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).
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