1. Chapter 5 Applying Consumer theory

2. 5 - 2 Copyright © 2012 Pearson Education. All rights reserved. Topics Deriving Demand Curves. How Changes in Income Shift Demand Curves. Effects of a Price Change. Cost-of-Living Adjustments. Deriving Labor Supply Curves.

3. 5 - 3 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.1 Deriving an Individual’s Demand Curve 26.70 Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PbPb PWPW b Budget Line, L 12.0 2.8 12.0 26.7 0 p b, $ per unit e 1 E 1 I 1 Beer (b), Gallons per year Wine, (W), Gallons per y ear (b) Demand Curve Initial optimal bundle of beer and wine Beer (b), Gallons per year L 1 (pbpb = $12) (a) Indifference Curves and Budget Constraints

4. 5 - 4 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.1 Deriving an Individual’s Demand Curve New Values P b = price of beer = $6 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PbPb PWPW b Budget Line, L Price of beer goes down! 4.3 12.0 2.8 12.0 6.0 26.7 0 p b, $ per unit L 2 (p b = $6) 26.7044.5 e 2 e 1 I 1 I 2 Beer (b), Gallons per year Wine, (W), Gallons per y ear (b) Demand Curve Beer (b), Gallons per year L 1 (p b = $12) E 1 44.5 E 2 (a) Indifference Curves and Budget Constraints

5. 5 - 5 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.1 Deriving an Individual’s Demand Curve New Values P b = price of beer = $4 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PbPb PWPW b Budget Line, L Price of beer goes down again! 4.3 5.2 12.0 2.8 12.0 6.0 4.0 26.7 0 44.558.9 p b, $ per unit L 2 (pbpb = $6)L 3 (p b = $4) 26.7044.558.9 e e 1 I 1 I 2 I 3 Beer (b), Gallons per year D 1, Demand for Beer Price-consumption curve Wine, (W), Gallons per y ear (a) Indifference Curves and Budget Constraints (b) Demand Curve Beer (b), Gallons per year L 1 (pbpb = $12) E 1 2 E 2 e 3 E 3

6. 5 - 6 Copyright © 2012 Pearson Education. All rights reserved. Price-Consumption Curve A line through optimal bundles at each price of one good (beer) when the price of the other good (wine) and the budget are held constant. The demand curve corresponds to the price-consumption curve.

7. 5 - 7 Copyright © 2012 Pearson Education. All rights reserved. Solved Problem 5.1 In Figure 5.1, how does Mimi’s utility at E 1 on D 1 compare to that at E 2 ? Answer:  Use the relationship between the points in panels a and b of Figure 5.1 to determine how Mimi’s utility varies across these points on the demand curve.

8. 5 - 8 Copyright © 2012 Pearson Education. All rights reserved. Solved Problem 5.2 Mahdu views Coke, q, and Pepsi as perfect substitutes: He is indifferent as to which one he drinks. The price of a 12- ounce can of Coke is p, the price of a 12- ounce can of Pepsi is p* and his weekly cola budget is Y. Derive Mahdu’s demand curve for Coke using the method illustrated in Figure 5.1.

9. 5 - 9 Copyright © 2012 Pearson Education. All rights reserved. Solved Problem 5.2 (cont.)

10. 5 - 10 Copyright © 2012 Pearson Education. All rights reserved. Effects of a Rise in Income Engel curve - the relationship between the quantity demanded of a single good and income, holding prices constant. Income-consumption curve shows how consumption of both goods changes when income changes, while prices are held constant.

11. 5 - 11 Copyright © 2012 Pearson Education. All rights reserved. Y 1 Figure 5.2 Effect of a Budget Increase on an Individual’s Demand Curve Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PWPW b Budget Line, L PbPb Win e, Gallons per y ear 0 2.8 26.7Beer, Gallons peryear 0 12 0 26.7Beer, Gallons peryear 26.7Beer, Gallons peryear I 1 P r ice of bee r, $ per unit Y, Budget E1E1 = $419 L 1 e 1 D 1 E 1 * Income goes up! $628

12. 5 - 12 Copyright © 2012 Pearson Education. All rights reserved. Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. W = Y PWPW - PWPW b Budget Line, L PbPb Income goes up! $628 Win e, Gallons per y ear 0 2.8 4.8 38.226.7Beer, Gallons peryear 0 12 0 38.226.7Beer, Gallons peryear 38.226.7Beer, Gallons peryear I 2 I 1 P r ice of bee r, $ per unit Y, Budget e 2 E 1 Y 1 = $419 Y 2 = $628 L 2 L 1 e 1 D 1 D 2 E 1 * E 2 E 2 * Figure 5.2 Effect of a Budget Increase on an Individual’s Demand Curve

13. 5 - 13 Copyright © 2012 Pearson Education. All rights reserved. Y Y Y Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $837. W = Y PWPW - PWPW b Budget Line, L PbPb Income goes up again! Win e, Gallons per y ear Income-consumption curve Engel curve for beer 0 2.8 4.8 7.1 49.138.226.7Beer, Gallons peryear 0 12 0 49.138.226.7Beer, Gallons peryear 49.138.226.7Beer, Gallons peryear I 2 I3I3 I 1 P r ice of bee r, $ per unit Y, Budget e 2 E 1 1 = $419 2 = $628 3 = $837 L3L3 L 2 L 1 e 1 D 1 D 2 D3D3 E 1 * E 2 E 2 * E 3 E 3 * e 3 Figure 5.2 Effect of a Budget Increase on an Individual’s Demand Curve

14. 5 - 14 Copyright © 2012 Pearson Education. All rights reserved. Solved Problem 5.3 Mahdu views Coke and Pepsi as perfect substitutes. The price of a 12-ounce can of Coke, p, is less than the price of a 12- ounce can of Pepsi, p*. What does Mahdu’s Engel curve for Coke look like? How much does his weekly cola budget have to rise for Mahdu to buy one more can of Coke per week?

15. 5 - 15 Copyright © 2012 Pearson Education. All rights reserved. Solved Problem 5.3

16. 5 - 16 Copyright © 2012 Pearson Education. All rights reserved. Consumer Theory and Income Elasticities Formally,  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  = -3%/1% = -3.

17. 5 - 17 Copyright © 2012 Pearson Education. All rights reserved. Consumer Theory and Income Elasticities (cont.) 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.

18. 5 - 18 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.3 Income-Consumption Curves and Income Elasticities As income rises the budget constraint shifts to the right.  The income elasticities depend on…. …where on the new budget constraint the new optimal consumption bundle will be Housing, Square f eet per y ear Food,Pounds peryear Food normal, housing normal Food inferior, housing normal Food normal, housing inferior b c e a L 1 L 2 I ICC 2 C 1 C 3

19. 5 - 19 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.4 A Good That Is Both Inferior and Normal When Gail was poor and her income increased..  …she bought more hamburger But as she became wealthier and her income rose…  ….she bought less hamburger and more steak. Y 2 Y 1 Y 1 Y 2 Y3Y3 Y 3 L 1 Y, Income L 2 L 3 e 2 e 3 e 1 E 2 E3E3 E 1 I 1 I 2 I 3 Hamburger peryear Income-consumption curve Hamburger peryear y All other goods per ear (a) Indiff erence Curves and Budget Constraints (b) Engel Curve Engel curve

20. 5 - 20 Copyright © 2012 Pearson Education. 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.

21. 5 - 21 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.5 Substitution and Income Effects with Normal Goods C = Y1Y1 - F Budget Line, L 1 Budget Line, L 2 (increase in salary) C = Y2Y2 - F

22. 5 - 22 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.6 Giffen Good When the price of movie tickets decreases the budget constraint rotates out… allowing the consumer to increase her utility. Nevertheless, the total effect is negative. WHY? Bas k etball, Ti ck ets per y ear Movies,Tickets peryear L 1 Total effect L 2 e 1 e 2 I 1 I 2

23. 5 - 23 Copyright © 2012 Pearson Education. All rights reserved. Even though the substitution effect is positive….  …the income effect is larger and negative (since this is an inferior good). Figure 5.6 Giffen Good

24. 5 - 24 Copyright © 2012 Pearson Education. All rights reserved. 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?

25. 5 - 25 Copyright © 2012 Pearson Education. All rights reserved. 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:

26. 5 - 26 Copyright © 2012 Pearson Education. All rights reserved. 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?

27. 5 - 27 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.7 The Consumer Price Index C 2 C 1 C, Units of clothing pe year e 2 e 1 I 1 L 1 L 2 I 2 F, Units offood peryear Y 1 /p 1 F 2 F 1 Y 1 /p 1 C Y 2 /p 2 C F Y 2 /p 2 F The firm ensures that Klaas can buy the same bundle of goods in the second year that he chose in the first year… But since Klaas is better off, the CPI adjustment overcompensates for the change in inflation C = Y1Y1 - F Budget Line, L 1 Budget Line, L 2 (increase in salary) C = Y2Y2 - F

28. 5 - 28 Copyright © 2012 Pearson Education. All rights reserved. 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?

29. 5 - 29 Copyright © 2012 Pearson Education. All rights reserved. True Cost-of-Living Adjustment C 2 C 1 C, Units of clothing per year e 2 e 1 I 1 L 1 e* L*L 2 I 2 F, Units of food per year Y 1 /p 1 F 2 F 1 Y 1 /p 1 C Y 2 /p 2 C Y*/p 2 C F Y 2 /p 2 F 2 F Y /p 2 * C = Y1Y1 - F Budget Line, L 1 Budget Line, L 2 (increase in salary) C = Y2Y2 - F

30. 5 - 30 Copyright © 2012 Pearson Education. All rights reserved. Table 5.1 Cost-of-Living Adjustments

31. 5 - 31 Copyright © 2012 Pearson Education. All rights reserved. CPI Substitution Bias Income adjustments based on CPI suffer from an upward bias. The CPI-based adjustment suffers from substitution bias – it ignores that consumers may substitute toward the relatively inexpensive good when prices change disproportionately.

32. 5 - 32 Copyright © 2012 Pearson Education. All rights reserved. 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.

33. 5 - 33 Copyright © 2012 Pearson Education. All rights reserved. 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*.

34. 5 - 34 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.8 Demand for Leisure Budget Line, L 1 Y = w 1 H Y = w 1 (24 − N). Each extra hour of leisure she consumes costs her w 1 goods. Y, Goods per day Time constraint H 1 = 8240 N1N1 = 16 024 H, Work hours per day N, Leisure hours per day H 1 = 8 N1N1 = 16 0 H, Work hours per day N, Leisure hours per day I 1 L 1 w, W age per hour (b) Demand Curve –w 1 1 Y 1 w 1 e 1 E1E1 (a) Indifference Curves and Constraints

35. 5 - 35 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.8 Demand for Leisure Budget Line, L 1 Y = w 1 H Y = w 1 (24 − N). Budget Line, L 2 Y = w 2 H Y = w 2 (24 − N). w 2 > w 1 Y, Goods per day Time constraint H 2 = 12H 1 = 8240 N 2 = 12 N1N1 = 16 024 H, Work hours per day N, Leisure hours per day H 2 = 12 N 2 0 H, Work hours per day N, Leisure hours per day Demand for leisure I 2 I 1 1 –w 2 L 1 L 2 w, W age per hour –w 1 1 e 2 Y 2 Y 1 w 1 w 2 e 1 E 2 (b) Demand Curve E1E1 H 1 = 8 N1N1 = 16 (a) Indifference Curves and Constraints

36. 5 - 36 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.9 Supply Curve of Labor

37. 5 - 37 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.10 Income and Substitution Effects of a Wage Change Since income effect is positive, leisure is a normal good. Y, Goods per d a y Time constraint H 2 H*H 1 240 N 2 N*N 1 0 Substitution effect Income effect Total effect H,Work hours per day N, Leisure hours per day I 2 I 1 L 2 L* L 1 e 2 e 1 e*

38. 5 - 38 Copyright © 2012 Pearson Education. All rights reserved. Solved Problem 5.5 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?

39. 5 - 39 Copyright © 2012 Pearson Education. All rights reserved. Solved Problem 5.5 (cont.)

40. 5 - 40 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.11 Labor Supply Curve That Slopes Upward and Then Bends Backward Y, Goods per d a y (a) Labor-Leisure Choice Time constraint H 2 H 3 H 1 240 H,Work hours per day E 1 E 3 E 2 L 2 I 2 I 3 I 1 L 3 L 1 e 2 e 1 e 3 w, W age per hour (b) Supply Curve of Labor Supply curve of labor H 2 H 3 H 1 240,Work hours per day At low wages, an increase in the wage causes the worker to work more…. H but at high wages, an increase in the wage causes the worker to work less….

41. 5 - 41 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.12 The Relationship of U.S. Tax Revenue and the Marginal Tax Rate

42. 5 - 42 Copyright © 2012 Pearson Education. All rights reserved. Figure 5.13 Per-Unit Versus Lump- Sum Child Care Subsidies