Chapter Five. Applying Consumer Theory

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1 Chapter Five Applying Consumer Theory

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

3 Figure 5.1 Deriving an Individual s Demand Curve Y 12.0 Budget Line, L Qy = I P y Initial Values - P x P y P x = price of X = $12 P y = price of Y = $35 I = Income = $419. Qx (b) Demand Cu rve P 12.0 L 1 (p b = $12) e E 1 I 1 Initial optimal bundle of X and Y X X 2009 Pearson Addison-Wesley. All rights reserved. 5-3

4 Figure 5.1 Deriving an Individual s Demand Curve Y 12.0 Budget Line, L 4.3 e 2 Qy = I P y - P x P y New Values P x = price of X = $6 P y = price of Y = $35 I = Income = $419. Qx (b) Demand Cu rve P 12.0 L 1 (p = $12) b e E I 1 I 2 L 2 (p b = $6) X Price of X goes down! 6.0 E X 2009 Pearson Addison-Wesley. All rights reserved. 5-4

5 Figure 5.1 Deriving an Individual s Demand Curve Y 12.0 Budget Line, L Qy = I P y - P x P y New Values P x = price of X = $4 P Y = price of Y = $35 I = Income = $419. Qx e 1 e (b) Demand Cu rve P L 1 (p = $12) b E 1 I 1 e 3 Price-consumption curve I 3 I 2 L 2 (p b = $6) L 3 (p b = $4) X Price of X goes down again! E 2 E 3 D 1, Demand for X X 2009 Pearson Addison-Wesley. All rights reserved. 5-5

7 2009 Pearson Addison-Wesley. All rights reserved. Figure 5.2 Effect of a Budget Increase on an Individual s Demand Curve Y L 1 Budget Line, L e 1 I 1 X P x Qy = I P Y - PY Qx I Initial Values P x = price of X = $12 P y = price of Y = $35 I = Income = $419. $628 Y 1 = $ E 1 * X Income goes up!

8 2009 Pearson Addison-Wesley. All rights reserved. Figure 5.2 Effect of a Budget Increase on an Individual s Demand Curve Y L 2 L 1 Budget Line, L e 2 e I 1 I 2 X P x Qy = I P Y - PY Qx I Initial Values P x = price of X = $12 P Y = price of Y = $35 I = Income = $419. $628 I 2 = $628 I 1 = $419 E 1 * E 2 * X Income goes up!

9 2009 Pearson Addison-Wesley. All rights reserved. Figure 5.2 Effect of a Budget Increase on an Individual s Demand Curve Budget Line, L Y L 3 L 2 L 1 e 3 e 2 e 1 I Income-consumption curve I 2 I 3 X P x Qy = I P Y - PY Qx I Engel curve for X Initial Values P x = price of X = $12 P Y = price of Y = $35 I = Income = $837. I 3 = $837 I 2 = $628 I 1 = $419 E 1 * E 2 * E 3 * X Income goes up again!

10 Solved Problem 5.1 Mahdu views Cragmont and Canada Dry ginger ales as perfect substitutes: He is indifferent as to which one he drinks.the price of a 12-ounce can of Cragmont, p, is less than the price of a 12-ounce can of Canada Dry, p*. What does Mahdu s Engel curve for Cragmont ginger ale look like? How much does his weekly ginger ale budget have to rise for Mahdu to buy one more can of Cragmont ginger ale per week? 2009 Pearson Addison-Wesley. All rights reserved. 5-10

12 Consumer Theory and Income Elasticities. Formally, where Y stands for income. Example % Q x % Y Q Q Y Y Q Y If a 1% increase in income results in a 3% decrease in quantity demanded, the income elasticity of demand is x = -3%/1% = -3. Y Q 2009 Pearson Addison-Wesley. All rights reserved. 5-12

13 Consumer Theory and Income Elasticities 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 2009 Pearson Addison-Wesley. All rights reserved. 5-13

14 Housing, Square feet per year Figure 5.3 Income-Consumption Curves and Income Elasticities Food inferior, housing normal L 2 L 1 ICC 1 a e b ICC 2 Food normal, housing normal I c ICC 3 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 Food normal, housing inferior Food, Pounds per year 2009 Pearson Addison-Wesley. All rights reserved. 5-14

15 All other goods per year 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 Pearson Addison-Wesley. All rights reserved. (a) Indifference Curves and Budget Constraints I, Income Y L 3 3 Y L 2 2 Y L 1 1 e 1 (b) Engel Curve I E3 3 I 2 I 1 E 1 Income-consumption curve e 3 e 2 E 2 I 3 I 2 I 1 Hamburger per year Engel curve Hamburger per year

16 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 Pearson Addison-Wesley. All rights reserved. 5-16

17 D, Movie DVDs, Units per year Figure 5.5 Substitution and Income Effects with Normal Goods 15 L 1 e 1 Initial Values P D = price of DVDs = $20 P C = price of CDs = $15 Y = Income = $300. Budget Line, L D = P C Y - C P D PD D = $300 $20 - $15 $20 C I C, Music CDs Units peryear 2009 Pearson Addison-Wesley. All rights reserved. 5-17

18 D, Movie DVDs, Units per year Figure 5.5 Substitution and Income Effects with Normal Goods Initial Values P D = price of DVDs = $20 P C = price of CDs = $15 15 L 1 L 2 e 2 e 1 Y = Income = $300. Budget Line, L D = Y P C P - C D PD D = $300 $20 - $15 $30 $20 C C, Music CDs Units peryear I 1 I 2 P C goes up Total effect = Pearson Addison-Wesley. All rights reserved. 5-18

19 D, Movie DVDs, Units per year Figure 5.5 Substitution and Income Effects with Normal Goods 15 L* L 1 L 2 e 2 e* e 1 Initial Values P D = price of DVDs = $20 Y = Income = $300. P C = price of CDs = $15 Budget Line, L Y = Income = $300. Budget Line, L Initial Values P D = price of DVDs = $20 P C = price of CDs = $15 D = $300 - $30 $20 $20 C What if we compensated Laura so she could afford Y the same P utility she had D before = the price - C of CDs C increased? P D PD In other words, how much income she would need to afford D = $300 indifference curve - $30 I 1, with the Cnew price of CDs ($30) $20 $20 I C, Music CDs Units peryear Income effect = -3 Substitution effect = -3 Total effect = -6 = Substitution Effect + Income Effect = -3 + (-3) I Pearson Addison-Wesley. All rights reserved. 5-19

20 Figure 5.6 Giffen Good Basketball, Tickets per year L 2 L 1 e 2 e 1 When the price of movie tickets decreases the budget constraint rotates out I 2 allowing the consumer to increase her utility. Total effect I 1 Movies, Tickets per year Nevertheless, the total effect is negative. WHY? 2009 Pearson Addison-Wesley. All rights reserved. 5-20

21 Figure 5.6 Giffen Good Basketball, Tickets per year L 2 L 1 L* e 2 Even though the substitution effect is positive. the income effect is larger and negative (since this is an inferior good). I 2 e 1 e* Total effect Income effect Substitution effect I 1 Movies, Tickets per year 2009 Pearson Addison-Wesley. All rights reserved. 5-21

22 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? 2009 Pearson Addison-Wesley. All rights reserved. 5-22

23 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: CPI for 2008 price of CPI for 2005 a burger Pearson Addison-Wesley. All rights reserved. 5-23

24 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? 2009 Pearson Addison-Wesley. All rights reserved. 5-24

25 C, Units of clothing per year Figure 5.7 The Consumer Price Index Y 1 /p 1 C Y 2 /p 2 C C 1 e 1 The firm ensures Budget Line, L 1 that Klaas can buy C = Y 1 But the since same Klas bundle is of P 1 - F F better goods off, in the CPI 1 1 P adjustment C P second year that he c overcompensates chose in the first Budget Line, L 2 (increase in salary) for year the change in C = Y 2 P inflation 2 - F F 2 P C 2 P c C 2 e 2 P 1 1 C P F I 2 I 1 L 1 L 2 F 1 F 2 Y 2 /p 2 F F, Units of food per year 2009 Pearson Addison-Wesley. All rights reserved Y 1 /p 1 F

26 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? 2009 Pearson Addison-Wesley. All rights reserved. 5-26

27 C, Units of clothing per year True Cost-of-Living Adjustment Y 1 /p 1 C Y 2 /p 2 C Y*/p 2 C C 1 e 1 Budget Line, L P C P F 1 P c C = Y 1 - F Budget Line, L 2 (increase in salary) 2 P F 2 P c C = Y 2 - F 2 P C C 2 e 2 P 1 1 C P F e* I 2 I 1 L 1 L* L 2 F 1 F 2 Y */p Y 2 /p F F F, Units of food per year 2009 Pearson Addison-Wesley. All rights reserved Y 1 /p 1 F

29 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 Pearson Addison-Wesley. All rights reserved. 5-29

30 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* Pearson Addison-Wesley. All rights reserved. 5-30

31 w, Wage per hour Y, Goods per day Figure 5.8 Demand for Leisure (a) Indifference Curves and Constraints Time constraint I 1 Budget Line, L 1 Y = w 1 H L 1 w 1 1 e 1 Y 1 Y = w 1 (24 N). 0 N 1 = H 1 = 8 0 (b) Demand Curve N, Leisure hours per day H, Work hours per day Each extra hour of leisure she consumes costs her w 1 goods. w 1 E 1 0 N 1 = 16 H 1 = 8 N, Leisure hours per day H, Work hours per day 2009 Pearson Addison-Wesley. All rights reserved. 5-31

32 w, Wage per hour Y, Goods per day (a) Indifference Curves and Constraints Figure 5.8 Demand for Leisure L 2 w 2 I 2 Time constraint Y 2 I 1 1 e 2 Budget Line, L 1 Y = w 1 H L 1 w 1 1 e 1 Y 1 Y = w 1 (24 N). 0 N 2 = 12 N 1 = H 2 = 12 H 1 = 8 0 N, Leisure hours per day H, Work hours per day Budget Line, L 2 (b) Demand Curve Y = w 2 H w 2 E 2 Y = w 2 (24 N). w 1 E 1 w 2 > w 1 Demand for leisure 0 N 2 = 12 H 2 = 12 N 1 = 16 H 1 = 8 N, Leisure hours per day H, Work hours per day 2009 Pearson Addison-Wesley. All rights reserved. 5-32

34 Y, Goods per d ay Figure 5.10 Income and Substitution Effects of a Wage Change L 2 I 2 Time const raint I 1 L* e* e 2 Since income effect is positive, leisure is a normal good. L 1 e 1 0 N * N 1 N H * H 1 H 2 0 Substitution effect Total effect Income effect N, Leisure hours per d ay H, Work hours per d ay 2009 Pearson Addison-Wesley. All rights reserved. 5-34

35 Solved Problem 5.3 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? 2009 Pearson Addison-Wesley. All rights reserved. 5-35

38 w, Wage per hour Figure 5.11 Labor Supply Curve That Slopes Upward and Then Bends Backward (a) Labor-Leisure Choice (b) Supply Curve of Labor Y, Goods per day L 3 I 2 I 1 I 3 e 3 Time const raint Supply curve of labor E 3 E 2 L 2 e 2 E 1 L 1 e 1 24 H 2 H H H, Work hours per day 0 H 1 24 H 3 H 2 H, Work hours per day At but low at high wages, wages, an increase an increase in the wage causes the worker worker to to less. work more Pearson Addison-Wesley. All rights reserved. 5-38

Chapter 5 Read this chapter together with unit four in the study guide. Applying Consumer theory

Chapter 5 Read this chapter together with unit four in the study guide Applying Consumer theory Topics Deriving Demand Curves. How Changes in Income Shift Demand Curves. Effects of a Price Change. Cost-of-Living