# Homegrown Demand

This material is replicated on a number of sites as part of the SERC Pedagogic Service Project

#### Summary

This exercise introduces students to the concept of a demand curve, and helps them understand how demand curves are derived. During the exercise students think about and submit the price they are willing to pay for a specific item. These prices are used to generate a demand curve. In particular, to generate the prices, the instructor auctions off three M&M packets to the highest bidders via a sealed-bid auction. The instructor enters the bids into the EconPort graphing software (see below). The data generated by the class forms a demand curve which motivates the class's introduction to demand curves.

Students often have trouble understanding that demand curves are visualizations of marginal benefits. Even when they have such an understanding, they often do not see the logic of ordering these values from highest to lowest for demand curves. This experiment helps students to grasp these concepts more readily. It also prepares students for studying (and participating in experiments about) competitive equilibrium theory and other market characteristics (e.g., taxes, price controls).

## Learning Goals

By participating in this experiment, students should be able to learn:

1. How marginal benefits, willingness to pay, and bid prices can be arranged to construct a demand curve and why it makes sense to organize them from highest to lowest;

2. What a step function (curves) is and why later lectures and their textbook describe demand curves as straight lines;

3. Why diminishing marginal benefits for individual consumers make sense.

## Context for Use

Time Required:

1. Running each experiment takes about 10-15 minutes (for classes of 30-120);

2. Entering the data in the EconPort graphing software takes about 1-2 minutes to navigate to the page and 2-3 seconds per student to enter the data;

3. Graphs are rendered immediately;

4. The resulting discussion takes approximately 40-45 minutes to complete and can be spread across classes.

Materials:

1. An index card (or other small piece of paper) for each student in class.

2. Three "fun size" packets of M&Ms (1.69 oz). Instead of M&Ms, the professor can choose any inexpensive good for which most students would have a positive reservation price.

3. The EconPort Supply and Demand Graphing Tool at:
http://www.econport.org/expjnlp/MarketChart.jnlp

The EconPort graphing tool requires the Java software be installed on your computer. If you do not have or are unsure whether your computer currently has the Java software installed, go to http://www.java.com.

Considerations:

1. Some professors prefer to run the experiment, enter the data and begin lecturing on demand in the same lecture period. Other professors prefer to run the experiment in a lecture period prior to introducing demand, entering the data between lectures, and then giving the demand lectures. In our opinion, neither approach dominates the other and thus the choice is left up to the professor;

2. If one runs the experiment prior to the lecture period, one can print or make PDFs of the classroom demand curves, which can be used as lecture handouts during the lecture.

3. In very large classes data for this exercise can be collected using clickers by asking students to enter their reservation prices using the clickers, rather than using the index cards.

## Description and Teaching Materials

Student instructions:

(These instructions are written assuming that the teacher reads them to students in class, but can easily be modified for reading outside of class prior to the lecture period. They can also be given in writing to students, but many professors simply read them to the students and highlight the key rules on the board. Index cards on which students will write bids can be passed out while the instructions are being read. If the students do the reading before class students can be given a pre-class assignment to test their understanding of the exercise.)

I am now going to run a classroom auction. Please listen carefully as I read the instructions for this auction. I am passing out blank index cards and you should each take ONE card. You should not write anything on this card until told to do so.

I (the teacher) will be auctioning off to the highest bidders "fun size" M&M packets (1.69 oz), which you can see here in my hand. I will sell three packets. You can each purchase a maximum of one packet. Prior to participating in the auction, think about the maximum price at which you would be willing to buy an M&M packet. You will be required to pay in U.S. currency, so please do not bid values above \$0 if you are not prepared to pay.

Please write on your index card your name and the maximum price that you are willing to pay for a packet of M&Ms. You do not write anything else on the card. Also, keep your decision private. When everyone is finished, all index cards will be collected.

The people with the three highest bids will each pay a price equal to their own bid, and will receive a packet of M&Ms. In the event of a tie, we will randomly break the tie.

Professor instructions:

1. Avoiding Students Paying in Real Currency: If you do not wish that the students pay in real currency, you can make the classroom experiment a hypothetical thought experiment. However, you cannot actually give the highest bidders the M&Ms in a thought experiment because students will find it costless to provide exceedingly large bids – and thus the resulting demand schedule likely will bear little resemblance to a demand schedule for M&Ms. Alternatively, you can try offering an endowment of extra credit points from which students can allocate to purchasing the M&M packets, but this approach has two disadvantages: (1) presenting the subsequent demand curves with a currency of extra credit points on the vertical axis may generate more confusion than elucidation in the lecture; and (2) students may not wish to part with scarce extra credit points for a packet of M&Ms and thus one might observe few reservation prices above zero. (Reference "Do You Need Incentives" page)

2. Tie Bids: Decide how you want to break a possible tie. If a two-way tie exists, then perhaps consider flipping a coin. One easy tie breaking rule that doesn't require bringing to the class a randomization device (e.g., dice) is to recite the alphabet, starting at "A," and ask students to sit down after the letter that begins their last name is called. When only three students remain standing, the auction ends.

3. Ebay auctions as an illustrative example: You may find it worthwhile to mention "Ebay" when first using the word "auction" to offer a concrete example of a real-world auction.

Data entry:

The data can be entered in class immediately after the experiment or out of class between lectures. Data entry in class is more transparent because students can see the values entered into the computer and then organized from highest to lowest. However, data entry in class takes away time from lecture. Data entry takes about 5 minutes of class with fewer than 75 students if one student reads the values and the professor enters them into the data screen.

1. Launch the EconPort Supply and Demand Graphing Tool at:
http://www.econport.org/expjnlp/MarketChart.jnlp

2. On the 'Data' tab, enter bids from the index cards. You do not have to sort the index cards prior to entry. After data entry, name your data set (such as 'Demand for M&Ms') and press the 'Save as Demand Schedule' button.

3. Display the demand schedule by switching to the 'Chart' tab and selecting your newly-created data series.

## Teaching Notes and Tips

This section provides a guided discussion for the instructor to use after the experiment.

Begin with some basic definitions and the sorted tables generated by the experiment.

Definition: The market for any good or service consists of all (actual or potential) buyers or sellers of that good or service.

In this experiment, the market consisted of 1 seller (me) and ## buyers (you).

Start with discussing the demand table generated by the first experiment and what it means.

In the experiment, buyers had to decide the maximum amount of money that would be willing to pay to obtain a packet of M&Ms (the highest price at which he or she would be willing to buy my packet rather than not buy it). If you bought a packet, you would incur a cost equal to their bid.

The teacher can now use the table to demonstrate for any price how many units of M&Ms would be purchased (demanded) and determine for any quantity the price that would lead to that quantity being purchased (demanded).

The teacher can tie this back to what was actually observed in the auction: To sell three packets, what price would have to be set? What price did the three packets sell for? Point out a price at which fewer than 3 students were willing to purchase a packet (excess supply). Point out a price at which more than 3 students were willing to purchase a packet (excess demand).

Note that we can visually present the values from this table in what economists call a demand curve. Below is an example of a demand curve generated from a class of 50 students.

Definition: The demand curve for a good or service tells us the total quantity of that good or service that buyers wish to buy at each price.

The demand curve is the set of all price-quantity pairs for which buyers are satisfied. ("Satisfied" means being able to buy the amount they want to at any given price.)

We can draw a demand curve when we know each buyer's bid.

Some teachers may wish to introduce (or re-introduce) the concept of economic surplus and show how it is represented by an area.

Note that a demand curve is just a visualization of marginal benefits. Point out how each segment on the graph corresponds to the "marginal benefit" to the economy of purchasing one more unit.

Notice that our classroom demand curve is a step curve. In your book and in later lectures, the demand curves are presented as straight lines. In reality, most demand curves are steps, but straight lines are a very good approximation. With many buyers and many sellers trading thousands or millions of units, or units that are perfectly divisible, the steps would be so tiny as to be not worth drawing. The straight line is much easier to draw and manipulate (similar to Production Possibility Curves, which are typically faceted surfaces but we often use smooth curved lines to represent them).

On the board (or in a handout) draw the demand curve for milk:

If the price were \$2/liter, buyers would demand 4000 liters per day. Another way of looking at it: the demand curve tells us that the marginal benefit from consuming the 4000th liter of milk is \$2 If milk suppliers only desired to sell 1000 liters of milk per day, they could charge as high as \$5/liter.

Underlying concept: People should be willing to buy a good or service as long as the price is less than or equal to the benefit they derive.

Demand curves slope downward for three reasons:

1. As the good becomes more expensive, people switch to substitutes.
2. As the good becomes more expensive, people can't afford to buy as much of it.
3. As an individual consumes more of a good, at some point his or her marginal benefit from consuming an additional unit will decline.

Extensions: