1 Chapter 6 From Demand to Welfare

Main Topics Dissecting the effects of a price change Measuring changes in consumer welfare using demand curves 2

3 Dissecting the Effects of a Price Change When a price increases two things happen: That good becomes expensive relative to others; consumers shift their purchases away from the more expensive good Consumers’ purchasing power falls Economists have learned a lot about consumer demand and welfare from thinking about price changes this way

4 Dissecting the Effects of a Price Change As the price of a good changes, the consumer’s well-being varies An uncompensated price change is one with no change in income A compensated price change is a price change and an income change that together leave the consumer’s well-being unaffected

5 if M=10, P B =0.25, then, ★ if Ps=0.5, then choose A ★ if Ps=1, purchasing power declines, L 2, and choose B As P increases, consumer is worse off b/c purchasing power is less how much $ would need to give consumer to compensate him for the higher P? if M=15 now, then L 3 and C. note that A~C from L 2 -L 3 : the effect of compensation on BL

6 L 1 -L 2 : uncompensated price change: price change with no change in M L 1 -L 3 : Compensated price change: price change and M change to leave the consumer unaffected What about a reduction of Ps? the consumer is better off L 1 -L 3 : compensated price change

7 Compensated Price Effects

If we assume that the good is normal, then the increase in price will result in a fall in the quantity demanded. This is for two reasons; the IE(have a limited budget, therefore can purchase lower quantities of the good) and the SE (swap with alternative goods that are cheaper). 8 Substitution and Income Effects

Due to the price of good x increasing, the budget line has pivoted from B1 to B2 and the consumption point has moved. The decrease in the quantity demanded can be divided into two effects; 9

1. SE: when the consumer switches consumption due to the price change alone but remains on the same indifference curve. To identify the SE, a new BL needs to be constructed. The BL B1* is added, this budget line needs to be parallel with the BL B2 and tangent to I1. Therefore, the movement from Q1 to Q2 is purely due to the SE 10

2. IE: consumption changes due to the having a change in purchasing power as a result of the price change. The higher price means BL is B2, hence the optimum consumption point is Q2. This point is on a lower indifference curve (I2). Thus, in the case of a normal good, the IE and SE work to reinforce each other. 11

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13 Direction of Substitution Effect Substitution effect of price increase is: Negative for price increase Positive for price decrease Consumer substitutes away from the good that becomes relatively more expensive 14

Direction of Income Effect Direction of income effect depends on whether the good is normal or inferior Increase in the good’s price reduces the consumer’s purchasing power Consumer will buy less of the good if it is normal, but more if it is inferior Income effect of a price increase is: Negative for normal good Positive for inferior good 15

IE: an increase in P will reduce purchasing power this will reduce Q if good is normal and increase Q if good is inferior IE<0 if good is normal IE>0 if good is inferior same direction Normal good: IE and SE move in same direction, both are (-) if P increases and both are (+) if P falls opposite direction inferior: IE and SE move in opposite direction: when P increases, IE increases Q while SE reduces it. 16

Substitution & Income Effects for Inferior Goods IE and SE work in opposite directions with inferior goods. As the price of X rises there is a decrease in real income. You can see that point A is the original point for X* and Y* on the original Budget Constraint.Budget Constraint 16

The price of X (inferior good) increased therefore decreasing the real income which caused the budget constraint to rotate inward because the X intercept changes as the price of X changes. Since the price of X increased the SE sets in as X is substituted by Y as shown by the movement A-B. 17

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However, since X is an inferior good, demand for X increases as income decreases therefore countering the SE. The IE is shown by the movement from B-C. C is where the combination of the substitution effect and the income effect settles. 19

20 Why Do Demand Curves Slope Downward? The Law of Demand states that demand curves slope downward SE is always consistent with Law of Demand For normal goods,IE reinforces substitution effect Normal goods always obey the Law of Demand Theoretically, if IE for an inferior good is large enough to offset substitution effect, could violate Law of Demand 19

A drop in the price of inferior good would raise the purchasing power, making the consumer better off: she will consume more of the other goods and less of the inferior good. Extreme Inferiority: Giffen Goods IE>SE and D curve slopes upward Giffen goods are inferior, and the amount purchased increases as the price rises 21

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23 Giffen goods are hard to find b/c: 1. most goods are normal 2. if spending on a good is a small fraction of M, a large increase in good’s P will not affect M significantly

24 Compensating Variation How can a consumer measure economics gains and losses in monetary terms? a common measure is compensating variation Compensating variation: the amount of money that exactly compensates the consumer for a change in circumstances Example: If the compensating variation for a gasoline tax is $50, then the consumer is better off with the tax as long as he receives a rebate for more than $50 Example: if CV for road improvement =$100, then the consumer is better off as long as his contribution is <$100

25 b/c 5$ fully compensate consumer from an increase in P from 0.5 to 1, the compensating variation for this P increase is $5 the compensating variation for P reduction is -$3.75 worked-out problem 6.2 in-text-exercise

26 Compensated Price Effects

27 Consumer Surplus Consumer surplus is the net benefit a consume receives from participating in the market for some good and, the amount of money that would compensate the consumer for losing access to the market, compensating variation Consumer’s D curve measures the gross benefit of consuming a good Consumer surplus is area below the D curve and above a horizontal line at the price

28 if Q=1, the highest P the consumer is willing to pay is $4000, but Q=0 if P is higher. Willingness to pay 1 st and 2 nd =$3000 and $2000 for 3 units and so on the consumer’s net benefit is is the difference between his gross benefit and the amount he pays

29 if P=$1500, the consumer will buy 3 units: he is: willing to pay $4000 for the first, pays $1500 and enjoys $2500 his net benefit from 2 nd unit: $1500 net benefit from the 3rd =$500 his consumer surplus:

30 Figure 6.6: Consumer Surplus

31 Using Consumer Surplus to Measure Changes in Welfare Some public policies alter prices and amounts of traded goods Consumer surplus is useful, allows us to measure change in net economic benefit from the policy This is another way to describe compensating variation for the policy Example: Policy reduces consumer surplus from $100 to $80 Must provide her with $20 to compensate fully for the policy’s effects

32 Figure 6.7: Change in Consumer Surplus When price = $2, consumer surplus is grey and brown shaded areas When price = $4, consumer surplus is grey area Brown area is change in consumer surplus