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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.
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.
6-2
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
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6-3
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.
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6-4
Measuring Consumer Surplus
Gross benefit of
first computer
Consumer surplus = sum of
the net benefits for all units
Net benefit of first
computer = $2,500
Price paid
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6-5
Example: Measuring Consumer
Surplus
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6-6
Using Consumer Surplus to Measure
Changes in Welfare
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6-7
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.
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6-8
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
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6-9
Cheese pizza (oz.)
Compensated Price Changes
Effect of
compensation
L3
C
A
B
Increase in price
of yogurt
L1
L2
Frozen yogurt (pints)
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6-10
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
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6-11
Substitution and Income Effects
Uncompensated price
effect
Cheese pizza (oz.)
L3
Substitution effect
C
A
Income effect
B
L2
L1
Frozen yogurt (pints)
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6-12
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
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6-13
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.
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6-14
Income Effect for a Normal Good
Uncompensated price
effect
Cheese pizza (oz.)
L
3
Substitution effect
Same
direction
C
A
Income effect
B
L2
L1
Frozen yogurt (pints)
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6-15
Income Effect for an Inferior Good
Uncompensated price
effect
Cheese pizza (oz.)
L3
Substitution effect
Opposite
direction
C
A
Income effect
B
L2
L1
Frozen yogurt (pints)
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6-16
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.
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6-17
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.
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6-18
Giffen Good
Uncompensated price
effect
Cheese pizza (oz.)
L
3
Substitution effect
C
L2
A
B
Income >
substitution
Income effect
L1
Frozen yogurt (pints)
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6-19
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.
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6-20
Effect of Wages on Hours of Work
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6-21
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.
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6-22
Normal Good – Compensated and
Uncompensated Demand Curves
Price ($/lb.)
Compensated demand curve
Substitution effect
C
B
Same
direction
A
Income effect
Uncompensated demand curve
Beef (lb.)
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6-23
Inferior Good – Compensated and
Uncompensated Demand Curves
Price ($/lb.)
Uncompensated demand curve
Substitution effect
B
C
Opposite
direction
A
Income effect
Compensated demand curve
Beef (lb.)
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6-24
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.
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6-25
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.
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6-26
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 wellbeing.
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6-27
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.
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6-28
Review – Compensated Demand
Curves
• Different compensated (Hicksian) demand curves
correspond to different levels of the consumer’s wellbeing
• 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
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6-29
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.
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6-30