Theory of The Firm Lecture 16 Dr. Jennifer P. Wissink ©2019 Jennifer P. Wissink, all rights reserved. March 20, 2019

Announcements: Micro Spring 2019 Please make sure you see the Bb message all about prelim 1. PICK UP your prelim 1 ASAP from the TA whose name you checked. ALL questions about grading go to me(Wissink) and only to me. Last day to give me re-grade requests is Monday March 25 in lecture, use this form. https://courses.cit.cornell.edu/econ1110jpw/regrade.pdf Be Mindful of MEL Stuff! Quiz#07 is now due this coming Friday! Quiz#08 has been posted and is due Friday March 29 Quiz#09 will be posted soon and will be due right after Spring Break Final Econ Week Event

i>clicker questions Consider only “own price” changes for goods where the consumer has a fixed income. If “X” is a normal good then its demand curve might be downward or upward sloping. it will never satisfy the law of demand. it will always satisfy the law of demand. it can’t have a substitution effect. it must only have an income effect. Consider only “own price” changes for goods where the consumer has a fixed income. If “Y” is an inferior good then its demand curve might be downward or upward sloping. it will never satisfy the law of demand. it will always satisfy the law of demand. it can’t have a substitution effect. it must only have an income effect. Consider only “own price” changes for goods where the consumer has a fixed income. If “W” is a good that violates the law of demand then it must be normal. it must be inferior. it might be inferior. it’s stupid. it’s hard to tell.

Carrots Beans

Why Consumer Theory Reason #2.1 – Tax&Rebate $aog or $mlo Slutsky’s TE/SE/IE Method: Use a bundle as the anchor– let us say, the original bundle. BLT&R BLO BLT gallons of gas

Why Consumer Theory Reason #2.2: “In Kind” vs. Cash – The Smalls $mlo BLfs BLfs BLo BLcash food

Why Consumer Theory Reason #2.2 “In Kind” vs. Cash – The Biggs $mlo BLcash BLfs BLo food

i>clicker question Tony is a successful utility maximizer with very nicely behaved preferences for ham and crackers. He has fixed income I=$1,000 to spend every month. For Tony, ham is a normal good and crackers are an inferior good. Suppose that going from March to April, Tony hears that the price of ham will increase. Income and the price of crackers will remain unchanged. Comparing April to March you predict Tony must buy more ham and must buy less crackers. must buy more ham and don’t know about crackers. must buy less ham and must buy more crackers. must buy less ham and don’t know about crackers. don’t know about ham and must buy more crackers.

Why Consumer Theory Reason #2.3 Two-Part Tariffs (Sam’s Club Example) Sam’s Club sells only X; Lots of firms sell Y; and Abe is a typical shopper. Suppose: IAbe = $2,000 PX = $10 and PY = $10 Initially Abe buys: Xo* =100 and Yo* =100 Perfectly competitive firms sell Y Sam’s Club has a monopoly on X Sam’s total cost to make X is total cost = $5X Sam’s idea: Offer Abe the following deal Abe pays $200 to join Sam’s Club and then... Sam lowers the price of X to PX = $8 Note: PY is still $10 and Abe’s income is still $2,000 Question: Is this a good idea? If so, for whom?

O N IAbe = $2000 Entry Fee to Sam’s = $200; PX = $8 and PY = $10 Note: By taking the deal Abe could still afford the original bundle Original bundle: Xo*=100 and Yo*= 100 Budget: $200 (to join) + $800 (spent on X) + $1,000 (spent on Y) = 2,000 IAbe = $2,000 PX = $10 and PY = $10 Xo* =100 and Yo* =100 Sam’s total cost: tc=5X Sam’s profit is $500 = $10∙10 – $5∙10 Y 200 IC0 ICnew 180 O N BLN BL0 225 Xold Xnew 200 X

Sam’s Club Graph - Results Consumer is on higher indifference curve, so better off! Sam’s Club makes more profit! Proof: pold = ($10-$5)100 = $500 pnew = $200 + ($8-$5)Xnew So…is p new - p old > 0? Is $200 + $3Xnew - $500 > 0? Is $3Xnew > $300? Is Xnew > 100? Yes. Since Xnew > 100 there is more profit! Q.E.D.

Why Consumer Theory Reason #2.4 The Odd Case of Labor/Leisure! BEWARE! Consider a day in the life of John. John is endowed with 24 hours of time. He can consume his time as Leisure (Z) or… He can sell his time at $w/hour as Labor (L). His time constraint is: Z + L = 24 Suppose John gets utility from Z and $aog. Suppose John’s only source of income is his labor income = $wL, which he spends on all other goods. Suppose the wage rate is currently $10/hour.

Z is relatively more expensive IC/BL Application #5: Reacting to a Wage Change: The Odd Case of Labor/Leisure! BEWARE! Suppose John’s wage ($w) increases INCOME EFFECT SUBSTITUTION EFFECT John feels RICHER–his endowment of time is more valuable Z is relatively more expensive Z normal Z inferior Quantity of Z demanded decreases Quantity of Z demanded increases  Labor supplied decreases Quantity of Z demanded decreases Labor supplied increases NOTE: This case is DIFFERENT, since when the price of leisure increased, John felt RICHER (not poorer). Beware! This situation can lead to a “backward bending demand for leisure” which generates a “backward bending supply of labor”!

The Odd Case of Labor/Leisure! BEWARE! $aog BL2 BL1 $240 BLO 24 Hours of Leisure Demanded (Z) Hours of Labor Supplied (L)

Backward Bending Leisure Demand and Labor Supply Curves Z=Leisure L=Labor John gets utility from Leisure(Z) and $aog. Leisure(Z) + Labor(L) = 24 hour and $w = hourly wage rate

Overtime Wages $aog $240 BLN BLO 24 Hours of Leisure Demanded (Z) Hours of Labor Supplied (L)