Demand and Welfare chapter 6 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-2 Learning Objectives Explain how to use demand curves to measure changes in consumer welfare. Distinguish between the two main effects of a price change and understand why demand curves generally slope downward. Understand the trade-off between consumption and leisure and explain how the wage rate affects labor supply. Distinguish compensated and uncompensated demand curves, and use compensated demand curves to measure consumer welfare more accurately. Use cost-of-living increases to measure changes in consumer welfare and explain why those measures may be biased. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-3 Overview Beyond determining equilibrium price and quantities, it is important to understand and measure changes in consumer welfare, whether through demand curves or cost-of-living indexes Economists find it useful to dissect the effects of a price change into one that depends only on the change in purchasing power (income effect) and one that depends only on the changes in relative price (substitution effect) We will also study a new type of demand curve that holds a consumer’s welfare fixed (compensated/Hicksian demand), instead of the one the holds income constant (uncompensated/Marshallian demand) An interesting example of demand is the demand for leisure, which allows us to derive the supply for labor Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-4 Measuring Changes in Consumer Welfare Compensating variation: amount of money that exactly compensates the consumer for a change in circumstances – Calculating compensating variations from consumer preferences is challenging, so economists usually calculate consumer surplus using the demand curve. Consumer surplus: the net benefit a consumer receives from participating in the market for some good. – Equivalently, it is the compensating variation for losing access to the market. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-5 Measuring Consumer Surplus Gross benefit of first computer Price paid Net benefit of first computer = $2,500 Consumer surplus = sum of the net benefits for all units Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-6 Example: Measuring Consumer Surplus Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-7 Using Consumer Surplus to Measure Changes in Welfare Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-8 Dissecting the Effects of a Price Change When the price of a good increases, two things happen: 1.Substitution effect. That good becomes more expensive relative to all other goods. Consumers tend to shift their purchases away from the more expensive good and toward other goods. 2.Income effect. The consumers’ purchasing power falls, and they must adjust their purchases accordingly. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-9 Compensated Price Changes An uncompensated price change consists of a price change with no change in income. A compensated price change consists of a price change and an income change that together leave the consumer’s well-being unaffected Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-10 Compensated Price Changes Frozen yogurt (pints) Cheese pizza (oz.) L1L1 C A L2L2 B Effect of compensation L3L3 Increase in price of yogurt Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-11 Substitution and Income Effects Substitution effect: the effect on consumption of a compensated price change. Income effect: the effect on consumption of removing the compensation after creating a compensated price change Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-12 Substitution and Income Effects Frozen yogurt (pints) Cheese pizza (oz.) L1L1 C A L2L2 B L3L3 Uncompensated price effect Income effect Substitution effect Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-13 Direction of Substitution Effect A compensated increase in the price of a good always causes the consumer to buy less of that good— she substitutes away from the good as it becomes more expensive Higher price of frozen yogurt Lower quantity consumed of frozen yogurt Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-14 Direction of Income Effect An increase in the price of a good reduces the consumer’s purchasing power, which causes her to buy less if the good is normal, and more if it is inferior. For a normal good, the income effect works in the same direction as the substitution effects. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-15 Income Effect for a Normal Good Frozen yogurt (pints) Cheese pizza (oz.) L1L1 C A L2L2 B L3L3 Uncompensated price effect Income effect Substitution effect Same direction Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-16 Income Effect for an Inferior Good Frozen yogurt (pints) Cheese pizza (oz.) L1L1 C A L2L2 B L3L3 Uncompensated price effect Income effect Substitution effect Opposite direction Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-17 The Direction of Income and Substitution Effects The substitution effect is negative for a price increase and positive for a price reduction. If a good is normal, the income effect is negative for a price increase and positive for a price reduction; it therefore reinforces the substitution effect. If a good is inferior, the income effect is positive for a price increase and negative for a price reduction; it therefore opposes the substitution effect. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-18 Downward-Sloping Demand Curves The Law of Demand states that demand curves usually slope downward The substitution effect is always consistent with the Law of Demand For a normal good, the income effect reinforces the substitution effect, so normal goods always obey the Law of Demand The income effect of an inferior good opposes the substitution effect. Giffen good. Theoretically, if the income effect is larger than the substitution effect for an inferior good, the amount purchased could increase when the price rises, violating the Law of Demand. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-19 Giffen Good Frozen yogurt (pints) Cheese pizza (oz.) L1L1 C A L2L2 B L3L3 Uncompensated price effect Income effect Substitution effect Income > substitution Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-20 Labor Supply and the Demand for Leisure For every bad, there is a corresponding good, defined by the absence of the bad. If people regard hours of work as a bad, the corresponding good is leisure. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-21 Effect of Wages on Hours of Work Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-22 Demand curves Until now we have considered an uncompensated demand curve or Marshallian demand curve that describes the relationship between the price and the amount consumed, holding the consumer’s income fixed and allowing her well-being to vary. A compensated demand curve or Hicksian demand curve holds the consumer’s well-being fixed while allowing her income to vary. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-23 Normal Good – Compensated and Uncompensated Demand Curves Beef (lb.) Price ($/lb.) Uncompensated demand curve A Compensated demand curve C Income effect B Substitution effect Same direction Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-24 Inferior Good – Compensated and Uncompensated Demand Curves Beef (lb.) Price ($/lb.) Compensated demand curve A Uncompensated demand curve Income effect C B Substitution effect Opposite direction Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-25 Cost-of-Living Index A cost-of-living index measures the relative cost of achieving a fixed standard of living in different situations Nominal income is the amount of money actually received in a particular period Real income is the amount of money received in a particular period, adjusted for changes in purchasing power that alter the cost of living over time. In practice, a cost-of-living index uses fixed weights to measure the percentage change in the cost of a fixed consumption bundle. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-26 Laspeyres Price Index A Laspeyres price index is a fixed-weight index based on the consumption bundle actually purchased in the base period. If prices change, consumers will substitute away from more expensive goods and toward those goods that are relatively cheaper. By keeping the original consumption bundle constant, the Laspeyres index overstates changes in the cost of living. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-27 Review – Consumer Welfare Consumer surplus is the compensating variation associated with the loss of access to a market. A change in consumer surplus is a measure of the change in a consumer’s well-being. A cost-of-living index can also be used to approximate changes in a consumer’s well- being. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-28 Review – Income and Substitution Effects The substitution effect is always negative for a price increase and positive for a price reduction. For a normal good, the income effect reinforces the substitution effect, so the demand slopes downward. For an inferior good, the income effect and the substitution effect work in opposite directions. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-29 Review – Compensated Demand Curves Different compensated (Hicksian) demand curves correspond to different levels of the consumer’s well- being In contrast, different uncompensated (Marshallian) demand curves correspond to different levels of the consumer’s income Compensated demand curves always slope downward Uncompensated demand curves usually slope downward, except in the (theoretical) case of Giffen goods, where the income effect is stronger than the substitution effect for an inferior good Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-30 Looking forward Next we will turn our attention toward how firms make production decisions. We will learn how choosing the most efficient methods among the many production technologies determines the production function, and how the size of the firm may affect the cost of production. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.