out from her original budget constraint. The yellow shaded region represents the increase in possible purchases she can make:

A Shift in Tina's Budget Constraint

On the other hand, if Tina still has only $100, but the price of wine changes from $20 a bottle to $10 a bottle, her budget constraint will pivot to reflect this change:

A Pivot in Tina's Budget Constraint

Consumer Behavior in Uncertain Situations

Choice Based on Expected Value

In some cases, buyers must make a purchase decision without knowing exactly what they're getting for their money. Deciding whether or not to buy a good without knowing exactly what the good is worth involves some degree of risk, as there is variation in the possible outcome. To make these decisions, buyers have to evaluate, to their best ability, how much the goods are really worth, and then decide how much they are willing to pay for the goods. For example, if Jevan is interested in buying stock in a new startup, he can't be sure what will happen to the value of his stock as time passes. The company could be a huge success, making his stock very valuable, it could be a moderate success, making his stock somewhat valuable, or it could be a failure, making his stock worthless. Before he decides to buy any stock, Jevan has to decide what is the most likely outcome, and what his stock is going to be worth: that is, based on the probability of different outcomes, Jevan has to assign the stock an expected value to compare against the present price. In order for Jevan to be able to calculate this expected value, he needs to account for all possible outcomes, so that the total probability will be equal to 1: let's assume that huge success, moderate success, and failure are the only possible outcomes, so the probability of at least one of them occurring is equal to 1. If Jevan thinks that there is a 1 in 8 chance that the startup will be a wild success, a 1 in 2 chance that it will be a moderate success, and a 3 in 8 chance that it will fail, then he has accounted for all possible outcomes, since the combined probabilities are equal to 1: (0.125 + 0.5 + 0.375) = 1 Next Jevan has to assign values to each outcome. In the event of huge success, Jevan thinks that each share of stock will be worth $20. In the event of moderate success, each

share will be worth $5. In the event of failure, each share is worth $0. Combining all of Jevan's assumptions gives us the following chart of his expectations:

Jevan's Expectations for the Startup Stock's Performance To find out the expected value (EV) of the stock, multiply the probability of each event by the value of each event, and sum the results: EV EV = = (0.125)(20) $5 + (0.5)(5) a + share (0.375)(0)

We find that Jevan expects the stock to be worth about $5, based on his assumptions about company performance. What this means is that Jevan will not be willing to pay more than $5 a share for this stock, since he believes it to be worth $5 a share. He will probably be willing to buy stock if the price is lower than $5, depending on how much he enjoys taking risks. How would we explain it if the price is lower than $5, but Jevan decides not to buy any stock? We know that he believes the stock to be worth $5, so we would expect him to buy stock if it is priced lower than $5 a share. This can be explained by Jevan's openness to taking risks. Because the future price of the stock is uncertain, and Jevan's estimate is only an estimate, if Jevan doesn't like taking risks, that is, if he is risk-averse, then he may choose not to buy any stock, even if the expected returns are positive; he is not willing to invest in a "good" investment because he is still afraid of the possibility that he might lose money. Someone who is risk-averse will choose investments with little variation in possible outcomes, and a high degree of predictability. On the other hand, if the price of the stock is over $5, and Jevan still decides he wants to buy stock, even though he believes it to be worth only $5 a share, then it may mean that he is risk-loving; he is willing to enter into an expected loss on the off chance that the company will make it big. This would be an extreme case; not all risk lovers will invest in stocks with negative expected values. More commonly, risk lovers will make investments that have positive expected values, but have very large variation in possible outcomes.

If Jevan is risk-neutral, then he will not buy stock with negative expected value, he will buy stock with positive expected value, and stock with 0 expected value makes no difference to him at all. Even if the risk is very high, if the expected returns are positive, he will make the purchase. Even if the risk is very low, if the expected returns are negative, he will refuse to buy stock. This type of decision-making based on probable outcomes is used in many different situations: buyers decide how much they are willing to pay for a used car based on the different probabilities that it is in mint condition, that it needs minor repairs, or that it is a useless piece of junk. Students decide how much to study based on their expected performance after different amounts of studying. Art lovers base their decisions on the probabilities that the pieces they are looking at are genuine or forged. In any case where the exact value of a good is unclear, buyers must make their decisions based on probable outcomes and possible worth. After making an estimate of expected value and assessing the risk involved, buyers can then attempt to maximize their utility based on their individual preferences for goods. Risk usually varies inversely with expected returns. That is, a high risk investment will often yield a much higher potential payoff than a low risk investment. This difference in value can be seen as a "reward" for buyers' willingness to take a higher risk. The "penalty" for taking a higher risk is the possibility of losing a lot of money if the investment fails. We can see this discrepancy in the high yields (and losses) in the stock market, which is relatively high risk, the moderate yields of mutual funds, which are relatively moderate risk, and the low yields of government bonds, which are relatively low risk. When a payoff is guaranteed, as with low risk investments, the payoff is usually small, and when a payoff is uncertain, as with high risk investments, the payoff is usually higher.