Transcript Chapter 6
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
Looking at Substitution and Income Effects
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
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Dissecting the Effects of a
Price Change
When a price increases, two things
happen:
That good becomes more 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
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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 (although it effects the
consumer’s bundle choices).
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Dissecting the Effects of a
Price Change
An example to help you understand…not exactly
the same, but similar is….
The US govt. pays wages to its employees.
As the US is a big place and costs of living vary
between areas, the govt. has to maintain similar
salaries (in terms of purchasing power) between
employees no matter where they work.
In some places, the costs and hence the pay is
substantially more than in other places.
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Effects of a Price Change
In other words, in some places, the
government has to pay additional money
to leave their employees’ welfare
unaffected by location.
This is similar to a compensated price
change.
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Figure 6.1: Compensated Price
Effects
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Substitution and Income Effects
Effect of a Compensated Price Change =
Effect of an Uncompensated Price
Change
+
Effect of Providing
Compensation
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Substitution and Income Effects
Uncompensated price change has two parts:
Substitution effect: the effect on consumption of a
compensated price change, causing the consumer
to substitute one good for another.
Isolates the influence of the change in relative prices.
Income effect: the effect on consumption of
removing the compensation after creating a
compensated price change, affecting the
consumer’s purchasing power
Isolates the influence of the change in purchasing power
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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
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Figure 6.2: Substitution and
Income Effects
Dark Gray = Uncompensated Price Effect
Grey=Substitution Effect.
Yellow=Income Effect
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Direction of Substitution Effect
Substitution effect of a price increase is:
Negative for price increase
Positive for price decrease
Consumer substitutes away from the
good that becomes relatively more
expensive
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Figure 6.3: Direction of the Substitution
Effect for a Price Increase
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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
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Figure 6.4: Direction of the
Income Effect for a Price Increase
Erin buys meat and
potatoes. Start at L1.
Potatoes are$.5/lb. Beef is
$3/lb. Income is $36/mon.
Price of potatoes falls to
$.25. Pivot to L2.
Impl. Compensation.
Subs. Effect: Move to bundle C…as potatoes are
now relatively cheaper.
Income Effect: No compen., move back to L2 and
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bundle B and buy less potatoes than with C.
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:
Negative for a price increase
Positive for a price reduction
For an inferior good, the income effect opposes
the substitution effect:
Positive for a price increase
Negative for a price reduction
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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, this could violate Law of Demand
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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
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Giffen Goods
Giffen goods are rare.
Why?
Most goods are normal.
If spending on a good accounts for a small
fraction of a consumer’s budget (as with
most products), even a large increase in the
good’s price doesn’t have much of an impact
on the consumer’s overall purchasing power.
So the impact of the income effect is small.
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Giffen Goods
Giffen good examples.
Potatoes in the Irish Potato Famine.
Shochu in Japan.
Low grade alcohol
If income goes up, people drink less and buy
better quality sake. Therefore it is an inferior
good.
But as price of shochu rises, people appear to
buy more and consume less sake.
A study estimates that price elasticity for
special grade sake is -6.11 and +8.81 for
shochu.
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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
Another….price of soup increases
compensation is given to make the
consumer as well off as before.
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Consumer Surplus
Consumer surplus is the net benefit a
consume receives from participating in the
market for some good
Consumer’s demand curve measures the
gross benefit of consuming a good
Consumer surplus is the area below the
demand curve and above a horizontal line at
the price
Amount of money that would compensate the
consumer for losing access to the market,
compensating variation
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Figure 6.6: Consumer Surplus
Remember…the formula for finding the area of a triangle, ie.
(b) is Height X Width X ½….
The formula for a square or rectangle is…?
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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 (cash or value) to if the
govt. wishes to compensate fully for the policy’s
effects
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Figure 6.7: Change in Consumer
Surplus
When price = $2,
consumer surplus is
grey and brown
shaded areas
When price = $4,
consumer surplus is
grey area
Brown area is
change in consumer
surplus
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Consumer Surplus Example
Abigail’s monthly demand curve for cell
phone service is W=300-200PW. W=# of
minutes and PW is price/minute of service.
Say that PW =$.50.
Calculate her consumer surplus.
Find Intercepts, draw curve, calc. surplus
What is PW increased to $1.00. What is
the change in Abigail’s consumer surplus?
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Consumer Surplus Example
If Abigail’s demand curve for minutes of wireless
telephone service is W = 300 – 200PW, then her
demand curve intersects the price axis at a price of
$1.50. (This is the lowest price at which she would
demand exactly zero minutes of wireless telephone
service; it can be found by plugging 0 in for W.) If the
price is $1, this means that the height of the triangle
that shows her consumer surplus is $0.50. To figure out
the width of the triangle, we only need to know how
many wireless minutes Abigail demands at the new
price of $1.00, which is just W = 300 – 200(1.00), or
100.
So the area of this triangle is ½($0.50)(100) = $25.
This represents a decrease in consumer surplus for
Abigail of $75, since we know from Worked-Out
Problem 6.3 that her original consumer surplus (at a
price of $0.50) was $100
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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…think of the
one we saw earlier in this chapter’s slides.
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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
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Cost-of-Living Indexes: Basics
Price indexes are often used to calculate real
income levels from nominal ones.
Nominal income is the amount of money
actually received in a particular period.
Real income is the amount of money received
in a particular period adjusted for changes in
purchasing power that alter the cost of living
over time.
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Cost-of-Living Indexes: Basics
Use to convert nominal income into real income
Real income
Nominalincome
Value of cost - of - livingindex
If real income has risen, then:
Nominal income has grown more rapidly than then cost of
living
Consumer should be better off
Or if real income is static then changes in prices have
been mirrored by changes in income.
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, ie. Cost of housing vs. cost of gasoline.
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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 which takes
the bundle purchased in the base period and
used in subsequent periods. But is this
approach the best one? Are there problems?
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Fixed-Weight Price Indexes
Laspeyres price index which takes the bundle
purchased in the base period and used in
subsequent periods.
But is this approach the best one? Are there
problems?
One issue is the substitution bias. Fails to
capture the consumer’s tendency to moderate
the impact of a price increase by substituting
away from goods that have become more
expensive.
Therefore, the index overstates the cost of
living.
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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
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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/or 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
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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
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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)
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Figure 6.11: Leisure Demand and
Labor Supply Curves
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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
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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
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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?
NO!
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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)
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Other Demand Curves
Uncompensated demand curves, AKA
Marshallian demand curves always slope
downward.
Compensated demand curves, AKA Hicksian
demand curves, correspond to different levels
of the consumer’s well-being.
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Other Demand Curves
Normal good – uncompensated demand curve
is flatter. (Income & Subs. Effects work in the
same direction so price change would produce
a larger change in the uncompensated
demand.)
Inferior – compensated demand curve is flatter.
(Income and subs. Effects work in opposite
directions.)
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Review Problems
Sam currently earns $30,000/year. The govt. is
considering a policy that would increase Sam’s
income by 12%, but raise all prices by 8%. What
is Sam’s compensating variation for the
proposed policy?
Can you compute it without knowing his
preferences? Why/not?
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Review Problems
If Sam is a utility maximizer, then he is spending
all $30,000 of his income on goods that make
him happy. If the government increased his
income by 12%, it would increase to $33,600. If
the prices increased by 8%, then his current
consumption bundle would increase in cost to
$32,400. At his previous level of consumption,
Sam now has $1,200 leftover to spend on more
goods and services. We could take this $1,200
from him and he would remain just as happy as
he was before. Therefore, the compensating
variation for this income and price change is
–$1,200.
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Review Problems
Is it possible for the true cost of living to rise for
one consumer and fall for another in response
to the same change in process?
Explain.
If yes, how…give an example with a graph.
If no, why not?
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Review Problems
It is possible because
people have different
preferences. In the
drawing to the right, a
decrease in the price of X
and an increase in the
price of Y affect consumer
A and consumer B
differently. Consumer A,
who prefers good X, is
better off (on a higher
indifference curve), and
consumer B, who prefers
good Y, is worse off (on a
lower indifference curve).
6-48