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 Adjustments. Deriving Labor Supply Curves. 5-2 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.1 Deriving an Individual s Demand Curve Budget Line, L Wine, (W), Gallons per y ear (a) Indifference Curves and Budget Constraints 12.0 W = Y P W - P b P W b Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. e 1 2.8 L 1 ( p b = $12) 0 26.7 (b) Demand Cu r v e p b, $ per unit 12.0 E 1 I 1 Beer (b), Gallons per year Initial optimal bundle of beer and wine 0 26.7 Beer (b), Gallons per year 5-3 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.1 Deriving an Individual s Demand Curve Budget Line, L W = Y P W - P b P W b New Values P b = price of beer = $6 P W = price of wine = $35 Y = Income = $419. Wine, (W), Gallons per y ear p b, $ per unit (a) Indifference Curves and Budget Constraints 12.0 4.3 2.8 0 12.0 L 1 ( p b = $12) (b) Demand Cu r v e e 1 26.7 E 1 e 2 44.5 I 1 I 2 L 2 ( p b = $6) Beer (b), Gallons per year Price of beer goes down! 6.0 E 2 0 26.7 44.5 Beer (b), Gallons per year 5-4 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.1 Deriving an Individual s Demand Curve Budget Line, L W = Y P W - P b P W b New Values P b = price of beer = $4 P W = price of wine = $35 Y = Income = $419. (a) Indif f erence Cu r v es and Budget Const r aints Wine, (W), Gallons per y ear p b, $ per unit 12.0 5.2 4.3 2.8 12.0 L 1 ( p b = $12) 0 26.7 44.5 58.9 (b) Demand Cu r v e e 1 E 1 e 2 I 1 e 3 Price-consumption curve I 2 I 3 L 2 ( p b = $6) L 3 ( p b = $4) Beer (b), Gallons per year Price of beer goes down again! 6.0 4.0 E 2 E 3 0 26.7 44.5 58.9 D 1, Demand for Beer Beer (b), Gallons per year 5-5 Copyright 2012 Pearson Education. All rights reserved.

Price-Consumption Curve A line through optimal bundles at each price of one good (beer) when the price of the other good (wine) and the budget are held constant. The demand curve corresponds to the price-consumption curve. 5-6 Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 5.1 In Figure 5.1, how does Mimi s utility at E 1 on D 1 compare to that at E 2? Answer: Use the relationship between the points in panels a and b of Figure 5.1 to determine how Mimi s utility varies across these points on the demand curve. 5-7 Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 5.2 Mahdu views Coke, q, and Pepsi as perfect substitutes: He is indifferent as to which one he drinks. The price of a 12- ounce can of Coke is p, the price of a 12- ounce can of Pepsi is p* and his weekly cola budget is Y. Derive Mahdu s demand curve for Coke using the method illustrated in Figure 5.1. 5-8 Copyright 2012 Pearson Education. All rights reserved.

Effects of a Rise in Income Engel curve - the relationship between the quantity demanded of a single good and income, holding prices constant. Income-consumption curve shows how consumption of both goods changes when income changes, while prices are held constant. 5-10 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.2 Effect of a Budget Increase on an Individual s Demand Curve Win e, Gallons per y ear L 1 Budget Line, L 2.8 0 e 1 I 1 26.7 Bee r, Gallons per y ear W = Y P W - P b P W b P r ice of bee r, $ per unit 12 E 1 Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. $628 0 Y, Budget D 1 26.7 Bee r, Gallons per y ear Income goes up! Y 1 = $419 E * 1 0 26.7 Bee r, Gallons per y ear 5-11 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.2 Effect of a Budget Increase on an Individual s Demand Curve Win e, Gallons per y ear L 2 L 1 Budget Line, L 4.8 2.8 0 e 1 e 2 I 1 26.7 38.2 Bee r, Gallons per y ear I 2 W = Y P W - P b P W b P r ice of bee r, $ per unit 12 E 1 E 2 Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $419. $628 0 Y, Budget D 2 D 1 26.7 38.2 Bee r, Gallons per y ear Income goes up! Y 2 = $628 Y 1 = $419 E * 1 E * 2 0 26.7 38.2 Bee r, Gallons per y ear 5-12 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.2 Effect of a Budget Increase on an Individual s Demand Curve Budget Line, L Win e, Gallons per y ear 7.1 4.8 2.8 0 L 3 L 2 L 1 e 3 e 2 e 1 I 1 Income-consumption curve I 3 I 2 26.7 38.2 49.1 Bee r, Gallons per y ear W = Y P W - P b P W b P r ice of bee r, $ per unit 12 E 1 E 2 E 3 Initial Values P b = price of beer = $12 P W = price of wine = $35 Y = Income = $837. 0 Y, Budget 26.7 38.2 49.1 Bee r, Gallons per y ear Engel curve for beer D 3 D 2 D 1 Income goes up again! Y 3 = $837 Y 2 = $628 Y 1 = $419 E * 1 E * 2 E * 3 0 26.7 38.2 49.1 Bee r, Gallons per y ear 5-13 Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 5.3 Mahdu views Coke and Pepsi as perfect substitutes. The price of a 12-ounce can of Coke, p, is less than the price of a 12- ounce can of Pepsi, p*. What does Mahdu s Engel curve for Coke look like? How much does his weekly cola budget have to rise for Mahdu to buy one more can of Coke per week? 5-14 Copyright 2012 Pearson Education. All rights reserved.

Consumer Theory and Income Elasticities Formally, where Y stands for income. Example % Q ξ = % 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 ξ = -3%/1% = -3. = Y Q 5-16 Copyright 2012 Pearson Education. All rights reserved.

Consumer Theory and Income Elasticities (cont.) 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. 5-17 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.3 Income-Consumption Curves and Income Elasticities Housing, Square f eet per y ear F ood in f e r io r, housing no r mal L 2 L 1 IC C 1 a e b IC C 2 F ood no r mal, housing no r mal 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 I c IC C 3 F ood no r mal, housing in f e rior F ood, P ounds per y ear 5-18 Copyright 2012 Pearson Education. All rights reserved.

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. (a) Indif f erence Curves and Budget Const r aints All other goods per y ear Y, Income Y 3 Y 2 Y 1 Y 3 Y 2 Y 1 L 3 L 2 L 1 e 1 (b) Engel Cu r ve E3 E 1 Income-consumption cu r v e e 3 e 2 E 2 Engel cu r v e I 1 I 3 I 2 Ham b urger per y ear Ham b urger per y ear 5-19 Copyright 2012 Pearson Education. All rights reserved.

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. 5-20 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.5 Substitution and Income Effects with Normal Goods C = Budget Line, L 1 Y 1 - F 1 P C 1 P F 1 P C Budget Line, L 2 (increase in salary) C = 2 Y 2 - F 2 P C P F 2 P C + P 1 1 C > + P F 5-21 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.6 Giffen Good Bas k etball, Ti ck ets per y ear L 2 L 1 e 2 When the price of movie tickets decreases the budget constraint rotates out I 2 e 1 allowing the consumer to increase her utility. Total effect Nevertheless, the total effect is negative. WHY? I 1 M o vie s, Ti ck ets per y ear 5-22 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.6 Giffen Good Bas k etball, Ti ck ets per y ear 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 Substitution ef f ect I 1 M o vie s, Ti ck ets per y ear Income ef f ect 5-23 Copyright 2012 Pearson Education. All rights reserved.

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? 5-24 Copyright 2012 Pearson Education. All rights reserved.

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 CPI for 2008 price of for 2005 a burger = 211.1 26.8 15 = 1.18 5-25 Copyright 2012 Pearson Education. All rights reserved.

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? 5-26 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.7 The Consumer Price Index C, Units of clothing pe year Y 1 / p 1 C Y 2 / p 2 C C 1 e 1 But The since firm Klaas ensures is better that Klaas off, the can CPI buy adjustment the same bundle of overcompensates goods in the second for year the that change he chose in inflation the first year C = Budget Line, L 1 Y 1 - F 1 P C 1 P F 1 P c Budget Line, L 2 (increase in salary) C = 2 Y 2 - F 2 P C P F 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 1 / p 1 F Y 2 / p 2 F F, Units of f ood per y ear 5-27 Copyright 2012 Pearson Education. All rights reserved.

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? 5-28 Copyright 2012 Pearson Education. All rights reserved.

True Cost-of-Living Adjustment C, Units of clothing per year Y 1 / p 1 C Y 2 / p 2 C Y * / p 2 C C 1 e 1 C = Budget Line, L 1 1 P C Y 1 - F 1 P F 1 P c Budget Line, L 2 (increase in salary) C = 2 Y 2 - F 2 P C P 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 1 / p 1 F Y * 2 / p 2 Y 2 / p 2 F F F, Units of food per year 5-29 Copyright 2012 Pearson Education. All rights reserved.

CPI Substitution Bias Income adjustments based on CPI suffer from an upward bias. The CPI-based adjustment suffers from substitution bias it ignores that consumers may substitute toward the relatively inexpensive good when prices change disproportionately. 5-31 Copyright 2012 Pearson Education. All rights reserved.

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. 5-32 Copyright 2012 Pearson Education. All rights reserved.

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*. 5-33 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.8 Demand for Leisure (a) Indifference Curves and Constraints Y, Goods per day I 1 Time constraint Budget Line, L 1 Y = w 1 H L 1 w 1 1 e 1 Y 1 Y = w 1 (24 N). Each extra hour of leisure she consumes costs her w 1 goods. w, W age per hour 0 N 1 = 16 24 24 H 1 = 8 0 (b) Demand Curve N, Leisure hours per day H, Work hours per day w 1 E 1 0 N 1 = 16 H 1 = 8 N, Leisure hours per day H, Work hours per day 5-34 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.8 Demand for Leisure (a) Indifference Curves and Constraints Y, Goods per day Y 2 L 2 w 2 I 2 I 1 1 e 2 Time const r aint Budget Line, L 1 Y = w 1 H Y 1 L 1 w 1 1 e 1 Y = w 1 (24 N). Budget Line, L 2 Y = w 2 H w, W age per hour 0 N 2 = 12 N 1 = 16 24 24 H 2 = 12 H 1 = 8 0 (b) Demand Curve E w 2 2 N, Leisure hours per day H, Work hours per day Y = w 2 (24 N). w 1 E 1 Demand for leisure w 2 > w 1 0 N 2 = 12 H 2 = 12 N 1 = 16 H 1 = 8 N, Leisure hours per day H, Work hours per day 5-35 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.10 Income and Substitution Effects of a Wage Change Y, Goods per d a y I 1 L 2 I 2 Time const r aint Since income effect is positive, leisure is a normal good. L * e * e 2 L 1 e 1 0 N * N 1 N 2 24 24 H * H 1 H 2 0 Substitution effect Total effect Income effect N, Leisure hours per d a y H, W o r k hours per d a y 5-37 Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 5.5 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? 5-38 Copyright 2012 Pearson Education. All rights reserved.

Figure 5.11 Labor Supply Curve That Slopes Upward and Then Bends Backward (a) Labor-Leisure Choice (b) Supply Cu r v e of Labor Y, Goods per d a y L 3 I 2 I 1 I 3 e 3 Time const r aint w, W age per hour Supply curve of labor E 3 E 2 L 2 e 2 E 1 L 1 e 1 24 H 2 H H 3 1 0 H, W o r k hours per d a y 0 H 1 24 H 3 H 2 H, W o r k hours per d a y At but low at high wages, wages, an increase an increase the in the wage causes the worker to work more. less. 5-40 Copyright 2012 Pearson Education. All rights reserved.