Lecture 5: Individual and Market Demand

Transcription

1 Lecture 5: Individual and Market Demand September 26, 2017

2 Overview Course Administration Change in Income and Changes in Consumption Figuring Out Your Demand Curve Income and Substitution Effects Individual Demand to Market Demand

3 Course Administration 1. Return Problem Set 3 2. Problem Set 5 is posted 3. me to post notes if you want to speed me up 4. Reminder: midterm October 17 One more class, then fall break, then the midterm Next class will have a problem set Sample midterm posted last year s had one lecture on supply before the midterm You instead have one lecture on taxes 5. Midterm review: Sunday Oct. 15, 3 to 5 pm, PHIL Any questions?

4 Ripped from the Headlines As a reminder, next week Afternoon Finder Presenter Maya Pendleton Ahoefa Ananouk Lauren Boyd Chris Rogers Stephen Haas Lilia Ledezma Evening Finder Presenter Deon Glaser Kathleen Gayle John Plack Zachary Poss J.J. Manswer Jared Anable

5 Income and Changes in Consumption

6 Concepts from Last Class Utility Indifference curves Budget constraint Utility is maximized when

7 Concepts from Last Class Utility Indifference curves Budget constraint Utility is maximized when MRS X,Y = P X P Y MU X MU Y = P X P Y

8 How do Changes in Income Affect Consumption? Income effect change in consumption due to a change in income When income increases, what happens to location of budget constraint?

9 How do Changes in Income Affect Consumption? Income effect change in consumption due to a change in income When income increases, what happens to location of budget constraint? shifts outward slope of budget constraint?

10 How do Changes in Income Affect Consumption? Income effect change in consumption due to a change in income When income increases, what happens to location of budget constraint? shifts outward slope of budget constraint? unchanged, since prices haven t changed shape of indifference curves?

11 How do Changes in Income Affect Consumption? Income effect change in consumption due to a change in income When income increases, what happens to location of budget constraint? shifts outward slope of budget constraint? unchanged, since prices haven t changed shape of indifference curves? nothing!

12 How do Changes in Income Affect Consumption? Income effect change in consumption due to a change in income When income increases, what happens to location of budget constraint? shifts outward slope of budget constraint? unchanged, since prices haven t changed shape of indifference curves? nothing! Does utility increase or decrease?

13 How do Changes in Income Affect Consumption? Income effect change in consumption due to a change in income When income increases, what happens to location of budget constraint? shifts outward slope of budget constraint? unchanged, since prices haven t changed shape of indifference curves? nothing! Does utility increase or decrease? at a minimum, does not decrease

14 Reminder: Some definitions Normal good good for which consumption increases with income Inferior good good for which consumption decreases with income Whether a good is normal or inferior depends on your income. Example?

15 Normal and Inferior Goods in Pictures Find the Inferior Good!

16 Income Elasticity and Types of Goods E D I = % Q % I Sign of E D I for inferior goods?

17 Income Elasticity and Types of Goods E D I = % Q % I Sign of EI D Sign of EI D for inferior goods? EI D < 0 for normal goods?

18 Income Elasticity and Types of Goods E D I = % Q % I Sign of EI D Sign of EI D for inferior goods? EI D < 0 for normal goods? EI D > 0

19 Income Elasticity and Types of Goods E D I = % Q % I Sign of EI D for inferior goods? EI D < 0 Sign of EI D for normal goods? EI D > 0 necessity goods: 0 < EI D 1 luxury goods: EI D > 1 EI D = 0: Income inelastic

20 Income Expansion Path We want to describe the basket of goods you consume at each possible income level Income expansion path optimal bundles at each income level Normal goods positive slope Inferior goods negative slope Note: Skipping Engel curves due to time constraints!

21 Your Demand Curve From First Principles

22 Using Income and Utility to Find Your Demand Curve Recall that a demand curve shows the quantity demanded at a given price In other words, what happens to consumption of X as price changes We now have the tools to figure this out for you We draw budget constraints and indifferences curves in Y vs X, but we need a P vs X graph for demand

23 Using Income and Utility to Find Your Demand Curve Q Y P Q X Q X

24 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 Q X

25 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 Q X

26 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 Q X

27 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 X 2 Q X

28 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 X 2 Q X

29 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 X 2 Q X

30 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 X 2 Q X

31 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 X 2 X 3 Q X

32 Using Income and Utility to Find Your Demand Curve Q Y P Q X X 1 X 2 X 3 Q X

33 What Shifts Your Demand Curve?

34 What Shifts Your Demand Curve? Changes in price move us along the demand curve

35 What Shifts Your Demand Curve? Changes in price move us along the demand curve Changes in tastes or income or prices of other goods may shift the demand curve How would we change the preferences in the previous example?

36 Income and Substitution Effects

37 Income and Substitution Effects Any change in quantity demanded comes from at least one of these two sources Substitution effect change in consumer s consumption choices due to a change in the relative prices of goods Income effect change in consumer s consumption choices due to a change in the consumer s income Note that policymakers can influence both of these margins.

38 Price Changes and the Total Effect Total Effect = Substitution Effect + Income Effect Total Effect = due to price + due to income

39 Isolating the Substitution Effect Change in consumption from A (old) to B (new) due to fall in P meals Substitution effect is the change in Q due to a change in the relative price of X and Y holding utility constant What would you consume if you were at the old happiness (utility), but prices changed? Call this A A to A is the substitution effect. With two normal goods, substitute toward the cheaper good

40 Isolating the Income Effect Income effect is change in consumption due to change in purchasing power With normal goods, you want more of both goods

41 Isolating the Income Effect Income effect is change in consumption due to change in purchasing power With normal goods, you want more of both goods

42 Why Do We Care About These Things That Aren t Even Real? Think about a trade-off between consumption and leisure You like both consumption and leisure More work more consumption More work less leisure

43 Why Do We Care About These Things That Aren t Even Real? Think about a trade-off between consumption and leisure You like both consumption and leisure More work more consumption More work less leisure Any policy that increases workers wages has an income and substitution effect What are these policies?

44 Why Do We Care About These Things That Aren t Even Real? Think about a trade-off between consumption and leisure You like both consumption and leisure More work more consumption More work less leisure Any policy that increases workers wages has an income and substitution effect What are these policies? Minimum wages Social Security Social Security Disability Insurance and...?

45 SSDI Enrollment Over Time From Autor and Duggan, Distinguishing Income from Substitution... May 2007

46 SSDI Enrollment Over Time From Autor and Duggan, Distinguishing Income from Substitution... May 2007

47 SSDI Example SSDI gives money to disabled working-age people in the US. It yields a substitution effect:

48 SSDI Example SSDI gives money to disabled working-age people in the US. It yields a substitution effect: benefits make leisure relatively cheaper than work work less income effect:

49 SSDI Example SSDI gives money to disabled working-age people in the US. It yields a substitution effect: benefits make leisure relatively cheaper than work work less income effect: benefits make you absolutely wealthier work less

50 SSDI Example SSDI gives money to disabled working-age people in the US. It yields a substitution effect: benefits make leisure relatively cheaper than work work less income effect: benefits make you absolutely wealthier work less The conceptual distinction between income and substitution effects is central to welfare analysis. If SSDI reduces labor supply through the substitution effect, this implies a deadweight loss. In effect, SSDI pays beneficiaries not to work. By contrast, reductions in labor supply that are due to the income effect do not imply a deadweight loss since there is no distortion of incentives (though, of course, the funding of transfer payments may incur deadweight losses). From Autor and Duggan, Distinguishing Income from Substitution... May 2007

51 How to Find Income and Substitution Effects Call initial optimal choice A. Then the price of one good changes. 1. Draw new budget constraint with price change. Find indifference curve tangent to this budget constraint. This is point B. A B is total change. 2. Isolate price change: Draw extra budget constraint that is parallel to the new budget constraint, but tangent to the original indifference curve. Point of tangency is A. A A is substitution effect. 3. Isolate income change: A to B is income effect prices are are the same and we examine only income change.

52 Walking Through Both Effects Q Y I/P Y I/P X,old Q X

53 Walking Through Both Effects Q Y I/P Y I/P X,old I/P X,new Q X

54 Walking Through Both Effects Q Y I/P Y I/P X,old I/P X,new Q X

55 Walking Through Both Effects Q Y I/P Y total effect total effect I/P X,old I/P X,new Q X

56 Walking Through Both Effects Q Y I/P Y I/P X,old I/P X,new Q X

57 Walking Through Both Effects Q Y I/P Y I/P X,old I/P X,new Q X

58 Walking Through Both Effects Q Y I/P Y I/P X,old I/P X,new Q X

59 Walking Through Both Effects Q Y I/P Y subst. effect subst. effect I/P X,old I/P X,new Q X

60 Walking Through Both Effects Q Y I/P Y I/P X,old I/P X,new Q X

61 Walking Through Both Effects Q Y I/P Y inc. effect inc. effect I/P X,old I/P X,new Q X

62 Walking Through Both Effects Q Y I/P Y total income substitution I/P X,old I/P X,new Q X

63 Walking Through Both Effects Q Y I/P Y total income substitution I/P X,old I/P X,new Q X

64 Walking Through Both Effects Q Y I/P Y total income substitution I/P X,old I/P X,new Q X

65 Substitutes, Complements and Indifference Curves Recall indifference curves for perfect complements Recall indifference curves for perfect substitutes Real-life indifference curves are probably usually between these two extreme cases The less curved the indifference curves are, the more substitutable the goods Do we expect a small or large change in the consumption of Y due to a price change in X if indifference curves are pretty straight?

66 What Determines Size of Income and Substitution Effects? Substitution Effect Depends on the curvature of the indifference curves Very curved indifference curves (closer to perfect complements) leads to smaller changes in response to price Very flat indifference curves (closer to perfect substitutes) leads to larger changes in response to price

67 What Determines Size of Income and Substitution Effects? Substitution Effect Depends on the curvature of the indifference curves Very curved indifference curves (closer to perfect complements) leads to smaller changes in response to price Very flat indifference curves (closer to perfect substitutes) leads to larger changes in response to price Income Effect Related to the quantity of each good consumer purchases before price change The more you spent on the good before the price change, the greater the effect of the price change on your budget Effect is largest for goods that make up the largest share of the budget

68 Monika eats chips and crackers. Income is $20 P chips = 1, P crackers = 2 Try It Out Yourself Her optimal choice at these prices is 16 bags of chips and 2 bags of crackers When P crackers,new = 1, Monika eats 8 bags of chips and 12 bags of crackers Questions 1. Draw the budget constraint and utility curves consistent with this description; put crackers on the x-axis 2. Find the income and substitution effects for crackers. Which is larger? 3. Are crackers a normal or inferior good? Chips?

69 er f s is income and substitution effects for crackers. Which is BC 1 Admin Income Your Demand Inc. and Sub. Ef. Mkt Demand larger? Are crackers a normal or inferior good? Chips? Total eff Total effect Chips A U 1 Solution: B Monika s Eating Habits 1. The price of chips has not changed, and Monica can still buy 20 bags of chip however, she can now afford twice as many crackers (20 bags). 2. Chips U 2 BC 1 BC Crackers Total effect a can still buy 20 bags of chips if she so chooses; (20 bags). The substitution effect is measured by holding utility at the initial level; it is th A to bundle A. The income effect is the movement from bundle A to bundle B. T ratio of the prices constant. For crackers, the income effect is larger than the subs 3. Crackers are a normal good because Monica purchases more when her purcha U 1 A Substitution effect A' B U 2 BC 1 BC ' BC Crackers Income effect

70 Individual Demand and Market Demand

71 Finally, Getting to Market Demand! Market demand is the sum of all individual demands Add individual demands horizontally For any price, add the quantities

72 Adding Horizontally

73 Using Algebra To Do This Suppose we have two demand curves Q Joe = P Q Jack = P

74 In Pictures Joe s Demand P 100 Joe Q

75 In Pictures Jack s Demand P 100 Joe 52 5 Jack 13 Q

76 Market Demand in Pictures P 100 Joe curve kinks at P=52, Q= blue = total market demand Jack Q

77 The Algebra of Demand Curve Addition At P > $52, Jack doesn t want any more At P > $100, Joe doesn t want any more No one wants to pay more than $100 The maximum total quantity demanded is Q = 18

78 The Algebra of Demand Curve Addition At P > $52, Jack doesn t want any more At P > $100, Joe doesn t want any more No one wants to pay more than $100 The maximum total quantity demanded is Q = 18 We write this as { Q Joe + Q Jack = P if 0 < P 52 Q M = Q Joe = P if 52 < P 100

79 In Case We Have Time: Adding Demand Curves In a very small town, only Jim and Alice want gasoline. Jim s demand is Q J = 15 3P and Alice s is Q A = 30 5P. 1. Find the equation for the market demand for gas 2. Draw the demand curve in a chart

80 Recap of Today Changes in Income and Utility Maximization Changes in Prices and Utility Maximization Income and Substitution Effects Market Demand

81 Next Class Turn in Problem Set 5 Taxes! Reading packet: Gruber, Chapter 19 skim 19.4