Chapter 5 – Part AApplications of

Rational Choice and Demand Theories

McGraw-Hill/Irwin Copyright © 2015 The McGraw-Hill Companies, Inc. All rights reserved.

5 -2

U1

Quantity of X5 6

AO

G

Su

bsid

y

4

1 2 3 4

1

2

3 Cost of the subsidy if the person consumes two units.

Flat Grants versus SubsidiesIncome = $3 and PX = $1. So this person

would be somewhere on the original budget constraint (indifference curve not shown). Suppose the government introduces a per unit subsidy program of $0.50 per unit on X -- to the consumer the price would fall from a dollar to 50 cents (and as such the person's budget constraint would rotate as shown above).

Quantity of X1 2 3 4 5 6

AO

G

3

2

4

Su

bsid

y

1

Su

bsid

y

Person consumes less X but is better off

Flat Grants versus Subsidies

5-3

How much did the government spend? At 50 cents a unit, it cost the government $1. The red line is the budget line if the government gives the consumer $1.00

If you want to make people as well off as possible, then simply transfer unrestricted cash to them. If you are more interested in them consuming good X, then do a per unit subsidy.

5-4

Food Stamp versus Cash Grantunder a Voucher System

5-5

Application: A Gasoline Tax And Rebate Policy

• Policy proposal made during the administration of President Jimmy Carter

• Goal: use gasoline taxes to help limit the quantity demanded of gasoline.– Tax revenue would then be used to reduce the

payroll tax (tax rebate).

• Would consumers buy the same amount of gasoline as before if the tax is rebated?

5-6Copyright © 2013 Pearson Education, Inc. • Microeconomics • Pindyck/Rubinfeld, 8e.

5-7

A Gasoline Tax and Rebate (text example)

5-8

The Intertemporal Choice Model

• How would rational consumers distribute their consumption over time?

• Two time periods: current and future. • Two alternatives (goods): current consumption

(C1) versus future consumption (C2).

5-9

The Intertemporal Choice Model Budget Constraint

• Present value: the present value of a payment of X dollars T years from now is X(1+ r)T, where r is the annual rate of interest.

• Present value of lifetime income: the horizontal intercept of the intertemporal budget constraint as the

5-10

Intertemporal Budget Constraint with Income in Both Periods, and Browsing or

Lending at the Rate r

Marginal rate of time preference: the number of units of consumption in the future a consumer would exchange for 1 unit of consumption in the present.

It declines as one moves downward

along an indifference curve.

5-11

The Optimal Intertemporal Allocation

5-12

Patience and Impatience

5-13

The Effect of a Rise in the Interest Rate

5-14

Slope = - Wage

U1

LeisureWork168128 HRS

Inco

me

$1,6

80

$400

Labor - Leisure

W3

W2

W1

Labour

Inco

me

0L2 L1

Labor supplied is the same at both W2 and W3

Labor - Leisure

5-15

5-16

W S

W1

Quantity of LaborL1 L2

W2

W3

Labor Supply Curve