Chapter 6 From Demand to Welfare McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics Dissecting the effects of a price change Measuring changes in consumer welfare using demand curves Measuring changes in consumer welfare using cost-of-living indexes Labor supply and the demand for leisure 6-2

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 6-3

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 6-4

Figure 6.1: Compensated Price Effects 6-5

Substitution and Income Effects Uncompensated price change has two parts: Substitution effect: the effect of a compensated price change, causing the consumer to substitute one good for another Income effect: the effect on consumption of removing the compensation, affecting the consumer’s purchasing power 6-6

Substitution and Income Effects Substitution effect involves: Movement along an indifference curve To a point where the slope is the same as the new budget line Income effect involves: Parallel shift in the budget constraint Toward the origin for a price increase Away from the origin for a price decrease 6-7

Figure 6.2: Substitution and Income Effects 6-8

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 6-9

Figure 6.3: Direction of the Substitution Effect for a Price Increase 6-10

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 6-11

Figure 6.4: Direction of the Income Effect for a Price Increase 6-12

Direction of Income and Substitution Effects Substitution effect is: Negative for a price increase Positive for a price reduction For a normal good, the income effect reinforces the substitution effect: For an inferior good, the income effect opposes the substitution effect: Positive for a price increase Negative for a price reduction 6-13

Why Do Demand Curves Slope Downward? The Law of Demand states that demand curves slope downward Substitution effect is always consistent with Law of Demand For normal goods, income effect reinforces substitution effect Normal goods always obey the Law of Demand Theoretically, if income effect for an inferior good is large enough to offset substitution effect, could violate Law of Demand 6-14

Figure 6.5: Giffen Good Giffen goods are inferior, and the amount purchased increases as the price rises Income effect is larger than the substitution effect 6-15

Compensating Variation How can a consumer measure economics gains and losses in monetary terms? 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 6-16

Consumer Surplus Consumer surplus is the net benefit a consume receives from participating in the market for some good Amount of money that would compensate the consumer for losing access to the market, compensating variation Consumer’s demand curve measures the gross benefit of consuming a good Consumer surplus is area below the demand curve and above a horizontal line at the price 6-17

Figure 6.6: Consumer Surplus 6-18

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 6-19

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 6-20

Measuring Changes in Consumer Welfare Using Cost-of-Living Indexes A cost-of-living index measures the relative cost of achieving a fixed standard of living in different situations Commonly used to measure changes in the cost of living over time Can be used to measure changes in consumer well-being due to public policies that alter prices or income Example: Consumer Price Index 6-21

Cost-of-Living Indexes: Basics Base value of one during some specific period Level of index in the base period is unimportant All that matters is percentage change in the index Example: Value of index in 1998 is 1; value in 2006 is 1.2, then cost of living has risen by 20% Ideally should allow us to quickly evaluate changes in consumer well-being following changes in prices and income 6-22

Cost-of-Living Indexes: Basics Use to convert nominal income into real income If real income has risen, then: Nominal income has grown more rapidly than then cost of living Consumer should be better off Ideally, change in real income should measure the change in the consumer’s well-being Difficult to construct a good cost-of-living index because different prices change by different proportions 6-23

Fixed-Weight Price Indexes Select a consumption bundle and measure its cost in multiple time periods, using prices at which the goods were available Fixed-weight price index: measures percentage change in the cost of a fixed consumption bundle Easy to calculate, requires no information about consumer preferences But what consumption bundle is appropriate? Example: Laspeyres price index 6-24

Labor Supply Consumer buy goods and services Many are also sellers (e.g., sell their work effort) Labor supply refers to the sale of a consumer’s time and effort to an employer To study labor supply, economists often study demand for leisure 6-25

Labor-Leisure Choice: An Example Javier’s possible income sources: Allowance of $30 per day (no strings attached!) Job that pays $5 per hour 14 hours per day available to allocate toward work and leisure Assume all money spent on food Decision about how many hours of leisure to enjoy (and thus how many to work) depends on his preferences 6-26

Figure 6.10: Labor-Leisure Choice With the dark red preferences, Javier chooses 8 hours of leisure (6 hours of work) per day With the light red preferences, Javier chooses not to work 6-27

Effect of Wages on Hours of Work How does a change in wage affect a consumer’s budget line? In Javier’s case, he will have $30 to spend on food regardless of his wage Wage change rotates his budget line, getting steeper with higher hourly wages Points of tangency between indifference curves and budget lines form a price-consumption path This leads to Javier’s leisure demand curve in Figure 6.11(b) 6-28

Figure 6.11: Leisure Demand and Labor Supply Curves 6-29

Labor Demand Curves Do labor demand curves obey the Law of Demand? Some people may have backward bending labor supply curves Increase in wage reduces the supply of labor for some range of wages Due to income effects: People own more time than they consume Increase in wage rate raises their purchasing power Increases their consumption of leisure, a normal good 6-30

Figure 6.12: Effects of Increase in Wage Rate Increase in wage rate leads to opposing income and substitution effects Income effect overwhelms substitution effect Wage increase results in reduced number of labor hours 6-31

Effect of Wages on Labor Force Participation Given that backward bending labor supply curves exist: Can a wage reduction cause someone who would not otherwise work to enter the labor market? NO! Can a wage increase drive someone who would otherwise work out of the labor market? 6-32

Figure 6.13: Effect of Wage Rate on Labor Force Participation A wage lower than the wage represented on the black budget line cannot lead Javier to enter the labor force A wage increase rotates the budget line upward and can entice him to choose to work (e.g., by selecting bundle G) 6-33