1. Consumer Theory Applications
Dr. Jennifer P. Wissink
©2011 John M. Abowd and Jennifer P. Wissink, all rights reserved.

2. Effect Of A Tax & Transfer Program: Initial Point
Consider the following preferences as shown in these indifference curves.
Question A: Income: $16 Price of food: $1 Price of shelter: $1
Food = ?? Shelter = ?? Indifference curve = ??

3. Answer A
Add the budget line to the graph and get to the highest indifference curve possible, while at the same time, being on the budget line.
Point A: Income: $16 Price of food: $1 Price of shelter: $1
Food = 7 units Shelter = 9 units Indifference curve = I4

4. Effect Of A Tax & Transfer Program: Addition Of Tax
Question B: Income: $16 Price of food: $1 Price of shelter: $1 NOW Add: A tax of $1 per unit on shelter, which we will assume doubles the price of shelter to the consumer.
Tax-inclusive price of shelter = ?? Food =?? Shelter =?? Indifference curve =??

5. Answer B
Point B Income: $16 Price of food: $1 Price of shelter: $1 NOW Add: A tax of $1 per unit on shelter, which we will assume doubles the price of shelter to the consumer.
Tax-inclusive price of shelter = $2 Food = 9 Shelter = 3.5 Indifference curve = I2

6. Effect Of A Tax & Transfer Program: Tax & Transfer
Question C: Income: $16 Price of food: $1 Price of shelter: $1 NOW Add: A tax of $1 per unit on shelter, which we will assume doubles the price of shelter to the consumer. … and a transfer payment of $8.
Tax-inclusive price of shelter = $2 Transfer inclusive income = $24 Food =?? Shelter =?? Indifference curve =??

7. Answer C
Question C: Income: $16 Price of food: $1 Price of shelter: $1 NOW Add: A tax of $1 per unit on shelter, which we will assume doubles the price of shelter to the consumer. … and a transfer payment of $8.
Tax-inclusive price of shelter = $2 Transfer inclusive income = $24 Food = 10 Shelter = 7 Indifference curve = I4

8. Tax And Transfer Systems Give Pure Substitution Effects
Notice in the example that the consumer ends up on the same indifference curve after the tax and transfer program as in the initial choice (I4).
Notice that we have isolated the pure substitution effect and knowledge of the substitution effect of the price change induced by the shelter tax is sufficient to predict the effect of the complete tax and transfer system.
In our example, tax receipts are $7 per person (= 7 units of shelter x $1 tax), while the transfer is $8 per person.
Notice that the tax and transfer system will necessarily get the consumer to buy less shelter and more food.

9. From The NYT (via Cornell)
February 16, 2006, Economic Scene
A Way to Cut Fuel Consumption That Everyone Likes, Except the Politicians, By ROBERT H. FRANK
SUPPOSE a politician promised to reveal the details of a simple proposal that would, if adopted, produce hundreds of billions of dollars in savings for American consumers, significant reductions in traffic congestion, major improvements in urban air quality, large reductions in greenhouse gas emissions, and substantially reduced dependence on Middle East oil. The politician also promised that the plan would require no net cash outlays from American families, no additional regulations and no expansion of the bureaucracy.
As economists often remind their students, if something sounds too good to be true, it probably is. So this politician's announcement would almost surely be greeted skeptically. Yet a policy that would deliver precisely the outcomes described could be enacted by Congress tomorrow — namely, a $2-a-gallon tax on gasoline whose proceeds were refunded to American families in reduced payroll taxes.
Proposals of this sort have been advanced frequently in recent years by both liberal and conservative economists. Invariably, however, pundits are quick to dismiss these proposals as "politically unthinkable.“
But if higher gasoline taxes would make everyone better off, why are they unthinkable? Part of the answer is suggested by the fate of the first serious proposal to employ gasoline taxes to reduce America's dependence on Middle East oil. The year was 1979 and the country was still reeling from the second of two oil embargoes. To encourage conservation, President Jimmy Carter proposed a steep tax on gasoline, with the proceeds to be refunded in the form of lower payroll taxes.
Mr. Carter's opponents mounted a rhetorically brilliant attack on his proposal, arguing that because consumers would get back every cent they paid in gasoline taxes, they could, and would, buy just as much gasoline as before. Many found this argument compelling, and in the end, President Carter's proposal won just 35 votes in the House of Representatives.

10. Food Stamps vs. Cash Suppose the following for the Parker family:
u(F, $mlo) where $mlo = “money-left-over” to spend on all other goods
I = $200
PF = $2/unit
Pmlo = $1
Consider three alternative government policies
no support
$200 in food stamps
$200 in cash

11. Food Stamps vs. Cash Notes: With no support the Parkers end up at O.
$mlo
Notes:
With no support the Parkers end up at O.
With either cash or food stamps money the Parkers end up at N.
The budget line under the food stamp program is the thick purple segment and the downward sloping purple segment.
The budget line with cash is the red and purple downward sloping segments.
The Parkers are indifferent between food stamps and cash.
BL$$
BLFS
200 N O
IC1
IC0
BLFS
BL0
BL$$
100
200
Food

12. Food Stamps vs. Cash
Suppose we offer the same deal to the Smiths. The Smiths are identical to the Parkers except they don’t like food as much.
Again, the budget line under the food stamp program is the thick purple segment and the purple segment.
Again, the budget line with cash is the red and purple segments.
However, unlike the Parkers, the Smiths prefer cash to food stamps!
$mlo
BL$$ N
IC$$
BLFS S
ICFS O
IC0
BLFS
BL0
BL$$
Food

13. Example: Sam’s Club Suppose: I = $2,000. PX = $10 and PY = $10.
Initially: X =100 and Y =100.
Perfectly competitive firms sell Y.
Sam’s Club has a monopoly (only seller) on X.
Average total cost of X for Sam’s Club is constant(horizontal!) and equal to $5.

14. Example: Sam’s Club Sam’s “deal”:
Pay $200 to join Sam’s Club then
PX = $8.
Note: This is called a “two-part tariff”
PY is still $10 and Income is still $2,000.
Note: you could still afford the old bundle:
Original bundle: Xold =100 and Yold = 100
Budget constraint: $2,000=$200+$800+$1,000.
Question: why are both the consumer and Sam better off?

15. Sam’s Club Graph Consumer is on higher indifference curve
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. Y
IC0
200
ICnew
180 O N
BLN
BL0
Xold
Xnew
200 X

16. The Odd Case Of Labor/Leisure and “All-Other-Goods” and Why Offer Overtime Wages
Consider Abe.
Consider one day in Abe’s life.
He has 24 hours of time.
He can consume his time as leisure (Z) or sell it to the market at the market wage (w) as Labor (L).
L + Z = 24
Along any budget line, $mlo=$wL
Abe gets utility from only 2 things: leisure and $money-left-over.
$mlo C
BL-higher wage D
BL-old
BL-OT B A
IC-old
Z*o
24 hours
Z=leisure

17. Z is relatively more expensive
Reacting To A Wage Change: The Odd Case Of Labor/Leisure & “money-left-over”
Suppose your wage increases
SUBSTITUTION EFFECT
INCOME EFFECT
Z is relatively more expensive
You feel RICHER–your endowment of time is more valuable
“Z” normal
“Z” inferior
Quantity of Z demanded increases
Quantity of Z demanded decreases
Quantity of Z demanded decreases
NOTE: This case is DIFFERENT, since when the price of leisure increased, you felt RICHER.
Beware!
This situation can lead to a “backward bending demand for leisure” which generates a “backward bending supply of labor”!