1. Chapter 5 Consumer surplus Household choice in input markets

2. Consumer Surplus The difference between the maximum amount a person is willing to pay for a good and its current market price

3. Example - Consider consumer surplus in the market for hamburgers... Millions of hamburgers per month Price ($) 17 $2.50 $5.00 Demand A E 23 B C

4. Example - Consider consumer surplus in the market for hamburgers... Millions of hamburgers per month Price ($) 17 $2.50 $5.00 Demand A E 23 B C Price ($) 17 $2.50 $5.00 Demand E 23 Total consumer surplus

5. Diamond/water paradox Water: –greatest value in use, little value in exchange –Plentiful supply –Each of us enjoys an enormous consumer surplus Diamond –Greatest value in exchange, little value in use

6. Household Choice in Input Markets Households must sell land, labor, and capital in markets for inputs in order to earn the income that they spend on goods and services. We will focus on the labor supply decision...

7. Labor supply In labor markets, households must decide: –Whether to work –How much to work –What kind of a job to take These decisions are affected by: –The availability of jobs –Market wage rates –The skill possessed by the household

8. Labor or Leisure? The labor supply decision involves a choice between consuming “labor” or “leisure”. Labor is defined as working in exchange for a wage. Leisure is defined as time spent doing nonmarket activities.

9. Example- Suppose Sally’s market wage is $10 per hour. Consider Sally. She has 24 hours per day to allocate between labor and leisure. If Sally chooses no hours of leisure per day, she will earn 24 times her hourly wage. (A) If Sally chooses no hours of work per day, she will earn no income but will enjoy 24 hours of leisure.(B) 24w 24 Hours of leisure per day A B Income per day 0

10. Example- Suppose Sally’s market wage is $10 per hour. Sally could choose to work 24 hours per day and earn $240. (A) Sally could choose to work no hours and earn no income. (B) Sally could choose to work 8 hours per day, earn $80, and “buy” 16 hours of leisure. (C) The “price” of leisure is $10 per hour. $240 24 Hours of leisure per day A B C Income per day $80 16 0

11. Example-suppose sally’s wage is $12 now Suppose Sally’s market wage rises from $10 per hour to $12 per hour Does she work MORE, or LESS? Depends $240 24 Hours of leisure per day A B C Income per day $80 16 0 $288 $96C’

12. What if wages increase? Consider the household’s response to an increase in wages. –The income effect says that the household can now afford to buy more leisure, however, –the substitution effect says that the opportunity cost of leisure is now higher; given the law of demand, the household will buy less leisure.

13. Labor Supply Curve A diagram that shows the quantity of labor supplied as a function of the wage rate Its shape depends on the income and substitution effects of a wage change.

14. Labor supply curve Since either of these effects can dominate, the labor supply curve can have several different shapes. Wage rate $/hour Units of labor Substitution effect > Income effect Income effect > Substitution effect Wage rate Units of labor $10 $12

15. Saving and Borrowing: Present vs. Future Consumption Households can use present income to finance future spending (i.e., save), or they can use future funds to finance present spending (i.e., borrow).

16. Interest Interest = the opportunity cost of present spending. When interest rates rise, present spending becomes more expensive.

17. Changes in interest rates have income and substitution effects. SUPPOSE INTEREST RATES RISE: Income effect: Households will now earn more on all previous savings, so they will save less Substitution effect: The opportunity cost of present consumption is now higher; given the law of demand, the household will save more.

18. Financial capital market The complex set of institutions in which suppliers of capital (households that save) and the demand for capital (business firms wanting to invest) interact. We won’t discuss in detail in our class.

19. Chapter Summary A household’s opportunity set describes what can be purchased; along with utility theory, it helps to describe what will be purchased. A household’s utility maximizing bundle of outputs has equal marginal utility per dollar spent on each good. The labor supply curve can be upsloping or backward bending, depending upon the relative strength of income and substitution effects. Saving and borrowing decisions depend on interest rates.