PPA 723: Managerial Economics Lecture 9: Applications of Consumer Choice

Managerial Economics, Lecture 9: Applications of Consumer Choice Outline  The Labor-Leisure Choice  Application to welfare programs  Measuring Consumer Welfare  The concept of consumer surplus

Managerial Economics, Lecture 9: Applications of Consumer Choice Deriving Labor Supply Curves  Use consumer-maximization diagram with income (= all goods consumed) on the vertical axis and leisure (= non- work) on the horizonal axis.  Income equals the wage times hours worked.  The wage rate is the price of leisure.

Managerial Economics: Consumer Choice Figure 5.8 Demand for Leisure Y, Goods per day Time constraint H 2 =12H 1 = 8240 N 2 =12N 1 =16024 H, Work hours per day N, Leisure hours per day H 2 =12H 1 = 8 N 2 =12N 1 =160 H, Work hours per day N, Leisure hours per day Demand for leisure I 2 I 1 1 –w 2 L 1 L 2 (a) Indifference Curves and Constraints w, Wage per hour (b) Demand Curve –w 1 1 e 2 Y 2 Y 1 w 1 w 2 e 1 E 2 E 1

Managerial Economics, Lecture 9: Applications of Consumer Choice Supply Curve of Labor  The supply curve of hours worked (labor) is the “mirror image” the of demand curve for leisure:  Every extra hour of leisure implies one fewer hours of work.

Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 5.9 Supply Curve of Labor w, Wage per hour (a) Leisure Demand Demand for leisure w 1 w N, Leisure hours per day E 1 E 2 w, Wage per hour (b) Labor Supply Supply of work hours w 1 w H, Work hours per day e 2 e 1

Managerial Economics, Lecture 9: Applications of Consumer Choice Income and Substitution Effects  A wage increase causes both income and substitution effects that alter an individual's demand for leisure and supply of hours worked.  The substitution effect leads to more work.  The income effect leads to more leisure.

Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 5.10 Income and Substitution Effects of a Wage Change Y, Goods per day Time constraint H 2 H*H N 2 N*N 1 0 Substitution effect Income effect Total effect H, Work hours per day N, Leisure hours per day I 2 I 1 L 2 L* L 1 e 2 e 1 e*

Managerial Economics, Lecture 9: Applications of Consumer Choice Goods per Day, Y  Leisure Hours per Day, L  Work Hours per Day Time Constraint 0L1L1 Guarantee 1 -wage L2L2   Leisure Choice with a Welfare Guarantee

Managerial Economics, Lecture 9: Applications of Consumer Choice  Leisure Hours per Day, L  Work Hours per Day Time Constraint 0L1L1 L2L2 L3L3 Income Effect Substitution Effect Slope = -w(1-t)    Guarantee Goods per Day, Y Leisure Choice with a Welfare Guarantee and “Tax” Rate

Managerial Economics, Lecture 9: Applications of Consumer Choice  Leisure Hours per Day, L  Work Hours per Day Time Constraint 0L1L1 L2L2 L3L3 Income Effect Substitution Effect Slope = -w(1+e)    Goods per Day, Y Leisure Choice with an EITC

Managerial Economics, Lecture 9: Applications of Consumer Choice Gross Income vs. Earned Income Source: Clifford F. Thies on the mises.org blog.

Managerial Economics, Lecture 9: Applications of Consumer Choice Implicit Marginal Tax Rates Source: Clifford F. Thies on the mises.org blog

Managerial Economics, Lecture 9: Applications of Consumer Choice Welfare Programs: Lessons  Income guarantees raise recipients’ utility but decrease their work effort.  Income guarantees with benefit reduction rates decrease work effort even more.  Training programs, child care credits, and the EITC raise utility while boosting work effort.

Managerial Economics, Lecture 9: Applications of Consumer Choice Consumers’ Welfare  Measuring welfare with utility functions is not practical for 2 reasons:  we don't know individuals' utility functions  we cannot compare utilities across individuals  Instead, we measure consumer welfare in dollars of willingness to pay  easier to measure than utility  can compare dollars across individuals

Managerial Economics, Lecture 9: Applications of Consumer Choice Measuring Consumer Welfare  Consumer surplus (CS) from a good =  benefit a consumer gets from consuming it (in $'s) minus its price  how much more you'd be willing to pay than you did pay for a good  A demand curve contains this information.  A demand curve reflects a consumer's marginal benefit= the amount a consumer is willing to pay for an extra unit.

Managerial Economics, Lecture 9: Applications of Consumer Choice Graphing an Individual's CS  For each quantity, the consumer surplus is the difference between willingness to pay for another unit (the individual’s demand curve) and actual payment (the price)  Total consumer surplus is the sum of these differences across all quantities consumed.

Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 9.1a Consumer Surplus CS 2 = $1 1 = $2 E 1 = $3E 2 = $3E 3 = $3 Price = $3 a b c q, Magazines per week p, $ per magazine (a) David’s Consumer Surplus Demand

Managerial Economics, Lecture 9: Applications of Consumer Choice Graphing Total CS in a Market  For each quantity, the consumer surplus is the difference between willingness to pay for another unit (the market demand curve) and the market price  Total consumer surplus is the sum of these differences across all quantities consumed.

Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 9.1b Consumer Surplus p 1 p, $ per trading card q 1 q, Trading cards per year DemandExpenditure,E Consumer surplus,CS Marginal willingness to pay for the last unit of output ’

Managerial Economics, Lecture 9: Applications of Consumer Choice Concluding Comment on CS  As we will see, consumer surplus is a key concept in policy economics.  It forms the basis for benefit-cost analysis.  CS is used to determine whether a policy is efficient and to measure the distortion in behavior caused by a tax.

Managerial Economics, Lecture 9: Applications of Consumer Choice Producer Surplus  Suppliers’ gain from participating in a market, too.  Their surplus is the difference between the amount for which a good sells and minimum amount necessary for the seller to produce that good.

Managerial Economics, Lecture 9: Applications of Consumer Choice Measuring PS Using the Supply Curve  Producer surplus for a competitive firm or market is:  the area above supply curve (which, as we will later learn, is the MC curve) and below price line up to quantity sold

Managerial Economics, Lecture 9: Applications of Consumer Choice PS 2 = $2 3 = $1 1 = $3 MC 2 = $2 3 = $3 4 = $4 1 = $1 p Supply q, Units per week p, $ per unit (a) A Firm’s Producer Surplus p* p, Price per unit Q * Market supply curve Q, Units per year Market price Variable cost,VC Producer surplus, PS (b) Market Producer Surplus Figure 9.3 Producer Surplus

Managerial Economics, Lecture 9: Applications of Consumer Choice Producer Surplus and Social Welfare  Some analysts define social welfare as consumer surplus plus producer surplus.  Others focus exclusively on consumer surplus.  This is an issue in normative analysis, that is, it involves value judgments.