MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11 th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College Chapter 5: Using Consumer Choice Theory

Copyright 2012John Wiley & Sons, Inc. 2 Learning Objectives Determine how an excise subsidy affects consumer welfare and why it results in a deadweight loss. Examine how the public provision of a certain quantity of a good such as education may lead to less consumption of the good. Analyze how a voucher program would affect the quantity of educational services chosen by parents for their children. (continued)

Copyright 2012John Wiley & Sons, Inc. 3 Learning Objectives (continued) Explore the impact of per-bag charges versus a fixed annual fee on the amount of trash generated by a community, recycling, and household welfare. Develop an intertemporal model that illuminates the consumer’s choice to save or borrow and shows how changes in endowment and the interest rate affect that choice. Understand how the theory of consumer choice can explain what types of financial assets an individual intent on saving for the future should purchase, or invest in.

Copyright 2012John Wiley & Sons, Inc. 4 Excise Subsidies, Health Care, and Consumer Welfare Excise subsidy – a form of subsidy in which the government pays part of the per-unit price of a good and allows consumers to purchase as many units as desired at the subsidized price Lump-sum transfer – a form of subsidy in which the government gives the consumer a cash grant to be spent in any way the recipient wants Consumers prefer a cash grant but they do not necessarily purchase more of an otherwise subsidized good

Copyright 2012John Wiley & Sons, Inc. 5 Figure Excise Versus Lump-Sum Subsidy

Using the Consumer Surplus Approach Implication – The consumer could be better off with an alternative subsidy of the same cost to the government Deadweight loss – a measure of the loss in well-being resulting (in this case) from the use of an excise subsidy It does NOT mean that the consumer is worse off under the excise subsidy than with no subsidy at all. Copyright 2012John Wiley & Sons, Inc. 6

Figure 5.2 – Excise Subsidy Using Consumer Surplus Copyright 2012John Wiley & Sons, Inc. 7

Copyright 2012John Wiley & Sons, Inc. 8 Subsidizing Consumption The government has two ways to subsidize consumption: Reduce the price Provide a particular quantity of the good or service at a price below the market price Examples: Health insurance Education Garbage disposal The Consumer’s Choice to Save or Borrow Investor Choice

Subsidizing Health Insurance: Obamacare Patient Protection and Affordable Care Act, enacted March 23, 2011 Major goal: reduce the number of people without health insurance Program components: subsidization of individual health insurance purchases (discussed here) Expansion of existing government welfare programs Copyright 2012John Wiley & Sons, Inc. 9

The Basics of Obamacare Health insurance policy offering specific coverage (determined by the government) to those eligible for the subsidy Regressive (subsidy decreases as income increases) Following slides: application of consumer choice theory to exsamine the effects of susidization Copyright 2012John Wiley & Sons, Inc. 10

Figure 5.3 – Health Insurance Subsidy’s Effect on the Budget Line Copyright 2012John Wiley & Sons, Inc. 11

Figure 5.4 – The Optimal Consumption Choice and the Resultant Deadweight Loss Copyright 2012John Wiley & Sons, Inc. 12

Figure Case Where Mandated Insurance Harms Subsidy Recipients Copyright 2012John Wiley & Sons, Inc. 13

Public Schools and the Voucher Proposal Alternative form of subsidy: government offers a specific quantity of a good at a cost that is below market price. Example: public school voucher Voucher program: a subsidy in which parents receive vouchers that can be used to purchase education at any school of their choice Copyright 2012John Wiley & Sons, Inc. 14

Figure 5.6 – Fixed-Quantity Subsidy: Education Copyright 2012John Wiley & Sons, Inc. 15

Paying for Garbage Original trash collection plan: residents pay a fixed annual price for pick up Those with less garbage subsidized those with more garbage New plan: residents purchase garbage collection bags at a price that exceeds their cost, which generate a net revenue that is used to finance garbage collection services Each household pays cost of own trash disposal Copyright 2012John Wiley & Sons, Inc. 16

Copyright 2012John Wiley & Sons, Inc. 17 Figure Consumer Choice: Garbage Disposal

Copyright 2012John Wiley & Sons, Inc. 18 Figure Trash Disposal: The Bag System

The Consumer’s Choice to Save or Borrow Decision to save (or borrow): a decision to rearrange consumption between various time periods. What factors influence decisions to save or borrow? Endowment point: the consumption mix available to the individual if no saving or borrowing takes place Copyright 2012John Wiley & Sons, Inc. 19

Copyright 2012John Wiley & Sons, Inc. 20 Figure Consumer Choice over Two Time Periods

Copyright 2012John Wiley & Sons, Inc. 21 Figure An Income Change and Intertemporal Choice

Copyright 2012John Wiley & Sons, Inc. 22 Figure Social Security and Saving

Copyright 2012John Wiley & Sons, Inc. 23 Figure Effect of a Change in Interest Rate on Saving or Borrowing

Copyright 2012John Wiley & Sons, Inc. 24 Investor Choice - Terminology Two characteristics of financial assets: return risk Tradeoff between return and risk Expected return – the summed value of each possible rate of return weighted by its probability Expected utility – the summed value of each possible utility weighted by its probability

Copyright 2012John Wiley & Sons, Inc. 25 Risk: Attitude and Utility Risk averse – a state of preferring a certain return to an uncertain prospect that generates the same expected return Risk neutral – a state of deriving the same utility from a certain return as from an uncertain prospect generating the same expected return Risk loving – a state of deriving less utility from a certain return than from an uncertain prospect generating the same expected return

Copyright 2012John Wiley & Sons, Inc. 26 Figure The Return-Risk Tradeoff

Copyright 2012John Wiley & Sons, Inc. 27 Figure Differences in Individuals’ Risk-Return Preferences

Copyright 2012John Wiley & Sons, Inc. 28 Figure Investor Preferences and Risk

Copyright 2012John Wiley & Sons, Inc. 29 Minimizing Exposure to Risk Insurance – an arrangement by which the consumer pays a premium in return for the promise that the insurer will provide compensation for losses due to misfortune Diversification – investing a given amount of resources in numerous independent projects instead of a single project in order to minimize exposure to risk

Copyright 2012John Wiley & Sons, Inc. 30 Figure 5.16 – Pricing Insurance

Copyright 2012John Wiley & Sons, Inc. 31 Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein.