PPA 723: Managerial Economics

1. PPA 723: Managerial Economics Lecture 9: Applications of Consumer Choice

2. Managerial Economics, Lecture 9: Applications of Consumer Choice Outline • The Labor-Leisure Choice • Application to welfare programs • Measuring Consumer Welfare • The concept of consumer surplus

3. Managerial Economics, Lecture 9: Applications of Consumer Choice Deriving Labor Supply Curves • Use consumer-maximization diagram with income (= all goods consumed) on the vertical axis and leisure (= non-work) on the horizonal axis. • Income equals the wage times hours worked. • The wage rate is the price of leisure.

4. Managerial Economics: Consumer Choice (a) Indifference Curves and Constraints Time constraint Y , Goods 2 I per day 2 L – w 2 1 1 I e 2 Figure 5.8 Demand for Leisure Y 2 1 L – w 1 1 e 1 Y 1 0 N = 12 N = 16 24 N , Leisure hours per day 2 1 24 H = 12 H = 8 0 H , Work hours per day 2 1 (b) Demand Curve w , Wage per hour E w 2 2 E w 1 1 Demand for leisure 0 N = 12 N = 16 N , Leisure hours per day 2 1 H = 12 H = 8 H , Work hours per day 2 1

5. Managerial Economics, Lecture 9: Applications of Consumer Choice Supply Curve of Labor • The supply curve of hours worked (labor) is the “mirror image” the of demand curve for leisure: • Every extra hour of leisure implies one fewer hours of work.

6. Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 5.9 Supply Curve of Labor (a) Leisure Demand (b) Labor Supply Demand for leisure Supply of work hours w , Wage w , Wage per hour per hour e E 2 2 w w 2 2 e 1 E 1 w w 1 1 0 12 16 0 8 12 N , Leisure hours per day H , Work hours per day

7. Managerial Economics, Lecture 9: Applications of Consumer Choice Income and Substitution Effects • A wage increase causes both income and substitution effects that alter an individual's demand for leisure and supply of hours worked. • The substitution effect leads to more work. • The income effect leads to more leisure.

8. Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 5.10 Income and Substitution Effects of a Wage Change Y , Goods Time constraint 2 I 2 per day L 1 I L * e e * 2 1 L e 1 0 N * N N 24 N , Leisure hours per day 1 2 24 H * H H 0 H , Work hours per day 1 2 Substitution effect Total effect Income effect

9. Goods per Day, Y Time Constraint -wage 1   Guarantee 0 L1 L2 Leisure Hours per Day, L Work Hours per Day Managerial Economics, Lecture 9: Applications of Consumer Choice Leisure Choice with a Welfare Guarantee

10. Time Constraint Slope = -w(1-t)    Substitution Effect Guarantee 0 L1 L2 L3 Income Effect Leisure Hours per Day, L Work Hours per Day Managerial Economics, Lecture 9: Applications of Consumer Choice Leisure Choice with a Welfare Guarantee and “Tax” Rate Goods per Day, Y

11. Time Constraint  Slope = -w(1+e)  Substitution Effect  0 L3 L1 L2 Income Effect Leisure Hours per Day, L Work Hours per Day Managerial Economics, Lecture 9: Applications of Consumer Choice Leisure Choice with an EITC Goods per Day, Y

12. Managerial Economics, Lecture 9: Applications of Consumer Choice Gross Income vs. Earned Income Source: Clifford F. Thies on the mises.org blog.

13. Managerial Economics, Lecture 9: Applications of Consumer Choice Implicit Marginal Tax Rates Source: Clifford F. Thies on the mises.org blog

14. Managerial Economics, Lecture 9: Applications of Consumer Choice Welfare Programs: Lessons • Income guarantees raise recipients’ utility but decrease their work effort. • Income guarantees with benefit reduction rates decrease work effort even more. • Training programs, child care credits, and the EITC raise utility while boosting work effort.

15. Managerial Economics, Lecture 9: Applications of Consumer Choice Consumers’ Welfare • Measuring welfare with utility functions is not practical for 2 reasons: • we don't know individuals' utility functions • we cannot compare utilities across individuals • Instead, we measure consumer welfare in dollars of willingness to pay • easier to measure than utility • can compare dollars across individuals

16. Managerial Economics, Lecture 9: Applications of Consumer Choice Measuring Consumer Welfare • Consumer surplus (CS) from a good = • benefit a consumer gets from consuming it (in $'s) minus its price • how much more you'd be willing to pay than you did pay for a good • A demand curve contains this information. • A demand curve reflects a consumer's marginal benefit= the amount a consumer is willing to pay for an extra unit.

17. Managerial Economics, Lecture 9: Applications of Consumer Choice Graphing an Individual's CS • For each quantity, the consumer surplus is the difference between willingness to pay for another unit (the individual’s demand curve) and actual payment (the price) • Total consumer surplus is the sum of these differences across all quantities consumed.

18. Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 9.1a Consumer Surplus p , $ per magazine (a) David’s Consumer Surplus a 5 b 4 = = CS $ 2 CS $ 1 1 2 c 3 Price $ 3 = 2 = = = E $ 3 E $ 3 E $ 3 Demand 1 2 3 1 0 1 2 3 4 5 q , Magazines per week

19. Managerial Economics, Lecture 9: Applications of Consumer Choice Graphing Total CS in a Market • For each quantity, the consumer surplus is the difference between willingness to pay for another unit (the market demand curve) and the market price • Total consumer surplus is the sum of these differences across all quantities consumed.

20. Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 9.1b Consumer Surplus ’ p , $ per trading card Consumer surplus, CS p 1 Expenditure, E Demand Marginal willingness to pay for the last unit of output q q , Trading cards per year 1

21. Managerial Economics, Lecture 9: Applications of Consumer Choice Concluding Comment on CS • As we will see, consumer surplus is a key concept in policy economics. • It forms the basis for benefit-cost analysis. • CS is used to determine whether a policy is efficient and to measure the distortion in behavior caused by a tax.

22. Managerial Economics, Lecture 9: Applications of Consumer Choice Producer Surplus • Suppliers’ gain from participating in a market, too. • Their surplus is the difference between the amount for which a good sells and minimum amount necessary for the seller to produce that good.

23. Managerial Economics, Lecture 9: Applications of Consumer Choice Measuring PS Using the Supply Curve • Producer surplus for a competitive firm or market is: • the area above supply curve (which, as we will later learn, is the MC curve) and below price line up to quantity sold

24. Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 9.3 Producer Surplus (a) A Firm’s Producer Surplus (b) Market Producer Surplus Supply p , Price per unit p , $ per unit Market supply curve 4 p PS = $ 3 PS = $ 2 PS = $ 1 1 2 3 Market price 3 p * 2 Producer surplus, PS 1 MC = $1 MC = $ 2 MC = $ 3 MC = $ 4 Variable cost, VC 1 2 3 4 0 1 2 3 4 * Q q , Units per week Q , Units per year

25. Managerial Economics, Lecture 9: Applications of Consumer Choice Producer Surplus and Social Welfare • Some analysts define social welfare as consumer surplus plus producer surplus. • Others focus exclusively on consumer surplus. • This is an issue in normative analysis, that is, it involves value judgments.