Managerial Economics Course Book PDF

COURSE BOOK Managerial Economics DLBBWME01_E Course Book Managerial Economics DLBBWME01_E 2 Masthead Masthead Publisher: IU Internationale Hochschule GmbH IU International University of Applied Sciences Juri-Gagarin-Ring 152 D-99084 Erfurt Mailing address: Albert-Proeller-Straße 15-19 D-86675 Buchdorf [email protected] www.iu.de DLBBWME01_E Version No.: 001-2023-0126 © 2023 IU Internationale Hochschule GmbH This course book is protected by copyright. All rights reserved. This course book may not be reproduced and/or electronically edited, duplicated, or distributed in any kind of form without written permission by the IU Internationale Hochschule GmbH. The authors/publishers have identified the authors and sources of all graphics to the best of their abilities. However, if any erroneous information has been provided, please notify us accordingly. Module Director 3 Module Director Prof. Dr. Andreas Simon Mr. Simon has been a professor in business administration at IU International University of Applied Sciences since 2020. Mr. Simon received his PhD in business administration with a focus on accounting and finance from the University of Queensland (Aus- tralia). After his doctoral studies, he was a visiting scholar at the Uni- versity of Michigan’s Ross School of Business (US) and the University of Mannheim (Germany). Mr. Simon’s research focuses on capital market research and the intersection between accounting and finance. He spent 12 years in the US as an associate professor of accounting, finance, and taxation at Pepperdine University’s Graziadio Business School, and as an assistant professor of accounting and finance at California Polytech- nic State University. Prior to his academic career, Mr. Simon worked in the assurance and business advisory for PriceWaterhouseCoopers in Berlin. He is also a trained banker, holds a Certified Public Accounting (CPA) license in the US, and runs his own consulting firm. 4 Contents Table of Contents Managerial Economics Module Director....................................................... 3 Introduction Managerial Economics 7 Signposts Throughout the Course Book.................................. 8 Learning Objectives................................................... 9 Unit 1 Fundamentals 12 1.1 Definition of Terms and Subjects of Economics..................... 12 1.2 How Do Economists Think?....................................... 15 Unit 2 The Invisible Hand of the Market 22 2.1 Supply and Demand............................................. 22 2.2 Market Equilibrium.............................................. 28 2.3 Elasticities...................................................... 32 2.4 Applications.................................................... 35 Unit 3 Consumer Decisions 40 3.1 Utility Theory................................................... 40 3.2 Willingness to Pay............................................... 47 3.3 Demand........................................................ 51 3.4 Applications.................................................... 55 Contents 5 Unit 4 Business Decisions I: Full Competition 62 4.1 Production..................................................... 62 4.2 Costs........................................................... 66 4.3 Offer........................................................... 72 4.4 Applications.................................................... 77 Unit 5 Business Decisions II: Incomplete Competition 82 5.1 Monopoly...................................................... 82 5.2 Monopolistic Competition........................................ 89 5.3 Oligopoly....................................................... 94 Unit 6 Business Decisions III: Game Theory 100 6.1 Methodology................................................... 100 6.2 Simultaneous Games........................................... 102 6.3 Sequential Games.............................................. 107 Unit 7 Advanced Microeconomics 114 7.1 Information Economy........................................... 114 7.2 Behavioral Economics........................................... 119 Appendix 1 List of References 128 Appendix 2 List of Tables and Figures 132 Introduction Managerial Economics 8 Introduction Signposts Throughout the Course Book Welcome This course book contains the core content for this course. Additional learning materials can be found on the learning platform, but this course book should form the basis for your learning. The content of this course book is divided into units, which are divided further into sections. Each section contains only one new key concept to allow you to quickly and efficiently add new learning material to your existing knowledge. At the end of each section of the digital course book, you will find self-check questions. These questions are designed to help you check whether you have understood the concepts in each section. For all modules with a final exam, you must complete the knowledge tests on the learning platform. You will pass the knowledge test for each unit when you answer at least 80% of the questions correctly. When you have passed the knowledge tests for all the units, the course is considered fin- ished and you will be able to register for the final assessment. Please ensure that you com- plete the evaluation prior to registering for the assessment. Good luck! Introduction 9 Learning Objectives The Managerial Economics course provides an overview of the fundamentals of economics. In particular, it addresses the issue of scarcity as a starting point for economic questions and presents economics as the science of markets. Building on these fundamentals, this course takes an in-depth look at three central themes of economics, the understanding of which is of great practical importance for a company’s decision-makers. Firstly, the interplay between supply and demand in markets is analyzed. Secondly, the text offers insights into how con- sumers behave in their respective markets. Thirdly, the course explains the theoretical foun- dations of entrepreneurial decisions on markets and of the strategic interaction with com- petitors. We will look at how these concepts can be applied practically. At the beginning of each chap- ter, a current, practice-relevant question is posed, later answered by the content of the text. The course thus concerns itself with both the theoretical examination and eventual applica- tion of economics. The main objective of this course is to convey the importance of eco- nomic understanding for business practice and its application for solving current challenges in company management. Unit 1 Fundamentals STUDY GOALS On completion of this unit, you will have learned … … what economic theory entails. … the central concepts of economics. … the two major branches into which economics can be divided. … how economists think and what methods they use. … why economists often come to different conclusions. DL-E-DLBBWME01_E-U01 12 Unit 1 1. Fundamentals Case Study Mr. Schmidt, the managing partner of a mid-sized company in the manufacturing industry, is sitting at the breakfast table. While contemplating what to have for break- fast, he goes through the day’s appointments in his mind. In the morning, he will meet with the production manager to discuss the purchase of a new production machine. Shortly before lunch, he will have a phone appointment with the advisor of his local bank to clarify some financial questions. After a business lunch with a new customer from the United States, Mr. Schmidt will meet with the head of human resources. They will discuss possible solutions for the shortage of skilled workers and how to fill long- standing vacancies in a timely manner. In the evening, he will have to decide whether to accompany his wife to the opera or play tennis with a business partner. Mr. Schmidt, skimming the newspaper, notices an article that addresses the question of whether Germany should set an example for China’s industrial and economic policy. Mr. Schmidt learns that even the so-called five “economic wise men” (the five members of the Council of Economic Experts) are divided on this point. While four of the five mem- bers of the Council recommend that the federal government refrain from industrial pol- icy intervention, one member is open to a guiding industrial policy. As a graduate engineer lacking a comprehensive education in economics, Mr. Schmidt is not sure what to make of this discussion. In particular, he is not aware of the conse- quences of any industrial policy intervention or waiver, and to what extent such a pol- icy would affect him as an entrepreneur and private individual. Additionally, it raises the question of the basis on which the economists’ respective recommendations are made and why they arrive at contradictory judgments in the first place. 1.1 Definition of Terms and Subjects of Economics Scarcity of Resources as a Starting Point of Economics Like Mr. Schmidt, people all over the world make a multitude of decisions in their pro- fessional and private lives every day. This involves both mundane issues, such as what breakfast to have or how to spend their free time, and more critical decisions, such as choosing a career or partner. Generally speaking, the human decision-making process means weighing alternatives and resolving conflicting goals. As a rule, in order to obtain something they want, people have to give up something that they also value. Opportunity costs In economics, one speaks here of opportunity costs. Mr. Schmidt, for example, is faced These are what must with the choice of spending the evening with his wife at the opera or a business part- be given up in order ner on the tennis court. If he opts to attend the opera with his wife, he will miss the to gain something chance to develop a better business relationship with his colleague. Students enrolled else. in universities or technical colleges must also contend with opportunity costs. The Unit 1 13 Fundamentals average student will not be able to simultaneously pursue a full-time job and manage a full-time course load. In this example, the opportunity costs of studying take the form of lost wages that could have been earned. Opportunity costs, therefore, always arise. This is because resources can only be used once and are not simultaneously available for more than one purpose. In both exam- ples, time is the resource unable to be allocated to both decisions. However, other resources, both tangible and intangible, are also subject to scarcity. In economics, scarce societal resources, which are necessary for the production of goods and services, are roughly divided into the following three categories known as the fac- tors of production: land, labor, and capital (Mankiw & Taylor, 2018). Factors of produc- tion Land encompasses all the natural resources produced by the earth such as under- These are resources ground mineral deposits, marine fish stocks, and foodstuffs. Labor is the physical and which, from an eco- mental performance of individuals that goes into any production process. Lastly, capital nomic standpoint, refers to the facilities and equipment (i.e., physical capital) required for producing are required for the goods and services. production of goods. At Mr. Schmidt’s company, there is currently an acute shortage of labor and capital. In order to counteract the shortage of capital as a production factor, a new manufacturing machine must be purchased. To address the shortage of skilled workers, a strategy must be developed. Due to the scarcity of resources, consumers, workers, and businesses have had to con- tinually make decisions and weigh the alternative choices in the best possible way. For each company, there are three basic questions that must be resolved (Mankiw & Taylor, 2018): Which goods and services should be produced? How much of these goods and services should be produced? Who should receive the produced goods and services? These questions would be easy to answer if scarcity were not a factor. Unfortunately, resources are not infinite, and neither organizations nor economies are ever truly able to produce enough goods and services that satisfy the needs and wants of every con- sumer all of the time. As an academic and scientific discipline, economics concerns itself with the methods for coping with this scarcity and the decisions one can take to mitigate its effects. Economics as the Study of Markets In addition to being described as the study of managing scarce societal resources, eco- nomics is often referred to as the study of markets (Bofinger, 2015). In the introductory example at Mr. Schmidt’s company, we have already encountered a few different mar- 14 Unit 1 Market kets: the labor market; the banking market; and the retail and wholesale markets, the A market is a collec- latter of which include the procurement of production equipment or the sales market tion of buyers and for the products within Mr. Schmidt’s company. sellers that deter- mine the price of The interaction between buyers and sellers is fundamental to all types of markets. For goods or services example, in retail and wholesale markets, buyers demand goods and services that the through potential or sellers offer. In a market economy system, the price and quantity of the individual real interactions. goods sold are determined by the joint interaction between buyers (potential or actual) and sellers. Here, the three basic questions of the economic problem are thus not Goods resolved through actions taken by the state or government. Rather, they are resolved This is a generic through the decentralized decisions made by numerous companies and households term for products (and/or individual people). Here, companies decide themselves which employees to (tangible goods) and hire and which products they should manufacture. Likewise, individual households services (intangible decide which company they want to work for and which products they want to buy. goods). By contrast, in a centrally administered economy, activity is directed by a central gov- ernment authority. Prices and wages are often subject to government regulation and, therefore, are not the result of free interaction between buyers and sellers within a market. The notion of a centralized economy proposes that the state can organize eco- nomic activity in a way that promotes overall prosperity and contributes to a more just and equal distribution of wealth. However, with the collapse of the Eastern Bloc around 1990, most countries worldwide underwent a transition from a centralized economy to a market economy (Mankiw & Taylor, 2018). Although the state does not usually set prices and wages itself in a market economy, it does have an important function there, too: protecting the integrity of the markets. This is because the pricing mechanism in markets can only work if the property rights of the participating buyers and sellers can be enforced. No farmer would cultivate a field if the harvest was expected to be stolen. Similarly, no department store would offer its goods if it could not be ensured that customers would pay for them. Therefore, it is important that state institutions, such as courts and the police, ensure that legal claims on the goods and services produced and purchased can actually be enforced. Whether the state should also intervene in the economic process of a market economy is a controversial issue even among economists. The diverging opinions of the afore- mentioned five “economic wise men” evince this. In general, state intervention is most likely to be endorsed in a market economy if it can increase the efficiency of the mar- Economic cake ket solution or promote fairness—that is, the (macro)economic cake is expanded or its This image is often distribution becomes more equal (Mankiw & Taylor, 2018). Whether and how state inter- used to describe the vention can achieve this at all, however, often depends on each specific case. This is sum of the economic the subject of numerous economic studies. activities of all per- sons in an economy. Subareas of Economics In general, economics can be divided into two central areas: microeconomics and mac- roeconomics. Microeconomics is concerned with the behavior and decisions of individ- ual economic units such as consumers, employees, investors, landowners, or commer- Unit 1 15 Fundamentals cial enterprises. It also addresses the question of how the respective economic units Microeconomics interact in particular markets. Macroeconomics, on the other hand, focuses on phe- This is a branch of nomena occurring within the economy as a whole such as the level and rate of growth economics that of gross domestic product, interest rates, unemployment, and/or inflation. However, the deals with the boundaries between microeconomics and macroeconomics are becoming increasingly behavior of individ- blurred. More and more frequently, macroeconomists initially analyze the behavior of ual economic enti- individual economic units in order to better understand the macroeconomic phenom- ties and their inter- ena of interest based on the microeconomic knowledge gained (Pindyck & Rubinfeld, action with the 2018). markets. The distinction between microeconomics and macroeconomics is particularly impor- Macroeconomics tant when individual economic decisions lead to unintended macroeconomic conse- This is a branch of quences. Thus, it may make sense for each individual private household to save and economics that consume less. However, if all households in an economy were to save by cutting back deals with variables on consumer spending, this would reduce the revenue of the companies. If, as a conse- regarding the econ- quence, companies got into financial difficulties and had to lay off employees, house- omy as a whole such hold income would decrease further. As a result, households may end up with fewer as the unemploy- assets despite an increased effort to save—this phenomenon is known as the savings ment rate, interest paradox (Bofinger, 2015). rate levels, or price increases. Savings paradox 1.2 How Do Economists Think? This is a situation in which the microeco- nomic increase in Economists as Scientists the propensity to save leads to a As in many other branches of scientific study, economics focuses on the explanation of reduction in overall observed phenomena and the prediction of future developments. For example, eco- economic wealth. nomics explains why demand for certain consumer goods declines (perhaps due to an increase in price) while the sales of other goods increase. Predictions are also made as to how, for example, the introduction of a tax on CO2 emissions affects the demand for electric cars. Explanations and forecasts in economics are based on scientific theories, as is common practice in science as a whole. There are basically two different methodological ways to gain new knowledge. The inductive method begins with a real-life observation from Inductive method which certain structures and relationships are derived. This observation forms the This is a scientific basis of a hypothesis and, in turn, a theory is developed. Conversely, using the deduc- method for gaining tive method begins with a theory from which a hypothesis is derived. It is tested based knowledge by draw- on empirical observations, later adjusted if necessary. Neither of the two methods is ing conclusions from better than the other. Rather, they are two different ways of conducting research, and empirical, individual both approaches can be closely linked (Mankiw & Taylor, 2018). observations about the general. The relationship between the induction and deduction methods can be illustrated through a classic example of observing swans. A researcher observing water birds on a lake over a period of time might find that all the swans present there are white. Accord- ing to the inductive method, they now formulate the hypothesis that all swans are 16 Unit 1 Deductive method white. They then test this hypothesis by means of further empirical observations on This is a scientific other lakes and rivers. If they continue to only encounter white swans there, the method for gaining researcher may develop a theory that explains the phenomenon of exclusively white knowledge in which swans. Other researchers could subsequently test the hypothesis and come to the conclusions are same conclusion, thus rendering the theory valid—until someone else observes a black drawn from the gen- swan. Once a black swan has been observed, the theory of the exclusively white swans eral to the particular. must be modified. In this case, one speaks of falsification. A researcher could then develop a new theory to explain why the majority of swans are white, taking into Falsification account the occurrence of black swans. According to the deductive method, hypotheses The refutation of a can be derived on the basis of this new theory, which also become the subject of scientific theory or empirical observation (Mankiw & Taylor, 2018). hypothesis through a counter-example is Economic researchers face a particular challenge when developing and reviewing theo- called falsification. ries. If, for example, economists observe in survey data that people with greater for- tunes claim to be happier in their lives, they must first discover the cause and effect. The question, therefore, is whether money makes people happy or, conversely, happier people are more likely to acquire a large fortune. One also speaks here of the problem of reverse causality. Furthermore, it is difficult to keep everything constant when using observational data from real life. Therefore, it is unclear whether (and to what extent) other omitted varia- Omitted variable bles may be responsible for the observed relationship between life satisfaction and An omitted variable wealth. For example, high-paying jobs may make people happier and more satisfied is a factor that has than do low-paying jobs. Thus, in this example, both the assets and the level of satis- not been taken into faction of these people are positively influenced by their profession. Here, the assets account and that can have no direct influence over the level of satisfaction, and vice versa. In the natural sci- explain the results of ences, controlled experiments can be carried out by the researcher in order to specifi- the investigation cally distinguish cause and effect from one another—that is, to address the problem of (instead of the varia- reverse causality in order to rule out the influence of omitted variables. ble under considera- tion). Unfortunately, this is not usually possible in economics. Rather, economists must often resort to natural experiments in which the investigation of a phenomenon is deter- Natural experiment mined by natural circumstances that are not under the control of the researcher con- This is an empirical ducting the experiment. Economists still take the division of Germany as a natural research method in experiment. From 1949 to 1990, two culturally and historically comparable regions on which the research German soil were exposed to very different political and economic conditions. If differ- units are divided ences between the East and West can still be found after German reunification in 1990, into an experimental economists conclude that the reason likely stems from the period of German division. group and a control For example, through taking German division as a natural experiment, researchers have group based on nat- found out that basic political convictions are influenced by the ruling parties. The gen- ural events that can- eral population in the eastern half of the county still has a significantly higher prefer- not be controlled by ence for a stronger state and state-organized redistribution than does the population the researcher. in the western half (Alesina & Fuchs-Schündeln, 2007). In recent years, laboratory experiments have increasingly found their way into the sci- entific methodology of economics, especially in the field of microeconomics. In this way, (micro)economic theories specifically can be tested in a similar way as in the natu- ral sciences. In practice, economic experiments are carried out in computer laborato- Unit 1 17 Fundamentals ries. Participants in the experiment, the test subjects, receive instructions according to Laboratory experi- the respective research question and must make decisions. Typically, the participants ment are monetarily compensated upon completion of the experiment. Laboratory experi- A laboratory experi- ments have two fundamental advantages over empirical work with observational data: ment is a man-made laboratory experiments are flexible, meaning the scientist directing the experiment can experimental control the external conditions and investigate research questions of interest in a more arrangement in targeted manner; laboratory experiments are also repeatable (this factor is called repli- which a scientist cability), meaning that the results can be checked by other researchers and, if neces- exercises specific sary, falsified. However, laboratory experiments in economics are limited to questions control and can concerning the decision-making behavior of individuals and (small) groups. Experimen- exert influence. tal testing of macroeconomic questions is usually not possible in a laboratory. As scientists, economists often use models to illustrate their theories. A model is an image of the real world in which details irrelevant to the investigation of a specific question are excluded based on a set of assumptions. The procedure is similar to an anatomical model used in secondary school biology lessons in which individual details of the human body are abstracted to achieve a certain didactic goal. Making assump- tions offers the researcher an advantage in that they help to reduce the complexity of the real world and, thus, make it easier to understand. However, there is a risk involved —that models based on assumption may deviate too much from reality. In the after- math of the financial crisis of 2008, macroeconomics in particular faced this accusa- tion. Many claimed its models were based on unrealistic assumptions and, therefore, could not have predicted the crisis. For this reason, it is imperative to constantly vali- date the assumptions required for a new model and to make appropriate decisions based on that analysis. That, in essence, is the art of scientific, academic thought (Man- kiw & Taylor, 2018). Economists as Political Consultants In the previous section, the focus was on the economist as an (objective) researcher concerned with the explanation of observed phenomena and forecasts deduced from a scientific methodology. In addition to this role, economists often need to make con- crete recommendations to improve economic outcomes and processes. One example is the German Council of Economic Experts, who publish their recommendations in an annual report as well as intermittent special reports (German Council of Economic Experts, n.d.). The article Mr. Schmidt read at the breakfast table focused on these five “economic wise men” and how they serve as political advisors and assess the guiding industrial policy in Germany. As academics, economists usually deal with positive issues; as policy advisors, they are often confronted with normative questions. Positive analyses are descriptive of how Positive analyses the world actually is. The claims made through positive analyses specifically can be A positive analysis objectively verified and, if necessary, refuted. Methodologically, both the inductive and makes verifiable the deductive procedure play a role here. By contrast, normative analyses are prescrip- statements to tive and aim to show how the world should be. Normative analyses also contain the describe the rela- researcher’s opinions and value judgments that elude objective examination and can- tionship between not simply be dismissed through falsification (Pindyck & Rubinfeld, 2018). cause and effect. 18 Unit 1 Normative analyses For example, a positive analysis by an economist could result in the suggestion that a A normative analysis tax on CO2 emissions would place a financial burden on commuters. The analysis thus is concerned with describes the relationship between cause and effect. Conversely, a normative state- the examination of ment by an economist might suggest that Germany should introduce a CO2 tax in the the following ques- interest of climate protection. This statement aims to show how the world should be tion: “What should and contains a value judgment with regard to the economist’s personal attitude be?” towards environmental protection. This example also shows that positive and norma- tive analyses can be related to each other, and that the result of positive analyses con- cerning how a CO2 tax actually works will, in fact, influence our normative views on the political measures we as a society want to see. Economists as Managers Economists are not only in demand as scientists or as policy advisors. They are also increasingly taking on positions of responsibility within private companies. For exam- ple, international technology companies have recently begun to recruit economists as employees and develop entire teams with economic expertise to handle strategic and operational issues (Athey & Luca, 2019). Two specific skills taught in economics prove to be particularly useful: the analysis of empirical relationships in data sets and the knowledge of how markets and incentive systems work (as well as their precise design). For example, on the introduction of its Express Pool service, Uber was advised by a team of economists who used experimental methods to rule out the possibility of a Cannibalization cannibalization effect on its other services (Fossett et al., 2018). Major companies such effect as Google, Yahoo!, and Microsoft also use the expertise of economists to design mar- This is the competi- ketplaces for the sale of advertising (Athey & Luca, 2019). The importance of economic tion and (partial) understanding will continue to increase as digitization progresses and the platform substitution of an economy expands, enabling managers to better understand digital business models, existing product due exchange ideas with experts in these fields, and make sustainable decisions in the to the marketing of a future. new product by the same supplier. Why Economists Contradict Each Other Platform economy This refers to inter- While reading the newspaper at his breakfast table, Mr. Schmidt asked himself how it net-based business can happen that economists contradict each other. According to the explanations in models that connect this lesson, two specific causes for this can be identified (Mankiw & Taylor, 2018): providers with inter- ested parties or cus- Economists disagree on whether a positive theory for how the world works is tomers in a digital actually valid. marketplace. Economists have different normative views on how the world should be and what politics should strive to achieve. The concrete example of a guiding industrial policy from Mr. Schmidt’s newspaper com- mentary shows that there is no consensus among economists as to how such state intervention actually works (i.e., in terms of positive analysis). Critics often refer to the targeted state subsidies for the solar industry in eastern Germany in the 2000s, which, after a reduction in subsidies and a drop in global market prices, ultimately resulted in Unit 1 19 Fundamentals numerous corporate insolvencies. On the other side of the debate, proponents of a guiding industrial policy are turning their attention to China and emphasizing the suc- cessful economic development in recent decades. These recent developments, includ- ing a guiding economic and industrial policy, are largely due to the state capitalism prevailing there. Normative analysis can also lead to different view points amongst economists, which is then expressed in contradictory recommendations—for example, the four economists of the German Council of Economic Experts who reject a guiding industrial policy are of the opinion that a free market is best suited to create prosperity and that the state should interfere as little as possible. Proponents of a guiding industrial policy, however, are more open to stronger state involvement—here and in other areas as well. Summary Economics is concerned with the management of scarce social resources, particu- larly labor, capital, and land. Because of this scarcity, we all make decisions every day that involve giving up something in order to gain something else. In doing so, we take the opportunity cost of our decisions into account. Economics is also often referred to as the study of markets, which focuses on ana- lyzing the interplay of buyers and sellers within markets and the state’s role. Economics can be roughly divided into macroeconomics and microeconomics. Explanations and predictions in economics are based on academic theories through which knowledge can be gained deductively (from the general to the spe- cific) or inductively (from the specific to the general). With the exception of laboratory experiments in microeconomics, controlled experi- ments in economics are usually not possible. This is why economists often rely on natural experiments (which cannot be controlled by the researcher.) As scientists, economists often deal with positive analyses, which can be falsified. As political consultants, they are also entrusted with crafting normative analyses. These include the economists’ value judgments. Both as scientists and as political advisors, economists can contradict each other in their judgments. 20 Unit 1 Knowledge Check Did you understand this unit? You can check your understanding by completing the questions for this unit on the learning platform. Good luck! Unit 2 The Invisible Hand of the Market STUDY GOALS On completion of this unit, you will have learned... … upon what supply and demand in a market depends. … the role the prices of goods play in a competitive market. … how balance is achieved in a competitive market. … what the invisible hand of the market entails. … what an economist means when talking about elasticities. DL-E-DLBBWME01_E-U02 22 Unit 2 2. The Invisible Hand of the Market Case Study Nina, a student, is very concerned about climate change and endangered species. She is also involved in the Fridays for Future movement. She was very pleased to learn that, in February of 2019, more than 1.7 million people across Bavaria, Germany had regis- tered in support of the petition for a referendum on “biodiversity and natural beauty in Bavaria—Save the Bees.” One of the best-known demands of the petition was a call for the proportion of agricultural land in Bavaria that is farmed organically to be increased from 10 percent (in 2018) to 30 percent by 2030 (Schwägerl, 2019). After the approval of the legislative text in the petition by the Bavarian parliament in July 2019, the Bavarian Farmers’ Association immediately reminded the public that the petition’s supporters were also obliged to support the proposed change and would be required to change their shopping habits and opt for more organic products. Some dai- ries already have a freeze on admissions, yielding long waiting lists of dairy farmers wanting to switch to organic production in order to avoid further excess supply and additional pressures on the price of milk. First, demand must increase, and consumers must be prepared to pay higher prices for organic milk in order to allow for an expan- sion of supply, the Farmers’ Association said (European Milk Board, 2019). The statements of the Farmers’ Association leave Nina somewhat perplexed. She was actually very pleased with the outcome of the referendum. Now, however, she does not understand why demand has to first increase in order for organic farming to expand. She is also unsure what the concept of supply and demand has to do with the price consumers have to pay for organic milk and how this price is actually determined. 2.1 Supply and Demand The Demand Curve as a Relationship Between Price and Level of Demand In view of the statements by the Bavarian Farmers’ Association, Nina thought about her own purchasing habits. She normally pays a lot of attention to her shopping habits and has found that, as a student, she prefers to buy cheaper milk from conventional farm- ing. The amount of organic milk each month depends on many factors, including price. In the table below, she has noted how many liters of organic milk she buys or would buy in a month and at what price. For example, at a price of two euros per liter, Nina does not buy organic milk and prefers to buy milk from conventional production. Prohibitive price Therefore, two euros is the prohibitive price for Nina. From time to time, when organic The prohibitive price milks costs less than two euros per liter, she buys it as a matter of principle. When the of a good is the price price is less than one euro per liter, she buys even more organic milk than she usually at which the quan- does and, for example, uses it more often in her cooking. However, at 20 liters per tity demanded is month, her saturation level is reached—that is, even if Nina were to be given organic zero. milk as a gift, she still could not consume more than 20 liters of milk in one month. Unit 2 23 The Invisible Hand of the Market Saturation level Nina’s Demand Table The demanded quantity of a good at Organic milk price per liter (€) Level of demand (liters/month) a price of zero is called the saturation level. 2.00 0 1.50 5 1.00 10 0.50 15 0.00 20 The table above shows that the lower the price, the more organic milk Nina buys. An economist would say that, in Nina’s case, the demand for organic milk is negatively dependent on the price. Such a relationship between price and quantity demanded can be observed for most goods and services in an economy. This defines the law of demand: under otherwise equal conditions (i.e., the same income or prices for other goods), the demand for a good decreases as the price increases, and, conversely, demand increases as the price falls (Mankiw & Taylor, 2018). To understand how markets work, one must look at the demand-related behavior of more than one person. This is done by totaling the demand levels of all buyers at any given price and obtaining what is called the market demand. The market demand can also be represented graphically as a demand curve. In the figure below, the quantity Demand curve demanded by all buyers of a good (Q) is plotted on the horizontal axis and the prices This is a graphic rep- of a good (P) on the vertical axis. resentation of the relationship between prices and the quantity of a good in demand within a market. 24 Unit 2 The downward slope of the demand curve (D) illustrates the negative relationship between price and quantity demanded in accordance with the law of demand: If the price of the product rises, the quantity demanded decreases. Conversely, if the quantity demanded increases, the price falls. A change in the price of a good thus causes a shift along the demand curve (Mankiw & Taylor, 2018). Thus far, we have considered the influence of price on market demand under the cete- Ceteris paribus ris paribus assumption, or assuming all other contributing factors remain the same. assumption Specifically, changes in a consumer’s income have so far played no role in their This Latin expression demand-related behavior. However, Nina, for example, could consume more organic means “all other milk as a result of an increase in financial aid or if she took on a part-time job. In things being equal” theory, Nina would be able to purchase more milk because of her more flexible budget, and is often assuming that the price of organic milk per liter has remained unchanged. The follow- assumed in simpli- ing figure shows the influence of factors other than price on the demand for a good. fied models of real- ity. Unit 2 25 The Invisible Hand of the Market A change such as a higher income, which leads to an increase in demand at any given price, is expressed in the figure by a shift in the demand curve to the right. This is mir- rored by a change that leads to a reduction in demand for any given price, such as lower income, but which is caused by a shift in the demand curve to the left (Mankiw & Taylor, 2018). As shown in the figure above, the demand curve can shift to the left or the right if the demand for goods change but the price remains the same. In addition to income, the following factors can also influence demand (Mankiw & Taylor, 2018). Consumer preferences: One example of this would be an increase in environmental awareness in the population that leads to an increase in demand for organic prod- ucts (causing a right shift in the demand curve). Population size and structure: One example of this is a society’s age distribution. This can lead to an increase in goods and services used more commonly by older people such as home-delivery food services or health resorts (causing a right shift in the demand curve). Advertising: For example, companies seeking to increase demand for their products (right shift in the demand curve) Consumer expectations: Regarding future price developments, that demand will decline if consumers expect prices to fall in the future (left shift in the demand curve). The price of related goods Regarding the prices of related goods, one must first consider the direction of the demand curve. A distinction must be made as to whether the goods in question are complementary or substitute goods. In our previous example, we have already seen 26 Unit 2 that Nina sometimes replaces organic milk with conventional milk. In economics, such Substitute goods replacements are referred to as substitute goods. If, for example, the price of milk from These are two goods conventional agriculture rises, Nina will substitute this milk with organic milk, which for which an causes a shift in the demand curve (in the above figure) to the right. If, on the other increase in the price hand, the quantity demanded of one good decreases when the price of another good of one leads to an increases, then we speak of complementary goods. For example, cereal and milk are increase in demand complementary goods. They are often eaten together at breakfast, and the demand for for the other. milk decreases when the price of cereal increases. Graphically, a price increase for cereal is expressed in the above figure by a shift in the demand curve of milk to the Complementary left. goods These are two goods for which an The Supply Curve as a Relationship between Price and Quantity Supplied increase in the price of one leads to a As with the quantity demanded, price also plays a decisive role in the quantity of a decrease in demand good offered. In the initial example, we learned that dairies in Bavaria have waiting lists for the other. of farmers who would like to switch to organic production. One of the reasons why farmers want to make this change is the higher price that dairies are prepared to pay for organic milk compared to conventional milk. Let’s look at an example. If we were to ask the Mayers, dairy farmers from the Allgäu region in Bavaria, how many liters of organic milk they would produce per month on their dairy farm according to the principles of organic farming, depending on the price paid per liter, you would get the following information: The Mayers’ Supply Table Organic raw milk price per liter (€) Quantity offered in thousands (liters/ month) 0.30 0 0.45 5 0.60 10 0.75 20 0.90 30 The Mayers cannot produce milk according to the principles of organic farming below a price of 30 cents per liter of raw milk. At a price of 45 cents per liter, however, they are prepared to make a partial farm conversion and produce around 5,000 liters per month. At a price of 90 cents per liter, they would even consider converting the entire farm and Unit 2 27 The Invisible Hand of the Market exclusively practice organic farming. The higher the price per liter of organic raw milk they are paid by the dairy, the more the Mayers convert the dairy farm to organic milk production ceteris paribus and the higher the quantity of organic milk they can offer. This positive dependence on price and supply quantity is typical of most goods and services offered in an economy. This is referred to as the law of supply. Law of supply All other factors Just as market demand is the sum of the individual demands of all potential buyers, being equal (the the supply quantities of all actual and potential sellers add up to the market supply. ceteris paribus The relationship between market supply and price can also be graphically represented assumption), the according to the demand curve. The following figure shows such a supply curve. For our quantity of a good purposes, the quantity offered by all actual and potential producers of a good (Q) is offered increases as plotted on the horizontal axis and the respective prices of a good (P) on the vertical the price of the good axis. increases, and vice versa. Supply curve This graphically rep- resents the relation- ship between prices and the quantity of a good offered in a market. The positive slope of the supply curve (S) illustrates the positive relationship between price and quantity offered, as already mentioned, in accordance with the law of supply. If the price of the good falls, the quantity offered decreases ceteris paribus, and, con- versely, the quantity offered increases if the price rises. Thus, a change in the price of a good causes a movement along the supply curve. Concerning market supply, it is also true that there are many other factors that can lead to a change in the quantity offered by individual producers. As shown in the figure below, the following factors lead to a shift in the supply curve (Mankiw & Taylor, 2018): 28 Unit 2 prices of production factors (e.g., if producers reduce their output volume or with- draw from a market altogether as a result of increases in the cost of labor or materi- als, causing a shift to the left in the supply curve) technological advancements (e.g., the invention of fertilizers or more efficient milk- ing parlors that increase the milk yield per cow and contribute to an increase in the availability and quantity of milk, causing a shift to the right in the supply curve) environmental and societal factors (e.g., failed harvests or regulations on the man- datory expansion of the proportion of organic farmland in Bavaria, the former caus- ing a shift to the left and the latter a shift to the right) expectations of suppliers (e.g., if producers anticipate rising prices in the future and are already expanding their production capacities, causing a shift to the right) the number of suppliers entering (causing a shift to the right) or exiting (causing a shift to the left) the market 2.2 Market Equilibrium Interaction of Supply and Demand on a Competitive Market It is possible to show how supply and demand determine the quantity sold and the price on a market by looking at them together. For this purpose, the supply and demand curves are plotted in the following figure. This results in a point at which the Market equilibrium supply and demand curves intersect: market equilibrium. This is a market sit- uation in which the Unit 2 29 The Invisible Hand of the Market quantity supplied corresponds to the quantity demanded. Price and quantity in market equilibrium are simply called equilibrium price or quan- tity. In market equilibrium, a stationary state has been reached in which the market Stationary state forces of supply and demand no longer strive for change. The quantity that consumers A system is in a sta- wish to purchase at the equilibrium price corresponds exactly to the quantity that pro- tionary state when a ducers are prepared to offer at that same price. In this context, economists speak of stable equilibrium market clearance, or the fact that the market has been cleared and there is neither a exists and the acting surplus of demand nor a surplus of supply. forces do not cause any further change. To understand why markets tend to be cleared, we first look at the situation when there is a price above the equilibrium price. As can be seen in the following diagram, a price above the equilibrium price represents an excess supply: 30 Unit 2 With the price (P1) above the equilibrium price (P0), there are more producers wanting to offer their goods than there are buyers wanting to purchase them. In such a situa- tion, there is movement along the supply and demand curve. In general, suppliers who are unable to sell their goods will be prepared to lower their prices, which will lead to a reduction in supply. In turn, according to the law of demand, a lower price contributes to consumers demanding more of that commodity. In the end, a balance between sup- ply and demand is achieved in the equilibrium price. For example, there is an excess supply in the market for organic milk in Bavaria (as mentioned previously). There are more farmers prepared to offer organic milk at the current market price than consum- ers who demand it. Market forces, as the Bavarian Farmers’ Association has correctly recognized, would thus work toward ensuring a decrease in the price of organic milk in the event that dairies allow more farmers to convert to organic farming. The Bavarian Minister of Agriculture, Michaela Kaniber, has also recognized the problem of falling pri- ces. Above all, Kaniber wants to increase demand and sees a great deal of potential there, especially in a changeover of the communal catering system (Hermannsen, 2019). However, if the price (P2) is below the equilibrium price (P0), there is excess demand, as shown in the graph above. At this price, the quantity offered is too small, and the buyers of goods are not able to buy the quantity they want. In such a situation, there is also a movement along the supply and demand curve: Suppliers will try to expand their supply volume and, in doing so, possibly increase the prices of their goods due to the higher costs associated with supply expansion. At first, due to the excess demand, they can also sell these goods. Only when prices continue to rise will an increasing number of consumers reduce the quantity demanded (in accordance with the law of demand), which ultimately leads to a balance between supply and demand. Unit 2 31 The Invisible Hand of the Market The Assumptions of the Market Model It should be noted that the market mechanism described above is a model (ie., a sim- Market mechanism plified representation of reality based on certain assumptions). In particular, the model This is the tendency, is based on a competitive market where there is a large number of suppliers and buy- on a (competitive) ers and where each buyer and seller represents only a very small share of the total vol- market, for prices to ume of the market (two-way polypoly). None of the individual market participants is change until the presumably large enough or has sufficient market power to influence the price on the market is cleared. market itself, at least not single-handedly. Rather, suppliers and consumers take the market price as a given and merely adjust their quantities accordingly. For this reason, Competitive market we also speak of price-takers and quantity adjusters. Moreover, in a competitive market This is a market with (i.e., a market with perfect competition) there are no market barriers or roadblocks for a very large number actual and potential suppliers or buyers. Therefore, there is free entry and exit. Another of buyers and sell- assumption of the market with perfect competition model is that all sellers offer iden- ers, whereby the tical (homogeneous) products. Therefore, a supplier has no reason to charge less than individual can only the market price for their goods, and if they charged more, consumers would buy them influence the market elsewhere. Additionally, in a competitive market, buyers and sellers have perfect or price to a minor complete information regarding all decision-relevant factors and make their own deci- extent and not in a sions completely independently of each other (Mankiw & Taylor, 2018). targeted manner. In reality, the assumptions of a competitive market only fully apply to a few markets. A frequently cited example of a market where the assumptions of full competition are largely valid is the market for agricultural products. Even if consumers neither have complete information nor know the prices across all supermarkets and farms, the product on the organic milk market, mentioned above, is largely homogeneous. Simi- larly, on both sides of the market, there is a large number of market players without market power (i.e., no single market player has total influence on the price). This sup- ports the assumption of a two-way polypoly. As a result, on the organic milk market, both the suppliers and consumers are generally price-takers and merely adjust their supply or demand volume according to the prevailing market price. The stock market is often cited as another example of a market in which the assumptions of full competi- tion are more or less met. However, the model can also serve as a useful frame of reference in analyses of mar- kets in which the assumptions do not apply. According to economic theory, the mecha- nism in a market with perfect competition leads to a market equilibrium that ensures an efficient allocation of economic resources. In this context, a state is described as Allocation efficient if it is pareto-optimal, i.e., if no other distribution of scarce resources is possi- This refers to the ble and at least no one participant can be better off without simultaneously putting issuance of scarce another participant at a disadvantage. In a competitive market in which all participants resources to differ- act as price-takers, all mutually beneficial bartering is carried out, and the resources of ent uses within an an economy are automatically, efficiently distributed without external intervention—for economy. example, by the state—as if guided by an invisible hand (Pindyck & Rubinfeld, 2018). The metaphor of the invisible hand is often attributed to moral philosopher Adam Smith (1723—1790), one of the founders of economics. In all actuality, however, he used the metaphor in a different context (Rothschild, 1994). 32 Unit 2 Pareto-optimal This is a situation in 2.3 Elasticities which it is not possi- ble to improve the position of one per- Elasticities of Demand son without making another person According to the law of demand, under otherwise equal conditions, the quantity of a worse off. good in demand decreases as the price increases. However, this does not say anything about the extent to which demand will decline in the event of a price increase. In order Elasticity to be able to make a precise statement on this, economists use elasticities. This is a number used as a measure An elasticity measures the sensitivity of one variable to the change of another. For of the percentage example, the price elasticity of demand measures the percentage change in the quan- change in one varia- tity of a good in demand in response to a percent change in price: ble due to a percent change in another. Change in quantity demanded in % Price elasticity of demand = Change in price in % The price elasticity of demand is normally a negative number since demand decreases when price increases, and vice versa. For example, if demand increases by 10 percent as a result of a 5 percent price decrease, the price elasticity of demand is: 10 % = −2 −5 % In economics, however, the minus sign is often neglected, and simply the amount of elasticity is used. If the price elasticity of demand is greater than one, as in the above example, demand is termed price-elastic because the percentage change in demand is greater than the percentage change in price. Conversely, the change in the quantity demanded being smaller in percentage terms than the price change is referred to as price-inelastic demand. Let’s take a look at the following example. The price per liter of premium fuel rises by 10 percent from 1.30 euros to 1.43 euros. As a result, a motorist decides to start walking short distances rather than take the car. Accordingly, the motorist only buys 95 liters of fuel in a month at the filling station instead of 100 liters. In this instance, the demand has fallen by 5%, meaning there will be a price elasticity of demand of −5 % = −0.5 = 0.5 10 % The availability of substitute goods is one of the factors that determines whether the demand for goods reacts to a price change elastically or inelastically. If substitute goods are available (i.e., ones that can easily replace the goods affected by a price increase), which are themselves not affected by changes in price, a price-elastic demand (i.e., a relatively strong percentage decrease in demand for the affected good) can be expected. Conversely, if there are no suitable substitutes for consumers, demand tends to be price-inelastic (Pindyck & Rubinfeld, 2018). Unit 2 33 The Invisible Hand of the Market Thus, the demand for organic milk, as previously mentioned in an earlier example, can be described as relatively price-elastic. Organic milk can easily be replaced by conven- tional milk or milk alternatives (e.g., oat-based or soy-based). On the other hand, the demand for fuels such as gasoline or diesel tends to be inelastic to price. Since many people are commuters dependent on their cars and the necessary fuel type cannot be replaced by another energy source in the short term (excluding hybrid cars), demand tends to react only slightly to price changes. It should be noted that elasticities can, by definition, assume absolute values between 0 and ∞. The closer the value is to 0, the more inelastic the demand is. This means that a price change leads to hardly any reaction in the quantity demanded. Conversely, the higher the absolute value of the price elasticity of demand, the more elastic the demand is and the greater the difference in quantity resulting from a price change. The two extreme cases are, therefore, a price elasticity of demand of 0 and ∞. If the price elasticity of demand is 0, we speak of a completely inelastic demand. The demand curve to the left in the following figure illustrates such elasticity. The demand curve is vertical, and consumers always demand the same quantity of a good regardless of price. With an elasticity with a limit value of ∞, however, one speaks of a completely elastic demand. The demand curve runs horizontally, as shown in the figure above on the right. In this context, even a slight price increase leads to a decline in demand to 0 (Pindyck & Rubinfeld, 2018). In addition to the price elasticity of demand, other demand elasticities can be deter- mined in practice. Two examples are income elasticity and cross-price elasticity of demand. The income elasticity of demand measures changes in demand for goods when consumer income changes: Change in demand quality in % Income elasticity of demand = Change in income in % 34 Unit 2 Normal goods Normal goods have a positive income elasticity of demand since higher income leads This refers to goods to higher demand for these goods. For normal goods, a further distinction can be that are consumed made. Necessary products (such as basic foodstuffs) have relatively small, positive more in absolute income elasticities since consumers have to buy certain quantities of them regardless terms when income of their income level. By contrast, luxury goods (such as caviar, jewelry, or yachts) are increases. characterized by relatively large, positive income elasticities. Consumers can—or must— do without them completely if their income is too low. Negative income elasticities, in Inferior goods turn, are a sign of inferior goods. The demand for these goods decreases with rising This refers to goods income or increases with falling income. Public transport is an example of an inferior that are consumed good, as people with higher incomes are more likely to own a car and therefore use less in absolute public transport less. terms when income increases. The cross-price elasticity of demand allows changes in demand for one good to be understood when the price of another good changes: Change in the demand quantity of good 1 in % Cross‐price elasticity of demand = Change in price of good 2 in % For substitute goods such as butter and margarine, the cross-price elasticity is positive. Here, consumers increasingly switch to margarine when the price of butter rises. For complementary goods such as cars and car tires, however, cross-price elasticity is neg- ative. In this example, a price increase for cars would typically lead to a decrease in demand for car tires. Supply Elasticities According to the demand elasticities mentioned in the previous chapter, supply elastic- ities can also be determined. For example, the price elasticity of supply measures the percentage change in the quantity of goods offered in response to a percentage change in price: Change in the quantity offered in % Price elasticity of supply = Change in price in % The price elasticity of supply is normally positive, as supply increases when the price rises, and vice versa. For example, if the quantity offered increases by 10 percent as a result of a 5 percent price increase, the price elasticity of the offer is 10 % =2 5 % The price elasticity of supply can assume values greater than or equal to 0. The closer the value is to 0, the more inelastic the offer is—that is, a price change hardly leads to a change in the quantity offered. The closer the price elasticity of supply goes towards ∞, the more elastic the supply is and the greater the quantity change resulting from a change in price. Unit 2 35 The Invisible Hand of the Market 2.4 Applications Supply and Demand During Winter Holidays The amount one must pay for a one-week ski vacation in the Alps can be easily explained using the basics presented in this lesson. We first compare the low season (i.e., time outside the winter holidays) versus the main travel season between the end of November and the start of January. The relatively large number of suppliers and demanders of ski vacations in the Alps makes it seem plausible, even at this stage, to use the competitive market model to determine the market equilibrium. According to the supply and demand curves (S1 and D1) for the low season (shown below), a market price of 450 euros for a week-long ski trip, including overnight stays and ski passes, will be established. At this price, the balance (i.e., the number of skiers per week), is 250,000 people. If fresh snow and bright sunshine are now predicted for the upcoming week, some ski enthusiasts will consider taking a week’s holiday and traveling to the mountains at short notice. In the figure, the demand curve shifts to the right accordingly. This results in a new market equilibrium (G2) at the intersection of the still valid supply curve (S1) and the new demand curve (D2). In order to satisfy the increased demand from the vacationers, for example, hoteliers have to increase their staff in the short term and heretofore dormant ski lifts have to be quickly reactivated. This means higher costs. As a result, the market price rises from 450 to 510 euros. At this new market price, the number of skiers increases to 320,000. If some ski resorts close because of an avalanche warning just that week, the overnight stays in these resorts will be canceled. In the figure, this leads to a left shift in the sup- ply curve from (S1) to (S2). Other resorts not affected by the avalanche risk may still have capacity available to accommodate more vacationers in the low season. However, this would be make for higher costs such as overtime for local staff. This translates into a higher price of 550 euros for a week-long ski vacation. For some ski enthusiasts who are considering a trip to the mountains, this price is already too high. Compared with the market equilibrium (G2), the number of vacationers therefore falls from 320,000 to 290,000. Compared to the initial situation in market equilibrium (G1), the market price has risen from 450 to 550 euros increase in demand (due to the weather forecast) and a decline in supply (due to resort closures). Also, the number of skiers has risen from 250,000 to 290,000 in the new market equilibrium (G3). 36 Unit 2 Elasticities in Winter Holidays In the off-season, the supply curve is relatively elastic, as shown in the figure above. The increase in demand due to the good weather forecast only leads to a relatively small price increase from 450 to 510 euros, as there is sufficient capacity of hotel rooms and ski lifts for vacationers. The situation is different during the high season. As the figure below illustrates, the supply curve becomes much steeper. It is said that the supply curve is relatively inelas- tic. The reason for this is that, in the high season, many hotels are fully booked for weeks at a time, and the ski slopes are already crowded starting in the early morning. It is therefore very difficult to expand supply in the short term. An increase in demand due to a favorable weather forecast (as we saw during the off-season) will, therefore, result in a much starker price increase during the peak season (Mankiw & Taylor, 2018). Unit 2 37 The Invisible Hand of the Market Summary The law of demand states that the lower the price of goods, the higher the demand. The demand curve illustrates this relationship. A change in the price of a good leads to movement along its demand curve, while other influencing factors (such as changes in consumer income, price changes for other goods, or advertising efforts by companies) lead to a shift in the demand curve. The law of supply states that the higher the price of a good, the higher the supply. The supply curve shows this relationship. Here, a change in the price of a good leads to movement along its supply curve, while other factors (such as the prices of production, technical progress, or social concerns) lead to a shift in the supply curve. In a competitive market, the interplay between supply and demand leads to a sta- tionary market equilibrium. There is neither a surplus of supply nor demand. Through the free play of market forces, an efficient and pareto-optimal allocation of scarce economic resources is achieved, as if guided by an invisible hand. The allocation is pareto-optimal if no actor can be better off without another being worse off. 38 Unit 2 Elasticities measure the sensitivity of one variable to a change in another. Two examples are the price elasticities of demand or supply. These measure the per- centage change in demand or supply of the good concerned in response to a per- centage change in the price. Knowledge Check Did you understand this unit? You can check your understanding by completing the questions for this unit on the learning platform. Good luck! Unit 3 Consumer Decisions STUDY GOALS On completion of this unit, you will have learned... … what economists mean by usefulness. … the meaning of indifference curves. … which characteristics exhibit indifference curves. … which factors influence a consumer’s willingness to pay. … how consumers divides their limited budget between different goods. … how the individual demand curve of a consumer can be derived. DL-E-DLBBWME01_E-U03 40 Unit 3 3. Consumer Decisions Case Study Mr. Huber is an employee in the development department of a large German automo- bile manufacturer. Just in time for this year’s International Motor Show in Frankfurt, Mr. Huber’s company will be presenting electric cars designed for the mass market for the first time. The CEO also announced the company’s plans to launch almost 70 electri- cally-powered models by 2028. Mr. Huber is very pleased about this, as he has often been concerned about the future viability of the German automotive industry. Now, he is looking toward the future with much more confidence. At the show, Mr. Huber spoke to an analyst for the automotive market. As an engineer, Mr. Huber is convinced of the technical advantages of the latest generation of electric cars. The analyst also shared Mr. Huber’s positive assessment of the current progress of the industry, but was less optimistic about the potential market success of electric cars. For example, it is not certain whether consumers will actually buy electric cars to the extent expected. After all, there are still a number of disadvantages from the custom- er’s point of view, such as the short operating range, long charging times, and the energy-intensive production of the batteries. All of this negatively affects the positive ecological assessment of an electric car. Last but not least, the significantly high pur- chase price (as compared to an internal combustion engine) represents a hurdle on the mass market that should not be underestimated. The analyst claimed that there is little benefit to the everyday consumer and spoke of how difficult it is to estimate the cur- rent willingness to pay, leaving Mr. Huber feeling less certain and less secure. 3.1 Utility Theory The Concept of Utility in Standard Microeconomic Theory In a market economy system, consumers are confronted with a variety of goods and services, in different forms, from which they can choose. In the automotive market, for example, customers can choose between different manufacturers, price classes, equip- ment features, and even (as mentioned in the introductory example) decide how the car is powered. The decisive factor for consumer behavior (i.e., the decision for or against buying goods) is the appreciation of the respective goods or service by the individual con- sumer. This applies to all markets. For example, Person A uses their car mainly for short distances to work or when shopping. Therefore, the shorter driving range of an electric car does not play a role in their purchasing decision. Person B, on the other hand, wants to travel long distances and therefore prefers a car with a combustion engine. They decide against the electric car mainly because of its insufficient driving range. Unit 3 41 Consumer Decisions In economics, the concept of utility is used to explain different consumer preferences. Utility This describes the value that the consumption of a good or service gives to a person. This term refers to The utility is a subjective measure and an ordinal concept. It is subjective because it the measure of sat- describes the personal preferences of an individual consumer without another person isfaction or content- necessarily sharing those preferences. For example, driving around the Nordschleife of edness that consum- the Nürburgring, a closed driving track in Germany, is probably of great utility to a ers derive from motorsports fan, whereas a passionate environmental activist may only shake their purchasing a certain head in disapproval. It is ordinal because the utility helps establish a hierarchy quantity of goods. between alternatives. However, ordinal utility cannot be used to determine absolute differences between consumer preferences in a mathematically precise manner. For example, it is possible to ask people in a survey to rank different car models according to their personal preferences on a utility scale of 1 to 10 and conclude that one auto- maker is more popular than another. If Peter rates a certain car with an 8 and Claudia with just a 4, one cannot conclude that Peter values the car twice as much as Claudia. The only possible conclusion is that Peter places the Ferrari higher on his utility scale than does Claudia (Mankiw & Taylor, 2018). Representation of Consumer Preferences by Means of Indifference Curves Utility is not only used as a measurement of the satisfaction provided by a single good, but also for that of a whole basket of goods. If, for example, one looks exclusively at Basket of goods the area of clothing and nutrition, it is possible to examine which basket of clothing The compilation of and food items a consumer prefers over another, i.e., which gives them greater utility. In certain quantities of the interest of simplification, no distinction will be made between the different types of one or more goods food and clothing offered—pasta, rice, tomato sauce, shirts, trousers, caps, etc. Only dif- is called a “bundle ferences between clothing and food units and their respective quantities will be con- of goods” or “basket sidered. For example, the following monthly shopping baskets, containing different of goods.” clothing and food units, are available to a consumer. Selection of Baskets of Goods Basket of goods Number of food units Number of clothing units A 20 30 B 10 50 C 10 40 D 30 20 E 30 40 42 Unit 3 Basket of goods Number of food units Number of clothing units F 10 20 When selecting the preferred basket of goods from the above table, the consumer is assumed to behave rationally and without contradiction in accordance with the stand- ard microeconomic model explaining consumer preferences. In particular, the following three assumptions are made (Pindyck & Rubinfeld, 2018). Completeness: The consumer is able to compare and rank the baskets of goods available for selection. For example, in the case of the two baskets of goods A and B, a consumer can decide which basket they prefer, or whether they are indifferent to the two baskets of goods, i.e., whether they would benefit equally from A and B. Transitivity: If a consumer prefers basket A over basket B and at the same time also prefers B over the third basket C, then we can deduce that they also prefer basket A over basket C. Similarly, if a consumer is indifferent towards A and B and also B and C, then it can be said that they are also indifferent towards baskets A and C. Unsaturation: Baskets of goods are assumed to be desirable, with the consequence that a consumer will always prefer a larger quantity of goods to a smaller one, although the difference may be small. The preferences of a consumer can be graphically represented by means of indiffer- Indifference curve ence curves. Using the example of the baskets of goods in the above table, an indiffer- The indifference ence curve describes all those combinations of clothing and food that provide the curve is used to same utility to a consumer, i.e., satisfy equally. In principle, there is an infinite number graphically represent of indifference curves. However, the following figure, which contains the six baskets of all combinations of goods from the above table, is limited to the representation of three such indifference bundles of goods curves for illustration purposes. that provide a con- sumer with the same degree of satisfac- tion. Unit 3 43 Consumer Decisions This is done by plotting the quantity of food on the horizontal axis and the quantity of clothing on the vertical axis. All combinations of food and clothing that lie on the indif- ference curve U1 provide the same utility to the consumer. Therefore, although the consumer buys more food in point A and more clothes in point B, they will ultimately derive the same utility from the combination of goods in both points. Likewise, they achieve the same satisfaction of needs with the basket of goods in point D as in points A and B, since all points lie on the same indifference curve U1. In point F, on the other hand, they consume both less food and less clothing than in point A. Because of the assumption of non-saturation (according to which more is always better), there must be a lower utility in point F. This is symbolized by the lower lying indifference curve U2. At point E, in turn, the consumer receives more clothing and more food than at point A, which is why there is a higher level of utility at point E. This is also shown by the higher U3 indifference curve. In the above example, the high- est level of satisfaction is therefore achieved with the indifference curve U3. The indif- ference curves U1 and U2 follow in descending order of priority. Properties of Indifference Curves Since indifference curves reflect consumer preference when choosing between differ- ent combinations of goods, they have the following four characteristics that reflect these preferences (Mankiw & Taylor, 2018). 44 Unit 3 Higher lying indifference curves are always preferred over lower lying indifference curves. Curves of indifference do not intersect each other. Indifference curves have a negative slope. Indifference curves are convex (curved inwards). The four properties mentioned above will be explained in more detail below. The first property of the indifference curves is already illustrated in the above figure, according to which higher-lying indifference curves symbolize a higher level of utility. Accordingly, consumers also always prefer baskets of goods on higher-lying indifference curves to baskets of goods on lower-lying indifference curves. This is because they prefer a larger quantity of goods to a smaller one due to the non-saturation. The second property states that indifference curves cannot intersect. In order to prove this, the opposite will be assumed, and it will be examined to what extent this results in contradictions to the assumptions on consumer behavior. The following figure aims to show two indifference curves that intersect at point Y. Since point X lies on the same indifference curve UX as point Y, the baskets of goods in question provide the same utility to the consumer. Moreover, since point Y is on the same indifference curve UZ as point Z, baskets of goods would therefore also satisfy the consumer equally on these two points. In line with the assumption of transitivity mentioned above, however, this would lead to the conclusion that baskets of goods also provide the same utility to consumers in points X and Z. However, this conclusion cannot be correct. Since the basket of goods in point X contains both more food and Unit 3 45 Consumer Decisions clothing than the basket of goods in point Z, point X must be of greater utility to the consumer. Therefore, intersecting indifference curves contradict the assumption of transitivity. According to the third property mentioned above, indifference curves have a negative slope. Here, the slope of an indifference curve indicates the ratio to which a consumer is willing to exchange one good for another. In economics, the absolute amount of this ratio is known as the marginal rate of substitution. In our example, we look at the Marginal rate of sub- exchange between food and clothing and, as a rule, consumers will want to purchase stitution both food and clothing. Consequently, if the amount of clothing is reduced, the amount This is the ratio at of food must increase in order to satisfy the consumer equally. For this reason, the which a consumer is slope of an indifference curve is usually also negative. If we look again at the first figure willing to exchange in this section, a consumer in point B, for example, is willing to give up 20 units of one good for clothing to get 10 additional units of food. The marginal rate of substitution in this case another. is, therefore, 2. However, the first figure in this section also illustrates that the exchange ratio along an indifference curve is not constant. When moving from point B to point A, the consumer is willing to give up 20 units of clothing to get 10 additional units of food. However, when moving from point A to point D, the consumer is only willing to give up 10 units of clothing to get 10 additional units of food. In the first case, therefore, the marginal rate of substitution is 2; in the second case, it is only 1. The difference is due to the fact that the consumer has more clothing and less food in the first starting point B than in the second starting point A and is, therefore, also prepared to give up more clothing in B than in A in order to receive 10 food units in return. In general, people are more will- ing to give or exchange something if they have an abundance of it than if they only have a little. For this reason, indifference curves usually also run convexly, i.e., curved inwards. The convex course of an indifference curve reflects the fact that the greater the quantity of a good already in his possession, the greater the consumer’s willingness to give up a unit of a good. To illustrate the fourth characteristic of indi

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