Chapter Five Applying Consumer Theory

© 2009 Pearson Addison-Wesley. All rights reserved. 5-2 Topics  Deriving Demand Curves.  How Changes in Income Shift  Demand Curves.  Effects of a Price Change.  Cost-of-Living Adjustments.  Deriving Labor Supply Curves.

© 2009 Pearson Addison-Wesley. All rights reserved. 5-3 Figure 5.1 Deriving an Individual’s Demand Curve p b, $ per unit e 1 E 1 I 1 Beer (b), Gallons per year Wine, (W), Gallons per y ear (a) Indifference Curves and Budget Constraints (b) Demand Curve Initial optimal bundle of Beer and Wine Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PbPb PWPW b Beer (b), Gallons per year L 1 (pbpb = $12) Budget Line, L

© 2009 Pearson Addison-Wesley. All rights reserved. 5-4 Figure 5.1 Deriving an Individual’s Demand Curve p b, $ per unit L 2 (p b = $6) e 2 e 1 I 1 I 2 Beer (b), Gallons per year Wine, (W), Gallons per y ear (a) Indifference Curves and Budget Constraints (b) Demand Curve New Values P b = price of beer = $6 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PbPb PWPW b Beer (b), Gallons per year L 1 (p b = $12) Budget Line, L E 1 Price of Beer goes down! 44.5 E 2

© 2009 Pearson Addison-Wesley. All rights reserved. 5-5 Figure 5.1 Deriving an Individual’s Demand Curve p b, $ per unit L 2 (p b = $6)L 3 (p b = $4) e e 1 I 1 I 2 I 3 Beer (b), Gallons per year D 1, Demand for Beer Price-consumption curve Wine, (W), Gallons per y ear (a) Indifference Curves and Budget Constraints (b) Demand Curve New Values P b = price of beer = $4 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PbPb PWPW b Beer (b), Gallons per year L 1 (p b = $12) Budget Line, L E 1 Price of Beer goes down again! 2 E 2 e 3 E 3

© 2009 Pearson Addison-Wesley. All rights reserved. 5-6 Effects of a Rise in Income  Engel curve - the relationship between the quantity demanded of a single good and income, holding prices constant

© 2009 Pearson Addison-Wesley. All rights reserved. Win e, Gallons per y ear Beer, Gallons peryear Beer, Gallons peryear 26.7Beer, Gallons peryear I 1 P r ice of bee r, $ per unit Y, Budget E1E1 Y 1 = $419 L 1 e 1 D 1 E 1 * Figure 5.2 Effect of a Budget Increase on an Individual’s Demand Curve Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PWPW b Budget Line, L PbPb Income goes up! $628

© 2009 Pearson Addison-Wesley. All rights reserved. Win e, Gallons per y ear Beer, Gallons peryear Beer, Gallons peryear Beer, Gallons peryear I 2 I 1 P r ice of bee r, $ per unit Y, Budget e 2 E 1 Y 1 = $419 Y 2 = $628 L 2 L 1 e 1 D 1 D 2 E 1 * Figure 5.2 Effect of a Budget Increase on an Individual’s Demand Curve Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PWPW b Budget Line, L PbPb Income goes up! $628 E 2 E 2 *

© 2009 Pearson Addison-Wesley. All rights reserved. Win e, Gallons per y ear Income-consumption curve Engel curve for beer Beer, Gallons peryear Beer, Gallons peryear Beer, Gallons peryear I 2 I3I3 I 1 P r ice of bee r, $ per unit Y, Budget e 2 E 1 Y 1 = $419 Y 2 = $628 Y 3 = $837 L3L3 L 2 L 1 e 1 D 1 D 2 D3D3 E 1 * Figure 5.2 Effect of a Budget Increase on an Individual’s Demand Curve Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $837. W = Y PWPW - PWPW b Budget Line, L PbPb Income goes up again! E 2 E 2 * E 3 E 3 * e 3

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 5.1  Mahdu views Cragmont and Canada Dry ginger ales as perfect substitutes: He is indifferent as to which one he drinks.The price of a 12-ounce can of Cragmont, p, is less than the price of a 12-ounce can of Canada Dry, p*. What does Mahdu’s Engel curve for Cragmont ginger ale look like? How much does his weekly ginger ale budget have to rise for Mahdu to buy one more can of Cragmont ginger ale per week?

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 5.1

© 2009 Pearson Addison-Wesley. All rights reserved Consumer Theory and Income Elasticities.  Formally,  where Y stands for income.  Example  If a 1% increase in income results in a 3% decrease in quantity demanded, the income elasticity of demand is  = -3%/1% = -3.

© 2009 Pearson Addison-Wesley. All rights reserved Consumer Theory and Income Elasticities  normal good - a commodity of which as much or more is demanded as income rises  Positive income elasticity  inferior good - a commodity of which less is demanded as income rises  Negative income elasticity

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.3 Income-Consumption Curves and Income Elasticities  As income rises the budget constraint shifts to the right.  The income elasticities depend on….  …where on the new budget constraint the new optimal consumption bundle will be Housing, Square f eet per y ear Food,Pounds peryear Food normal, housing normal Food inferior, housing normal Food normal, housing inferior b c e a L 1 L 2 I ICC 2 C 1 C 3

© 2009 Pearson Addison-Wesley. All rights reserved. Figure 5.4 A Good That Is Both Inferior and Normal  When Gail was poor and her income increased..  …she bought more hamburger  But as she became wealthier and her income rose…  ….she bought less hamburger and more steak. Y 2 Y 1 Y 1 Y 2 Y3Y3 Y 3 L 1 Y, Income L 2 L 3 e 2 e 3 e 1 E 2 E3E3 E 1 I 1 I 2 I 3 Hamburger peryear Income-consumption curve Hamburger peryear All other goods per y ear (a) Indifference Curves and Budget Constraints (b) Engel Curve Engel curve

© 2009 Pearson Addison-Wesley. All rights reserved Effects of a Price Change  substitution effect - the change in the quantity of a good that a consumer demands when the good’s price changes, holding other prices and the consumer’s utility constant.  income effect - the change in the quantity of a good a consumer demands because of a change in income, holding prices constant.

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.5 Substitution and Income Effects with Normal Goods Initial Values P D = price of DVDs = $20 P C = price of CDs = $15 Y = Income = $300. D = Y PDPD - PDPD C Budget Line, L PCPC C, Music CDs Units peryear 1220 L1L1 e1e1 I1I1 D, M o vie D VD s, Units per y ear 15 D = $300 $20 - C $15

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.5 Substitution and Income Effects with Normal Goods Initial Values P D = price of DVDs = $20 P C = price of CDs = $15 Y = Income = $300. D = Y PDPD - PDPD C Budget Line, L PCPC C, Music CDs Units peryear L1L1 L2L2 e1e1 e2e2 I1I1 I2I2 D, M o vie D VD s, Units per y ear 15 D = $300 $20 - C $15 P C goes up… $30 Total effect = -6

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.5 Substitution and Income Effects with Normal Goods  What if we compensated Laura so she could afford the same utility she had before the price of CDs increased?  In other words, how much income she would need to afford indifference curve I 1, with the new price of CDs ($30) Initial Values P D = price of DVDs = $20 P C = price of CDs = $15 Y = Income = $300. e* L1L1 L* L2L2 e1e1 e2e2 I1I1 I2I2 $20 C C D = Y PDPD - PDPD Budget Line, L PCPC D = $300 - $30 Initial Values P D = price of DVDs = $20 P C = price of CDs = $15 Y = Income = $300. Budget Line, L D = $300 $20 - C $30 C, Music CDs Units peryear Income effect = -3 Substitution effect = Total effect = -6 D, M o vie D VD s, Units per y ear 15 = Substitution Effect + Income Effect = -3 + (-3)

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.6 Giffen Good Bas k etball, Ti ck ets per y ear Movies,Tickets peryear L 1 Total effect L 2 e 1 e 2 I 1 I 2 When the price of movie tickets decreases the budget constraint rotates out… allowing the consumer to increase her utility. Nevertheless, the total effect is negative. WHY?

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.6 Giffen Good Bas k etball, Ti ck ets per y ear Movies,Tickets peryear L 1 L* Income effect Substitution effect L 2 e 1 e 2 e* I 1 I 2 Total effect  Even though the substitution effect is positive….  …the income effect is larger and negative (since this is an inferior good).

© 2009 Pearson Addison-Wesley. All rights reserved Inflation Indexes  Inflation - the increase in the overall price level over time.  nominal price - the actual price of a good.  real price - the price adjusted for inflation.  How do we adjust for inflation to calculate the real price?

© 2009 Pearson Addison-Wesley. All rights reserved Inflation Indexes (cont.)  Consumer Price Index (CPI) – measure the cost of a standard bundle of goods for use in comparing prices over time.  We can use the CPI to calculate the real price of a hamburger over time.  In terms of 2008 dollars, the real price of a hamburger in 1955 was:

© 2009 Pearson Addison-Wesley. All rights reserved Effects of Inflation Adjustments  Scenario: Klaas signed a long-term contract when he was hired. According to the COLA clause in his contract, his employer increases his salary each year by the same percentage as that by which the CPI increases. If the CPI this year is 5% higher than the CPI last year, Klaas’s salary rises automatically by 5% over last year’s.  Question: what is the difference between using the CPI to adjust the long-term contract and using a true cost-of-living adjustment, which holds utility constant?

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.7 The Consumer Price Index C 2 C 1 C, Units of clothing per y ear e 2 e 1 I 1 L 1 L 2 I 2 F, Units offood peryear Y 1 /p 1 F 2 F 1 Y 1 /p 1 C Y 2 /p 2 C F Y 2 /p 2 F C = Y1Y1 - F Budget Line, L 1 Budget Line, L 2 (increase in salary) C = Y2Y2 - F The firm ensures that Klaas can buy the same bundle of goods in the second year that he chose in the first year… But since Klas is better off, the CPI adjustment overcompensates for the change in inflation

© 2009 Pearson Addison-Wesley. All rights reserved True Cost-of-Living Adjustment  True cost-of-living index - an inflation index that holds utility constant over time.  Question: how big an increase in Klaas’s salary would leave him exactly as well off in the second year as in the first?

© 2009 Pearson Addison-Wesley. All rights reserved True Cost-of-Living Adjustment C 2 C 1 C, Units of clothing per y ear e 2 e 1 I 1 L 1 e* L* L 2 I 2 F, Units offood peryear Y 1 /p 1 F 2 F 1 Y 1 /p 1 C Y 2 /p 2 C Y*/p 2 C F Y 2 /p 2 F 2 F Y /p 2 * C = Y1Y1 - F Budget Line, L 1 Budget Line, L 2 (increase in salary) C = Y2Y2 - F

© 2009 Pearson Addison-Wesley. All rights reserved Table 5.1 Cost-of-Living Adjustments

© 2009 Pearson Addison-Wesley. All rights reserved Labor-Leisure Choice  Leisure - all time spent not working.  The number of hours worked per day, H, equals 24 minus the hours of leisure or nonwork, N, in a day: H = 24 − N.  The price of leisure is forgone earnings.  The higher your wage, the more an hour of leisure costs you.

© 2009 Pearson Addison-Wesley. All rights reserved Labor-Leisure Choice: Example  Jackie spends her total income, Y, on various goods.  The price of these goods is $1 per unit.  Her utility, U, depends on how many goods and how much leisure she consumes: U = U(Y, N).  Jackie’s earned income equal: wH.  And her total income, Y, is her earned income plus her unearned income, Y* : Y = wH + Y*.

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.8 Demand for Leisure Y, Goods per d a y Time constraint H 1 = 8240 N1N1 = H, Work hours per day N, Leisure hours per day H 1 = 8 N1N1 = 16 0 H, Work hours per day N, Leisure hours per day I 1 L 1 (a) Indifference Curves and Constraints w, W age per hour (b) Demand Curve –w 1 1 Y 1 w 1 e 1 E1E1 Budget Line, L 1 Y = w 1 H Y = w 1 (24 − N). Each extra hour of leisure she consumes costs her w 1 goods.

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.8 Demand for Leisure Y, Goods per d a y Time constraint H 2 = 12H 1 = 8240 N 2 = 12 N1N1 = H, Work hours per day N, Leisure hours per day H 2 = 12 N 2 0 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, W age per hour –w 1 1 e 2 Y 2 Y 1 w 1 w 2 e 1 E 2 Budget Line, L 1 Y = w 1 H Y = w 1 (24 − N). Budget Line, L 2 Y = w 2 H Y = w 2 (24 − N). w 2 > w 1 (b) Demand Curve E1E1 H 1 = 8 N1N1 = 16

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.9 Supply Curve of Labor

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.10 Income and Substitution Effects of a Wage Change Since income effect is positive, leisure is a normal good. Y, Goods per d a y 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*

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 5.3  Enrico receives a no-strings-attached scholarship that pays him an extra Y* per day. How does this scholarship affect the number of hours he wants to work? Does his utility increase?

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 5.3

© 2009 Pearson Addison-Wesley. All rights reserved Application Leisure-Income Choices of Textile Workers

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.11 Labor Supply Curve That Slopes Upward and Then Bends Backward Y, Goods per d a y (a) Labor-Leisure Choice Time constraint H 2 H 3 H H,Work hours per day E 1 E 3 E 2 L 2 I 2 I 3 I 1 L 3 L 1 e 2 e 1 e 3 w, W age per hour (b) Supply Curve of Labor Supply curve of labor H 2 H 3 H 1 240,Work hours per day At low wages, an increase in the wage causes the worker to work more…. H but at high wages, an increase in the wage causes the worker to work less….

© 2009 Pearson Addison-Wesley. All rights reserved Figure 5.12 Relationship of Tax Revenue to Tax Rates

© 2009 Pearson Addison-Wesley. All rights reserved Cross Chapter Analysis: Child- Care Subsidies