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Chapter 6
From Demand to Welfare
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
Dissecting the effects of a price changeMeasuring changes in consumer welfare
using demand curvesMeasuring changes in consumer welfare
using cost-of-living indexesLabor supply and the demand for leisure
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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 fallsEconomists have learned a lot about
consumer demand and welfare from thinking about price changes this way
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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
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Figure 6.1: Compensated Price Effects
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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
Income effect: the effect on consumption of removing the compensation, affecting the consumer’s purchasing power
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Substitution and Income Effects
Substitution effect involves:Movement along an indifference curveTo a point where the slope is the same as
the new budget line
Income effect involves:Parallel shift in the budget constraint
Toward the origin for a price increaseAway from the origin for a price decrease
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Figure 6.2: Substitution and Income Effects
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Direction of Substitution Effect
Substitution effect of price increase is:Negative for price increasePositive for price decrease
Consumer substitutes away from the good that becomes relatively more expensive
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Figure 6.3: Direction of the Substitution Effect for a Price Increase
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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 powerConsumer 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 goodPositive for inferior good
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Figure 6.4: Direction of the Income Effect for a Price Increase
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Direction of Income and Substitution Effects
Substitution effect is:Negative for a price increasePositive for a price reduction
For a normal good, the income effect reinforces the substitution effect:Negative for a price increasePositive for a price reduction
For an inferior good, the income effect opposes the substitution effect:Positive for a price increaseNegative for a price reduction
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Why Do Demand Curves Slope Downward?
The Law of Demand states that demand curves slope downward
Substitution effect is always consistent with Law of Demand
For normal goods, income effect reinforces substitution effectNormal goods always obey the Law of Demand
Theoretically, if income effect for an inferior good is large enough to offset substitution effect, could violate Law of Demand
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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
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Compensating Variation
How can a consumer measure economics gains and losses in monetary terms?
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
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Consumer Surplus
Consumer surplus is the net benefit a consume receives from participating in the market for some good
Amount of money that would compensate the consumer for losing access to the market, compensating variation
Consumer’s demand curve measures the gross benefit of consuming a good
Consumer surplus is area below the demand curve and above a horizontal line at the price
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Figure 6.6: Consumer Surplus
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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 $80Must provide her with $20 to compensate fully for
the policy’s effects
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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
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Measuring Changes in Consumer Welfare Using Cost-of-Living Indexes
A cost-of-living index measures the relative cost of achieving a fixed standard of living in different situations
Commonly used to measure changes in the cost of living over time
Can be used to measure changes in consumer well-being due to public policies that alter prices or income
Example: Consumer Price Index
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Cost-of-Living Indexes: Basics
Base value of one during some specific periodLevel of index in the base period is
unimportantAll that matters is percentage change in the
indexExample: Value of index in 1998 is 1; value in 2006
is 1.2, then cost of living has risen by 20%Ideally should allow us to quickly evaluate
changes in consumer well-being following changes in prices and income
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Cost-of-Living Indexes: Basics
Use to convert nominal income into real income
If real income has risen, then: Nominal income has grown more rapidly than then cost of
living Consumer should be better off
Ideally, change in real income should measure the change in the consumer’s well-being
Difficult to construct a good cost-of-living index because different prices change by different proportions
index living-of-cost of Value
income Nominal income Real
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Fixed-Weight Price Indexes
Select a consumption bundle and measure its cost in multiple time periods, using prices at which the goods were available
Fixed-weight price index: measures percentage change in the cost of a fixed consumption bundle
Easy to calculate, requires no information about consumer preferences
But what consumption bundle is appropriate?Example: Laspeyres price index
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Labor Supply
Consumer buy goods and servicesMany are also sellers (e.g., sell their
work effort)Labor supply refers to the sale of a
consumer’s time and effort to an employer
To study labor supply, economists often study demand for leisure
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Labor-Leisure Choice:An Example
Javier’s possible income sources:Allowance of $30 per day (no strings attached!)Job that pays $5 per hour
14 hours per day available to allocate toward work and leisure
Assume all money spent on foodDecision about how many hours of leisure to
enjoy (and thus how many to work) depends on his preferences
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Figure 6.10: Labor-Leisure Choice
With the dark red preferences, Javier chooses 8 hours of leisure (6 hours of work) per day
With the light red preferences, Javier chooses not to work
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Effect of Wages on Hours of Work
How does a change in wage affect a consumer’s budget line?
In Javier’s case, he will have $30 to spend on food regardless of his wage
Wage change rotates his budget line, getting steeper with higher hourly wages
Points of tangency between indifference curves and budget lines form a price-consumption path
This leads to Javier’s leisure demand curve in Figure 6.11(b)
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Figure 6.11: Leisure Demand and Labor Supply Curves
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Labor Demand Curves
Do labor demand curves obey the Law of Demand?
Some people may have backward bending labor supply curves
Increase in wage reduces the supply of labor for some range of wages
Due to income effects:People own more time than they consumeIncrease in wage rate raises their purchasing powerIncreases their consumption of leisure, a normal
good
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Figure 6.12: Effects of Increase in Wage Rate
Increase in wage rate leads to opposing income and substitution effects
Income effect overwhelms substitution effect
Wage increase results in reduced number of labor hours
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Effect of Wages on Labor Force Participation
Given that backward bending labor supply curves exist:Can a wage reduction cause someone who
would not otherwise work to enter the labor market?NO!
Can a wage increase drive someone who would otherwise work out of the labor market?NO!
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Figure 6.13: Effect of Wage Rate on Labor Force Participation
A wage lower than the wage represented on the black budget line cannot lead Javier to enter the labor force
A wage increase rotates the budget line upward and can entice him to choose to work (e.g., by selecting bundle G)
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