Consumer Theory, Markets and Economic Welfare

1. Consumer Theory, Markets and Economic Welfare

2. Topics 1. Competitive consumer: preferences, budget sets, choices. Price and income effects. 2. Firms: transform multiple inputs into outputs. 3. Private ownership economy with initial ownership of goods and firms, markets, trades, prices, feasible allocation, compet. equilibrium. 4. Pareto efficiency. 5. Externalities: fundamental or not. 6. Two Fundamental Welfare Theorems, their limited relevance; other advantages of markets

3. Competitive Consumer (a model) • Price-taking, rational optimizer • Acts as if it cannot affect prices (no market power); pays for what it gets (no stealing). • Buys best affordable bundle of goods. • Best according to preferences represented by indifference sets. • Affordable bundles = bundles in budget set.

4. Competitive Consumer (a model) • Bundles • Indifference Curves, abbreviated INDIFF • Budget Sets show affordable bundles • Optimal Choices

5. Bundles of Goods: represented by points showing amounts of any goods X and Y Y (4,20) (5, 15) (20,15) (15, 5) X 5 15 20

6. Preferences: represented by indifference sets (curves), sets of bundles the consumer finds equally good. Y (4,20) (5, 15) (20,15) (15, 5) X 5 15 20

7. Budget Set = Set of affordable bundles Budget Set normally looks like a triangle. Upper boundary is Budget Line, the set of barely affordable bundles, where whole budget is spent. y x

8. Optimal Choice Consumer buys best affordable bundle. Optimal bundle is black pointin budget line, on highest indifference curve touching budget set. y x

9. Optimal Choice If preferences were different, a different point would be chosen, but best indiff curve would still be tangent to budget line: their slopes are equal at the optimal bundle. y x

10. Optimal Choice If the budget were bigger but prices the same, the budget linewould be higher, parallel to the original line, and a different point would be chosen. Shift in choice is income effect. y x

11. Meaning of Indiff Curve Shapes Negative slope of indiff curve corresponds to both goods being desired. Curve shaped like  corresponds to preference for moderate amounts of all goods, not a large amount of one of them. y x

12. Slope = vertical change / horizontal change = (20−15) / (4 −5) =−5/1 (4,20) (5, 15) (20,15) (15, 5) 5 15 20

13. Y (4,20) (5, 15) (20,15) Slope = −10/10= −1= −Rate of Substitution: consumer is willing to give up 10 units of Y to get 10 units of X. (15, 5) X 5 15 20

14. Y (4,20) (5, 15) (20,15) Diminishing Rate of Substitution: Rate from black to red bundle is bigger (5) than from red to blue bundle (1). Consumer's willingness to pay for more X falls as X rises. (15, 5) X 5 15 20

15. Y (4,20) (5, 15) (20,15) Marginal Rate of Substitution (MRS) = − limit of slopes = − slope of tangent line= rate of substitution for small change (15, 5) X 5 15 20

16. Y (4,20) (5, 15) (20,15) Curve shape implies preference for moderation: average consumption (10, 10) is preferred to red and blue bundles. (10, 10) (15, 5) X 5 15 20

17. Indifference Curves • Assume at least one desirable good (Y) indiff sets are curves. Higher is better. Standard Indiff Curves (1) stop only at axes (2) All goods desirable  negative slopes (3) Preference for moderation Diminishing rate of substitution Less willing to pay for additional units Indiff curves shaped like: 

18. Standard Indifference Curves One through every point, but we can't draw them all. Y (4,20) (5, 15) (15, 5) X 5 15 20

19. NOT Standard Indifference Curves WHY NOT? Y X 5 15 20

20. NOT Standard Indifference Curves All points in blue indifference set must be equally good, but blue point is better than green point. Standard indifference curves don't cross each other. Y X 5 15 20

21. NOT Standard Indifference Curves Standard curves only stop at the axes. If the red curve is standard it must continue and cross the blue curve (then it is not standard) Y X 5 15 20

22. NOT Standard Indifference Curves Standard curves only stop at the axes. If the red curve is standard it must continue and cross the blue curve or go below it, but with the wrong curvature. Y X 5 15 20

23. Standard Indifference Curves must be able to fit around each other and keep their  shape without crossing each other. Y X 5 15 20

24. NONSTANDARD preferences are possible. This consumer does not prefer moderate consumption. Moving along an indiff curve to the right, substituting X for Y makes additional units of X MORE VALUABLE for the consumer. Y X 5 15 20

25. NONSTANDARD preferences are possible. Moving from the blue point to the right (raising X, without reducing Y) makes this consumer WORSE OFF. At the blue point, the consumer is satiated in X. Y X 5 15 20

26. NONSTANDARD preferences are possible. Moving from the blue point to the right (raising X, without reducing Y) makes this consumer WORSE OFF. At the blue point, the consumer is satiated in X. Y X 5 15 20

27. NONSTANDARD preferences are possible. Moving from the blue point to the right (raising X, without reducing Y) makes this consumer WORSE OFF. At the blue point, the consumer is satiated in X. Y X 5 15 20

28. Why Indifference Curves? Water+Diamond Paradox: Water necessary but free; diamonds unnecessary, expensive. Prices depend on availability (supply), but why are consumers willing to pay so much more for diamonds? Answer:Willingness to pay depends on how much of ALL goods the consumer starts with.

29. Diamonds Slope = vertical change / horizontal change = (20−15) / (4 −5) =−5/1 Starting at black point, with a lot of diamonds and little water, consumer is willing to pay a lot for one more unit of water. (4,20) (5, 15) (15, 5) Water 5 15 20

30. Diamonds (4,20) Starting at red point, with more water, less diamonds than at black point, consumer is less willing to pay for more water. Diminishing Rate of Substitution (5, 15) (15, 5) Water 5 15 20

31. Diamonds (4,20) Starting at blue point, with more water, less diamonds, consumer is willing to pay less for more water. Diminishing Rate of Substitution Beyond the blue point, additional water is almost worthless (willingness to pay for more is near 0). (5, 15) (15, 5) Water 5 15 20

32. Finding Budget Line Example: price of X = px = 2, price of Y = py = 3, income or budget = 12. Find intercepts. What economic meaning?Maximum affordable amounts of Y and X. y x

33. Finding Budget Line Example: price of X = px = 2, price of Y = py = 3, income or budget = 12. Find intercepts. How much Y is affordable when none of X is bought? Whole budget spent on Y: py∙y =12, 3y = 12, y = 12/3 = budget/py =4.

34. Finding Budget Line Example: price of X = px = 2, price of Y = py = 3, income or budget = 12. Maximum affordable amount of X when no Y is bought: px x = 2x = 12, x = 12/2 = 6. Budget line joins points (0, 4) and (6, 0). y 4 x 6

35. Finding Budget Line Example: price of X = px = 2, price of Y = py = 3, income or budget = 12. Another way: Find one point on line (we found an intercept). Then find budget line slope. Slope =−px/py. Why? y 4 px py x

36. Finding Budget Line Example: price of X = px = 2, price of Y = py = 3, income or budget = 12. Budget line slope =−px/py. Why?To move to right on budget line, sell Y, buy X. What is cost of py = 3 units of X? pxpy = 2∙3. To get that money, how many units of Y does consumer sell?2 units at price py =3. Gives up 2 of Y to get 3 of X. Moves down 2 and 3 to right. Slope = −2/3 =−px/py

37. Finding Budget Line Example: price of X = px = 2, price of Y = py = 3, income or budget = 12. Consumer stays on budget line giving up 2=px units of Y, getting 3=py units of X, moves down 2 and 3 to right. Slope = −2/3 =−px/py y 4 px py x

38. General Budget Line px=price of X, py=price of Y, I =income (budget) Budget Line = set of barely affordable bundles Cost = px x + py y = I = budget , py y = I −px x, y = (I/ py)+ (−px /py)x budget line equation vertical interceptslope = − (I/ py)(I/ px)= −px /py y I/ py I/ px x

39. Effects of Income Changes I up, prices fixed: y = (I/ py)+ (−px /py)x Vertical interceptrises, slope stays same. Income effects are changes in amounts of X and Y bought. This consumer moves from blue to red point, buys more of both goods. y I/ py I/ px x

40. Effects of Income Changes I up, prices fixed: This consumer moves from blue to blackpoint, buys more X, but less Y. A good is called inferiorover a range of incomes if the consumer buys less when income is higher. Over this income range, good Y is inferior for this consumer. Note: It is not possible for a good to be inferior at all income levels. Why not? If Y is inferior, the consumer buys more when income is lower. But on the black budget line, the consumer cannot afford as much Y as at the blue dot. y I/ py I/ px x

41. Effects of Income Changes I up, prices fixed: Income effects are changes in amounts of X and Y bought. A good is NORMAL over a range of incomes if it is not inferior. (Its consumption does not fall when income rises.) This consumer moves from blue to redpoint, buys more of both goods. Both goods are normal for the consumer over this income range. y I/ py I/ px x

42. Effects of Price Changes pxup, py and I fixed: y = (I/ py)+ (−px /py)x Vertical intercept stays same (same maximum amount of Y if no X bought). slope = −px /pyrises in magnitude (absolute value) Steeper budget line. Less X affordable for given Y. y I/ py I/ px x

43. Effects of Price Changes pxup, py and I fixed: y = (I/ py)+ (−px /py)x Vertical intercept stays same (same maximum amount of Y if no X bought). slope = −px /pyrises in magnitude (absolute value) Steeper budget line. Less X affordable for given Y. Budget set shrinks. y I/ py I/ px x

44. Effects of Price Changes Ifpxfalls, with py and I fixed: Vertical intercept stays same (same maximum amount of Y if no X bought). slope = −px /pyfalls in magnitude (absolute value) Flatter budget line. More X affordable for given Y. y I/ py I/ px x

45. Effects of Price Changes Ifpxfalls, with py and I fixed: Vertical intercept stays same (same maximum amount of Y if no X bought). slope = −px /pyfalls in magnitude (absolute value) Flatter budget line.More X affordable for given Y. Budget set expands. y I/ py I/ px x

46. Effects of Price Changes Ifpy falls (good Y cheaper) with px and I fixed: Vertical intercept rises (more Y affordable). slope = −px /py rises in magnitude (absolute value) Steeper budget line.Budget set expands. I/ py I/ px x

47. Effects of Price Changes Ifpy falls (good Y cheaper) with px and I fixed: With these preferences, optimal bundle shifts from blue bundle to green. Amounts of both goods rise, Y more than X. I/ py I/ px x

48. Effects of Price Changes Ifpy falls (good Y cheaper) with px and I fixed: With other preferences, optimal bundle shifts from blue bundle to red. Amount of X rises, but Y falls. This can only happen if good Y is inferior over a range of incomes. The quantity demanded rarely falls when the price falls. I/ py I/ px x

49. Main Conclusion for Welfare Analysis Optimal choices are bundles where indiff curve is tangent to budget line, with same slope. − budget line slope = px /py= −Indiff curve slope = MRS = willingness to pay Y per unit of X In competitive markets, all consumers who buy the goods face the same prices, have equal MRS (willingness to pay). I/ py I/ px x

50. Kinked Budget Lines: Labor Supply with TANF Benefits Indifference curves usually represent preferences for desirable goods. We use leisure (desirable) instead of labor to study labor supply. Consider a consumer who can work any number of hour up to full time in a year at wage rate $10/hour. Full time = 40 hours/week for 50 weeks = 2000 hours/yr. Any hours out of the 2000 not spent working are counted as leisure consumption: Work time + Leisure time = 2000 hrs. We will consider the effect of TANF welfare benefits (Temporary Assistance for Needy Families) on a consumer's budget set and choice of labor supply.