Chapter 6

1. Chapter 6 From Demand to Welfare 1

2. Main Topics • Dissecting the effects of a price change • Measuring changes in consumer welfare using demand curves • Labor supply and the demand for leisure 2

3. Dissecting the Effects of aPrice Change • When a price increases two things happen: • That good becomes 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 3

4. Dissecting the Effects of aPrice 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 4

5. if M=10, PB=0.25, then, • if Ps=0.5, then choose A • if Ps=1, purchasing power declines, L2, and choose B • As P increases, consumer is worse off b/c purchasing power is less • how much $ would need to give consumer to compensate him for the higher P? • if M=15 now, then L3 and C. • note that A~C • from L2-L3: the effect of compensation on BL 5

6. L1-L2: uncompensated price change: price change with no change in M • L1-L3: Compensated price change:price change and M change to leave the consumer unaffected • What about a reduction of Ps? • the consumer is better off • L1-L3: compensated price change 6

7. Compensated Price Effects

8. Substitution and Income Effects • Effect of a compensated price change = effect of an uncompensated price change + effect of providing compensation • effect of the uncompensated price change: to shift consumption from A-B • the effect of compensation is to shift consumption from B-C 8

9. Substitution and Income Effects • Uncompensated price change has two parts: • Substitution effect: the effect of a compensated price change, causing the consumer to substitute one good for another (L1-L3) and (L1-L5) • Income effect: the effect on consumption of removing the compensation, affecting the consumer’s purchasing power (C-B) and (E-D) 9

10. 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 • isolates effect of changes in relative prices • Income effect involves: • Parallel shift in the budget constraint • Toward the origin for a price increase • Away from the origin for a price decrease • isolates effect of changes in purchasing power. 10

11. Substitution and Income Effects

12. Direction of Substitution Effect • with a declining MRS, L1:A • after a compensated increase in Ps:L2:B and A~B • and B has less S than A since Ps is higher now • with no assumption about MRS: if A~B, then: • his best point on L2 (high P) must lie to the left of X and best choice on L1 (low P) must lie to the right of X. 12

13. Figure 6.3: Direction of the Substitution Effect for a Price Increase

14. Direction of Substitution Effect • Substitution effect of price increase is: • Negative for price increase • Positive for price decrease • Consumer substitutes away from the good that becomes relatively more expensive 14

15. 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 15

16. IE: an increase in P will reduce purchasing power • this will reduce Q if good is normal and increase Q if good is inferior • IE<0 if good is normal • IE>0 if good is inferior • Normal good: IE and SE move in same direction, both are (-) if P increases and both are (+) if P falls • inferior: IE and SE move in opposite direction: when P increases, IE increases Q while SE reduces it. 16

17. Figure 6.4: Direction of the Income Effect for a Price Increase

18. 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 18

19. Why Do Demand Curves Slope Downward? • The Law of Demand states that demand curves slope downward • SE is always consistent with Law of Demand • For normal goods,IE reinforces substitution effect • Normal goods always obey the Law of Demand • Theoretically, if IE for an inferior good is large enough to offset substitution effect, could violate Law of Demand 19

20. Figure 6.5: Giffen Good • consumer chooses D (not B) • Potatoes are more inferior than in figure 6.4 • IE>SE • and D curve slopes upward

21. 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

22. Giffen goods are hard to find b/c: • most goods are normal • if spending on a good is a small fraction of M, a large increase in good’s P will not affect M significantly 22

23. Compensating Variation • How can a consumer measure economics gains and losses in monetary terms? a common measure is compensating variation • 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 • Example: if CV for road improvement =$100, then the consumer is better off as long as his contribution is <$100 23

24. b/c 5$ fully compensate consumer from an increase in P from 0.5 to 1, the compensating variation for this P increase is $5 • the compensating variation for P reduction is -$3.75 • worked-out problem 6.2 • in-text-exercise 6.2 24

25. Compensated Price Effects

26. Consumer Surplus • Consumer surplus is the net benefit a consume receives from participating in the market for some good • and, the amount of money that would compensate the consumer for losing access to the market, compensating variation • Consumer’s D curve measures the gross benefit of consuming a good • Consumer surplus is area below the D curve and above a horizontal line at the price 26

27. if Q=1, the highest P the consumer is willing to pay is $4000, but Q=0 if P is higher. • Willingness to pay 1st and 2nd =$3000 and $2000 for 3 units and so on • the consumer’s net benefit is is the difference between his gross benefit and the amount he pays 27

28. if P=$1500, the consumer will buy 3 units: he is: • willing to pay $4000 for the first, pays $1500 and enjoys $2500 • his net benefit from 2nd unit: $1500 • net benefit from the 3rd =$500 • his consumer surplus: 2500+1500+500 28

29. Figure 6.6: Consumer Surplus

30. 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 to compensate fully for the policy’s effects 30 6-20

31. 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