Give Me More Food!

Also known as the iso-utility curve, an indifference curve plots out the various combinations of goods that deem you indifferent because each point along the curve yields the same level of satisfaction. In Graph 1, U1(utility curve 1) yields the least satisfaction, while U3 (utility curve 3) yields the most satisfaction. To put it simply, an indifference curve is a graphical representation of one’s indifference schedule.

indifference curveGraph 1
Image source: Flypapereffect

Assumptions
The indifference curve follows two assumptions: full rationality, and diminishing marginal rate of substitution (MRS). Consumers are expected to behave in a rational manner, always aiming to maximise total utility. If a consumer knows that having too much of something reduces his utility, he will not make a particular decision. With reference to Graph 1, the consumer will always know that the choices at U3 makes him happier, as compared to U1, or U2.

MRS is defined as the amount of good A that a consumer is willing to trade off for good B while maintaining the same level of utility. Assuming that U3 yields satisfaction level 100, MRS measures how much of good A the consumer will give up, to get more of good B. The willingness to trade usually slows down after a certain point, thus the concept of a diminishing MRS. It simply means that the substitution rate is decreasing. This assumption makes the indifference curve convex to the origin. 

Budget Constraint

IC.pngGraph 2
Image source: Econmentor

Like all realistic scenarios, the indifference curve is faced with a budget constraint – one cannot exceed his/her endowment. It appears as a straight line in the model. The term “budget” is used loosely in this topic, because it can represent anything – wealth, time, capacity, etc.. It is important to identify the right constraints, so that we can make the right decisions within our means. An incorrect budget constraint may lead to sub-optimal decisions. To be able to make the right decisions, economists make use of the indifference curve and budget line to solve the optimisation problem. How exactly do we choose an optimal bundle?

Room for Dessert?
In an economist’s optimisation problem, the hipster quote “there is always room for dessert”, may not necessarily be true.

 

Let’s assume we have a friend Jane, who has a sweet tooth. Every day, she has to decide how much of her dinner to consume, so that she can still have dessert after her meal. While she is obsessed with dessert, it does not supply her with adequate nutrients, and there is a limit to how much food she can ingest. Here we have an optimisation problem – Jane needs to maximise her well-being by choosing the optimal bundle of how much to eat for dinner, and dessert. If you find that the above scenario familiar, you’ve already been thinking like an economist!

 

Choosing the Right Bundle
Jane’s first step is to determine her satisfaction levels for various bundles. Without a doubt, she will prefer IC5 (indifference curve 5) in Graph 2 because it makes her happiest. However, with her current budget constraint (stomach capacity), she can never achieve IC5. She would go for IC3 instead, because that’s the highest satisfaction she can achieve, with her current budget constraint.

The story does not end there, because there are various bundles along the same indifference curves. The bundles each yield the same level of satisfaction, but some exceeds the budget constraint. Having more dinner, and less dessert keeps Jane healthy, but her stomach cannot take all the food. On the other hand, having less dinner, and more dessert also makes her feel bloated. The only bundle Jane should choose, would be the point on IC3 that is tangent to her budget constraint. At that point A, she finishes her dinner, and dessert feeling satisfied, instead of stuffed. 

The beauty of the indifference curve is that it is a concept extendable to even the simplest decision-making scenario, rather than being a strictly economics-related model. Adore two dresses, but only have money to purchase one? You’ll realise that you start asking yourself the practicality of the dress, number of times you will actually wear that dress, and if it is worth the value. Your brain subconsciously calculates your utility for both dresses, causing you to purchase the one that you prefer. 

 

Optimal Menu Pricing Theory

In the past, travellers were concerned by language barriers and potential cultural differences when visiting foreign countries. Today, to remain connected to the Internet and the rest of the world has become the most pressing issue when travelling abroad. When a traveller first touches down, he asks not where the tour guide is, but seems to be more interested in where can he purchase a local call card that allows him to stay contactable throughout his trip.

Being absolutely inexperienced in a foreign country, how should a traveller select a phone plan that is best suited to his needs without paying more than what he would have valued it? In economics terms, how can a traveller determine his optimal bundle of choice given that he has asymmetrical information overseas?

Here we study the decision of an exchange student who visits Australia, Sydney for the first time and has to purchase a phone plan that serves two main functions: sufficient surfing data for daily usage and international call minutes.

Optus is one of the three main phone plan providers in Australia who offers a wide variety of phone plans at different prices.

OPTUS
Optus prepaid phone lines pricing. Optus.com.au

 

For those who are disturbed by chunks of data, a $30-plan (Plan 30) offers 3GB worth of data, with international calls charged at standard rates. A $40-plan (Plan 40) and $50-plan (Plan 50) offers 7GB and 10GB worth of data respectively. Unlimited international calls are available only for Plans 40 and 50.

Unless you’re trained with economics intuition, it is rather unnoticeable that the differences in prices are not proportionate to the package offered. Between Plans 30 and 40, a $10 difference gives you additional 4GB worth of data and unlimited international calls. On the contrary, an identical $10 difference between Plans 40 and 50 offers only additional 3GB worth of data.

The discrepancy in benefits despite paying the same amount is due to the Optimal Menu Pricing theory, which is a fairly common practice in the telecommunications industry.

This theory posits that sellers offer a product line by creating slight variations among the products, for the purpose of second-degree price differentiation. It relies greatly on the belief that rational consumers will always be willing to pay more for increased benefits as long as consumer surplus is maximised, and that it is in the sellers’ interest to extract maximum profit from every transaction. This brings us to our first conclusion: sellers want to price products as high as possible, while consumers want to maximise consumer surplus as much as they can. This will only work if the consumer surplus from paying more exceeds that of a cheaper bundle. How is that possible?

The seller deliberately lowers the quality of the cheaper plan by removing many desirable features so as to decrease prices and consumers’ value towards the plan, hence reducing willingness to pay. On the contrary, the more expensive plan usually includes much better features so as to increase consumers’ value towards the plan. Sellers can then increase the price of the more expensive plan since consumers have a higher tendency to purchase it, as long as prices are set to induce consumers to believe that they gained more surplus than if they had chosen the cheaper plan.

Plans 30, 40 and 50 are prepaid plans, which suggests that they are largely targeted at travellers, international students or those on a business trip. Optus understands this particular group of market, and can accurately pinpoint the features that will drastically affect willingness to pay.

The ability of sellers to artificially reduce the quality of the inferior plan to make the consumers more willing to spend on the expensive plan was no coincidence. It happens because the sellers are aware of what the target market wants, and that this group of people faces an inelastic demand curve for the products. Perfectly competitive market exists because sellers do not have full knowledge about the market and thus have to rely on supply and demand to determine prices. On the other hand, markets of monopolistic nature are sellers that know their target market, and can adjust their product bundles and prices according to what consumers are willing to pay.

Starbucks to go, and a quick economics class please!

How many times have you walked into Starbucks, purchase a drink, curse at how coffee prices at Starbucks always seem to be increasing, but end up rationalising that the drink is worth every cent you paid? After all, the immediate and tangible benefit gained from the transaction is exactly what you chose to pay for. While Starbucks customers walk out of the renowned cafe, satisfied with the caffeine fix and “The Starbucks Experience”, many fail to notice the smart implementation of pricing strategies that go into the pricing decisions of each cup of coffee.

Price Insensitivity

Starbucks is blessed with the ability to raise prices without negatively affecting demand or compromising on overall revenue. Are they? According to Tucker Dawson (2013), a one percent increase in the price of Starbucks products actually led to a 25% increase in revenue. A mere 10-cent increase in the price of tall-sized drinks resulted in less than proportionate decrease in quantity demanded. This was not pure coincidence.

Throughout Starbucks’ growth, raising prices was one of their marketing strategies to filter out consumers who are price sensitive and with lower willingness to pay. By doing so, retained consumers are more likely to have higher willingness to pay and have a less elastic demand for Starbucks’ coffee. Given this knowledge about their existing customers and their inelastic demand curves, Starbucks was able to more accurately predict price increases that can maximise their profit and reduce dead weight loss.

Psychology Pricing

Another pricing strategy that Starbucks incorporates is the anchor pricing tactic, which plays on consumer psychology, making them believe that price is always relative. Anchor pricing tactic is the tendency where consumers rely mostly on the first piece of information offered to make purchase decisions.

Imagine Peter, a diehard Starbucks fan who usually purchases tall (small) sized drinks. An increase in prices of tall sized drinks makes him reconsider his purchase basket, since now he can enjoy a larger volume of his favourite drink with a  less than significant top-up. Is it more worth it stick to his current consumption bundle, or would he be better off topping up an additional few cents and gain utility that is higher than the amount paid?

The moment consumers choose to pay more for something that, when compared to the first option, is perceived to have higher value-for-money shows anchor pricing at work. The next time you think higher prices translate into better products or services, think again. Your mind may have been convinced to value the company or brand by only referring to the price set by the company. Starbucks is not the only company that plays around with your mind. Mega sales and items on promotion are just more ways to demonstrate how anchor pricing work (and very effectively I must say). Empowered with this new knowledge, do you really know what you’re paying for, and are you truly appreciative of what the brand has to offer?

Can Demand & Supply Explain Long Queues at ATMs?

From Econs 101, we learn that the demand and supply model is designed to capture the intuitive aspect of how a market works, and then used to describe how prices will fluctuate in a particular economy. The model, though simple, can be used to determine almost anything – equilibrium prices, wages and even exchange rates.

The relationship between demand and supply reflects the forces behind resource allocation. In market economy theories, resources are always allocated in the most efficient way.

Quick Recap!

Demand refers to the quantity of products (or services) desired by the buyers. A higher demand will lead to higher prices, thus the demand curve is downward sloping. Supply refers to the quantity of products (or services) supplied by the producers. Higher market prices lead to increases in supply, thereby giving the supply curve an upward slope. When both curves are put together, the cross intersection, better known as the equilibrium point, is where the demand and supply are equal. At this point, the market is functioning most efficiently, since resources supplied is the same as the amount demanded.

d&s.jpg

Can we tweak aspects of the model to explain the long queues found at almost every ATM during Chinese New Year?

Chinese New Year (CNY) may be one of the busiest periods for banks in Singapore. Every year, long queues can be found forming in front of banks and automated teller machines (ATM). Two weeks before the festive, people queue up to withdraw cash for red packets* that are to be distributed during CNY. On the day of Li Chun**, people queue up again to deposit money into their banks as there is the belief that depositing money on that day was auspicious and would ensure wealth and prosperity.

*Monetary gifts that are given to the younger generation during CNY.
**Start of Spring, and believed to be an auspicious day.

long queue
Long queue at Yishun Central POSB Branch, 2015. http://www.facebook.com

Now if we were to look at this situation economically and plot it into a graph, here’s a few things we need to change in the basic model. Instead of looking at prices, we measure the waiting time of individuals before they can use the ATM while the X-axis reflects the number of ATMs available for use. The demand curve plots a user’s willingness to wait. We can see that the market is far from its equilibrium point.

longqueue

The CNY period thus become a shock as it causes the market to deviate from its original equilibrium point. The upward movement of the demand curve while holding supply constant does not only lead to an increase in waiting time, but also led to dead weight loss in the market. Assuming everyone in the market would have preferred to deposit money on the same day but each individual has his/her own willingness to wait, those who had less patience would skip the queue and went home to sleep instead. The next time you see long queues at ATMs and decide to postpone your choice to use an ATM, remember these people have more patience than you!

The next question to consider is, is the shift in demand always that high every year? The answer is no, not anymore. In a Straits Times article on 25th January, banks are making use of technology to reduce waiting time for consumers. This reduces waiting time as consumers can reserve the cash in advance and head down to bank branches for collection. The demand curve would shift downwards slightly since bulk of the demand for ATM services come from the money deposit practice on Li Chun, which cannot be done over the application.

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With the new shift in demand curve (D2), the waiting time is reduced and dead weight loss is lesser as technology progress sieved out people who could do without engaging the services of an ATM. Increase in pop-up ATMs (not plotted in graph) will shift the supply curve leftwards, which also reduces waiting time and dead weight loss.

Can More be done to completely eliminate waiting time?

There are only two ways to reduce waiting time, reduce demand or increase supply. Given the local culture and their strong beliefs, we know that reducing demand might only happen in the long run, therefore making increasing supply our only solution. Increasing the supply of ATMs cannot be a permanent solution either, since there is always a limit to the quantity businesses are willing to supply before the marginal costs gets higher than the marginal benefit. As such, the current solution can only reduce waiting time to a certain extent and cannot yet completely eliminate said waiting time.

Should we be explaining ATM queues with the supply-demand model?

Unlike prices or wages that are usually constant for some periods of time and its fluctuation cannot be tracked by the naked eye, ATM queues fluctuate frequently and can be observed if you walk to it. The example of ATMs employed in this article serves to illustrate how a demand and supply model can be used to explain many daily phenomenons that we see but are much oblivious to. Think about it, how often do you see the ATMs being fully utilised on an normal afternoon? In fact, the waiting time seems to always be on two opposites of a spectrum – crazy long queues or eerily empty.

Is Grab Hitch Really Cheaper?

Private hire vehicles have grown to become an alternative mode of transport that is affordable and convenient. Service providers such as Grab and Uber are constantly coming up with newer and cheaper services so as to increase their market share. An example of such is Grab Hitch, where drivers pick up riders who are going to the same destination. Unlike conventional cab services, Hitch drivers are part time drivers who offer to share a ride with paying riders. This helps drivers earn some dollars to cover some of their driving expenses. While end consumers like myself pleasurably engage these services, what are the hidden economic costs that we are actually being forced to pay?

On a busy morning, a hitch from my home in the North-eastern part of Singapore to NUS would take 30 minutes if the driver gets on the expressway (left image). On the other hand, the toll-free route (right image) takes about 40 minutes to reach the same destination. Logically, one would take the expressway route since it gets to the destination faster. That wasn’t the case for most of my hitches. In fact, I noticed that the drivers always took the 40-minute route. But that wasn’t without explanation.

Why Drivers Prefer the Toll-free Route?

Grab Hitch drivers, like any other producers, want to maximise profit while minimising costs. Traveling on the expressway during the peak hours can cost up to $7 of ERP charges (road tolls). Considering that Hitch drivers receive around $12-14 for a trip to NUS, $7 of road tolls is more than half of what they are being paid.

Also, taking the expressway would mean they travel longer distances (24 km) as compared to the toll free route (22 km). The extra 2 km traveled can accumulate to higher amounts of petrol consumed at the end of the month. This extra cost can be, of course, minimised if the driver took the toll free route.

petrol price
Shell Station Prices taken on 13 February 2018 http://www.google.com

However, it is not necessarily true that every driver prefer the toll-free route. While minimising financial costs is of utmost importance in decision making, our brain subconsciously measures economic costs. A driver who is in a rush may not mind paying extra if it enables him to reach his destination on time. On the other hand, a driver who has all the time in the world may prefer the toll-free road even though it requires more traveling time. Such economic costs cannot be measured in monetary terms and cannot be reflected in our accounting books. Nonetheless, they have some impact on our daily decisions.

What Hidden Costs are we Paying?

Hitch riders are very similar to the drivers, except riders seek to maximise their welfare (instead of profits) while minimising the price paid (costs). But given the analysis previously, drivers will most likely prefer the cost minimising route while riders prefer the time-cost minimising route. Would you not like an extra 15 minutes of sleep time if you could?

The same trip from home to NUS, costs approximately $18 with full time Grab drivers, excluding the additional road tolls that are charged to consumers. The difference of $10 (trip fare + road tolls) thus becomes the amount of money that consumers are paying if they value their time more.

Before you come to the conclusion that we are saving merely 10 minutes of our time by paying $10, think again. Expressways usually have four lanes, and a speed limit of 80 to 90 km/h (though sometimes you can see cars going faster than that). Major expressways are connected, which means cars do not have to exit the expressway to merge onto another expressway. A trip from home to NUS on expressways can go up to 35 minutes unless there are major accidents. This is very rare because most accident-created jams clear up pretty quickly.

Unlike expressways, toll-free routes are usually long and winding, with traffic lights once every few metres. The speed limit is usually capped at 60km/h and most of the time, cars cannot accelerate that much before having to stop again at the next traffic light. Zebra crossings also contribute in slowing down cars. Last but not least, cars are prohibited from using bus lanes during the peak hours. All these factors increase the time needed to travel from one point to another. The time spent on taking the toll-free route can go up to 45 to 60 minutes if traffic is bad (or if you get stuck at every traffic light because you have bad luck).

Comparing the travel time of both routes, we spend almost up to double of that time on the car if we take the toll-free route. Now are we paying $10 for a mere 10 minutes, or for 30 minutes of our time?