Download Chapter 05

Chapter Five
Applying Consumer
Theory
Topics
 Deriving Demand Curves.
 How Changes in Income Shift
 Demand Curves.
 Effects of a Price Change.
 Cost-of-Living Adjustments.
 Deriving Labor Supply Curves.
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5-2
Budget Line, L
W=
Y PW
Wine, (W), Gallons per year
Figure 5.1 Deriving
an Individual’s
Demand Curve
(a) Indifference Cu rves and Budget Const raints
Pb
b
PW
12.0
e1
2.8
0
12.0
Beer (b), Gallons per year
Initial optimal bundle of
Beer and Wine
(b) Demand Cu rve
0
© 2009 Pearson Addison-Wesley. All rights reserved.
26.7
pb, $ per unit
Initial Values
Pb = price of beer = $12
PW = price of wine = $35
Y = Income = $419.
I1
L1 (pb = $12)
E1
26.7
Beer (b), Gallons per year
5-3
Budget Line, L
W=
Y PW
Wine, (W), Gallons per year
Figure 5.1 Deriving
an Individual’s
Demand Curve
(a) Indifference Cu rves and Budget Const raints
12.0
e2
4.3
Pb
b
PW
e1
2.8
I2
0
Price of Beer goes down!
44.5
Beer (b), Gallons per year
(b) Demand Cu rve
12.0
E1
E2
6.0
0
© 2009 Pearson Addison-Wesley. All rights reserved.
26.7
L2 (pb = $6)
pb, $ per unit
New Values
Pb = price of beer = $6
PW = price of wine = $35
Y = Income = $419.
I1
L1 (p = b$12)
26.7
44.5
Beer (b), Gallons per year
5-4
Budget Line, L
W=
Y PW
Wine, (W), Gallons per year
Figure 5.1 Deriving
an Individual’s
Demand Curve
(a) Indifference Cu rves and Budget Const raints
12.0
e3
5.2
e2
4.3
Pb
b
PW
Price of Beer goes down
again!
2.8
I2
I1
L1 (p = b$12)
26.7
44.5
L2 (pb = $6)
58.9
L3 (pb = $4)
Beer (b), Gallons per year
pb, $ per unit
(b) Demand Cu rve
12.0
E1
E2
6.0
E3
4.0
0
© 2009 Pearson Addison-Wesley. All rights reserved.
I3
e1
0
New Values
Pb = price of beer = $4
PW = price of wine = $35
Y = Income = $419.
Price-consumption curve
26.7
44.5
58.9
D1, Demand for Beer
Beer (b), Gallons per year
5-5
Effects of a Rise in Income
 Engel curve - the relationship between
the quantity demanded of a single good
and income, holding prices constant
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5-6
Wine, Gallons per year
Figure 5.2 Effect of a
Budget Increase on an
Individual’s Demand Curve
2.8
Budget Line, L
Pb
b
PW
Initial Values
Pb = price of beer = $12
PW = price of wine = $35
$628
Y = Income = $419.
Price of bee r, $ per unit
0
12
e1
26.7
I1
Beer, Gallons per year
E1
D1
0
26.7 38.2
Beer, Gallons per year
Y, Budget
W=
Y PW
L1
Income goes up!
Y1 = $419
0
© 2009 Pearson Addison-Wesley. All rights reserved.
E 1*
26.7
Beer, Gallons per year
Wine, Gallons per year
Figure 5.2 Effect of a
Budget Increase on an
Individual’s Demand Curve
L2
L1
e2
4.8
2.8
Budget Line, L
Initial Values
Pb = price of beer = $12
PW = price of wine = $35
$628
Y = Income = $419.
Income goes up!
Price of bee r, $ per unit
Pb
b
PW
12
26.7 38.2
E1
I2
Beer, Gallons per year
E2
D2
D1
0
26.7 38.2
Y2 = $628
Y1 = $419
0
© 2009 Pearson Addison-Wesley. All rights reserved.
I1
Beer, Gallons per year
Y, Budget
W=
Y PW
0
e1
E 2*
E 1*
26.7 38.2
Beer, Gallons per year
Wine, Gallons per year
Figure 5.2 Effect of a
Budget Increase on an
Individual’s Demand Curve
L3
L2
L1
Income-consumption curve
e3
7.1
4.8
2.8
Budget Line, L
Initial Values
Pb = price of beer = $12
PW = price of wine = $35
Y = Income = $837.
Income goes up again!
Price of bee r, $ per unit
Pb
b
PW
12
26.7 38.2 49.1
E1
E2
I2
I3
Beer, Gallons per year
E3
D3
D2
D1
0
26.7 38.2 49.1
E 3*
Y2 = $628
0
Beer, Gallons per year
Engel curve for beer
Y3 = $837
Y1 = $419
© 2009 Pearson Addison-Wesley. All rights reserved.
I1
Y, Budget
W=
Y PW
0
e2
e1
E 2*
E 1*
26.7 38.2 49.1
Beer, Gallons per year
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?
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5-10
Solved
Problem 5.1
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5-11
Consumer Theory and Income
Elasticities.
 Formally,
Q
%Q Q
Q Y
x


%Y Y Y Q
Y
 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
x = -3%/1% = -3.
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5-12
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
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5-13
Housing, Square feet per year
Figure 5.3 Income-Consumption
Curves and Income Elasticities
 As income rises
the budget
constraint shifts to
the right.
Food inferior,
housing normal
L2
ICC 1
a
Food normal,
housing normal
 …where on the
new budget
constraint the new
optimal
consumption
bundle will be
ICC 2
b
L1
 The income
elasticities depend
on….
e
c
ICC 3
Food normal,
housing inferior
I
Food, Pounds per year
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5-14
 When Gail was
poor and her
income increased..
(a) Indifference Curves and Budget Constraints
All other goods per year
Figure 5.4 A Good That
Is Both Inferior
and Normal
Y3 L3
Y2
 ….she bought less
hamburger and
more steak.
e3
1
Y1 L
I3
e2
e1
 …she bought more
hamburger
I2
I1
Hamburger per year
(b) Engel Curve
Y, Income
 But as she became
wealthier and her
income rose…
Income-consumption curve
L2
Y3
E3
Y2
E2
Engel curve
Y1
E1
Hamburger per year
© 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.
5-16
Figure 5.5 Substitution and Income
Effects with Normal Goods
D, Movie DVDs, Units per year
Initial Values
PD = price of DVDs = $20
PC = price of CDs = $15
Y = Income = $300.
15
Budget Line, L
L1
PC
C
D=
PD
$300 - $15 C
D=
$20
$20
Y PD
e1
I1
12
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20
C, Music CDs Units peryear
5-17
Figure 5.5 Substitution and Income
Effects with Normal Goods
D, Movie DVDs, Units per year
Initial Values
PD = price of DVDs = $20
PC = price of CDs = $15
Y = Income = $300.
Budget Line, L
15
L1
Y
PD -
D=
L2
e2
e1
PC
C
PD
$300 - $15
$30 C
D=
$20
$20
I1
I2
6
12
20
C, Music CDs Units peryear
PC goes up…
Total effect = -6
© 2009 Pearson Addison-Wesley. All rights reserved.
5-18
Figure 5.5 Substitution and Income
Initial Values
Values
Effects with NormalInitial
Goods
P = price of DVDs = $20
D, Movie DVDs, Units per year
D
price of =
CDs
= $15
PD = price Pof
$20
C =DVDs
Income = $300.
PC = price Yof= CDs
= $15
Budget Line, L
Y = Income = $300.
$30
$300
C
D=
$20
$20
Budget Line, L
L*
15
L1

L2
e*

e1
e2
What if we compensated Laura so
PCutility she
Y the
she could afford
same
D before
= Pthe price of CDs C
had
PD
increased? D
In other words, how much income
she would need to afford
indifference curve I1, with the new
price of CDs ($30)
$300 - $30 C
D=
$20
$20
I1
I2
6
Income effect = -3
9
12
20
C, Music CDs Units peryear
Substitution effect = -3
Total effect = -6 = Substitution Effect + Income Effect = -3 + (-3)
© 2009 Pearson Addison-Wesley. All rights reserved.
5-19
Basketball, Tickets per year
Figure 5.6
Giffen Good
When the price of movie
tickets decreases the budget
constraint rotates out…
L2
e2
L1
I2
e1
Total effect
allowing the consumer to
increase her utility.
I1
Movies, Tickets per year
Nevertheless, the total effect
is negative. WHY?
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5-20
 Even though the
substitution effect is
positive….
Basketball, Tickets per year
Figure 5.6
Giffen Good
L2
 …the income effect
is larger and
negative (since this
is an inferior good).
e2
L1
I2
L*
e1
e*
Total effect
Substitution effect
I1
Movies, Tickets per year
Income effect
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5-21
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?
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5-22
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:
CPI for 2008
211.1
 price of a burger 
15  1.18
CPI for 2005
26.8
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5-23
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?
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5-24
C, Units of clothing per year
Figure 5.7 The Consumer Price Index
Y1 /pC1
Y2 /pC2
C1
e1
The firm ensures
Budget Line, L1
that Klaas can buy
1
P
Y
But
since
Klas
is
F
the same bundle of
1
F
C=
better
off,
the
CPI
1
1
goods in
PC
Pc
adjustment
second year that he
Budget Line, L2 (increase in salary)
overcompensates
chose in the first
2
for
the change in
year…
PF
Y2
inflation
C=
- 2 F
2
Pc
PC
 PC  PF
1
e2
C2
1
I2
I1
L1
F1
F2
Y1/pF1
L2
Y2 /pF2
F, Units of food per year
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5-25
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?
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5-26
C, Units of clothing per year
True Cost-of-Living Adjustment
Budget Line, L1
C=
Y1 /pC1
PC
1
PF
-
1
1
c
F
P
Budget Line, L2 (increase in salary)
Y2 /pC2
Y* /pC2
C1
Y1
C=
e1
Y2
PC
2
-
PF
2
Pc
2
 PC  PF
1
e2
C2
F
1
e*
I2
I1
L1
F1
F2
Y1/pF1
L*
L2
Y2* /pF2
Y2 /pF2
F, Units of food per year
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5-27
Table 5.1 Cost-of-Living Adjustments
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5-28
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.
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5-29
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*.
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5-30
Y, Goods per day
(a) Indifference Curves and Constraints
Figure 5.8 Demand
for Leisure
Time constraint
I1
Budget Line, L1
L1
–w1
Y = w1H
1
Y1
Y = w1(24 − N).
0
24
e1
N1 = 16
H1 = 8
24
0
N, Leisure hours per day
H, Work hours per day
Each extra hour
of leisure she
consumes costs
her w1 goods.
w, Wage per hour
(b) Demand Curve
E1
w1
0
© 2009 Pearson Addison-Wesley. All rights reserved.
N1 = 16
H1 = 8
N, Leisure hours per day
H, Work hours per day
5-31
Y, Goods per day
(a) Indifference Curves and Constraints
Figure 5.8 Demand
for Leisure
Time constraint
I2
L2
–w2
I1
1
e2
Y2
Budget Line, L1
L1
–w1
Y = w1H
1
e1
Y1
Y = w1(24 − N).
0
24
N2 = 12
H2 = 12
N1 = 16
H1 = 8
24
0
N, Leisure hours per day
H, Work hours per day
Budget Line, L2
Y = w2H
w, Wage per hour
(b) Demand Curve
E2
w2
Y = w2(24 − N).
E1
w1
w2 > w1
Demand for leisure
0
© 2009 Pearson Addison-Wesley. All rights reserved.
N2 = 12
H2 = 12
N1 = 16
H1 = 8
N, Leisure hours per day
H, Work hours per day
5-32
Figure 5.9 Supply Curve of Labor
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5-33
Y, Goods per d ay
Figure 5.10 Income and Substitution
Effects of a Wage Change
Time const raint
I2
L2
Since income
effect is positive,
leisure is a normal
good.
I1
L*
e2
e*
L1
e1
0
N*
24
H*
N1 N 2
H1 H2
Substitution effect Total effect
24
N, Leisure hours per d ay
0
H, Work hours per d ay
Income effect
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5-34
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?
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5-35
Solved Problem 5.3
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5-36
Application Leisure-Income Choices
of Textile Workers
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5-37
Figure 5.11 Labor Supply Curve That
Slopes Upward and Then Bends Backward
L3
(b) Supply Curve of Labor
Time const raint
I3
I2
I1
L2
E3
E2
e3
e2
E1
L1
24
Supply curve of labor
w, Wage per hour
Y, Goods per d ay
(a) Labor-Leisure Choice
e1
H2
H
3
H1
0
H, Work hours per d ay
0
H1 H3
H2
24
H, Work hours per d ay
butlow
At
at high
wages,
wages,
an increase
an increase
in the wage causes the worker
worker
to
work to
less….
work more….
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5-38
Figure 5.12 Relationship of Tax
Revenue to Tax Rates
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5-39
Cross Chapter Analysis: ChildCare Subsidies
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5-40