Chapter 05 - Applications of Rational Choice and Demand TheoriesChapter 5APPLICATIONS OF RATIONAL CHOICE AND DEMAND THEORIESBoiling Down Chapter 5The tools developed in the preceding chapters are useful in analyzing many policy op-tions and situations of consumer choice. In the case of a gasoline tax with a rebate, the taxon gasoline is designed to conserve fuel without making the consumer substantially worseoff. Here the substitution away from fuel because of the price increase (substitution effect)is greater than the increased spending on fuel that comes because of the tax rebate (incomeeffect) and so the policy objective is achieved.The school voucher example shows how the present school funding policy of tax-fi-nanced public schools limits the consumer choices and discourages many parents from in-creasing the quality of education beyond that provided by the public system. This is be-cause any private education must be totally self-financed by the family while the school taxis also paid. Faced with this double school payment, most parents opt for public school ed-ucation only. However, if they were allowed to use the school tax to purchase the educationof their choice, they would end up buying more education, and we would have a morehighly educated population.There is usually a difference between what a consumer has to pay for a good and whatshe would be willing to pay for a good. If the decision to buy is an easy one, it means thatmore utility was gained than was given up from a purchase. The difference is called con-sumer surplus. It can be measured by taking the difference between the area under the de-mand curve of the items bought and the amount that the consumer paid for the goods. Theseller will sometimes try to capture some of this consumer surplus by charging a flat up-front access fee for the product or service in addition to a per unit charge.Consumer theory tools make it possible to compare the welfare of alternative situa-tions and policies. When prices change from one year to the next, consumers will adjusttheir market basket and their overall welfare will be impacted. Consider a consumer who isutility maximizing with a given set of prices. Then the relative prices change over time butthe consumer is still able to buy his original market basket. However, a wise consumer willsubstitute toward the good that has fallen in price and away from the higher priced good.By observing the budget constraints and the new consumer’s choices, it is possible to showthat increased welfare results from the price changes or that the consumer can maintain hisutility level with a lower level of income. The ability to substitute toward lower prices andaway from higher prices is a powerful strategy for improving welfare.5-1Chapter 05 - Applications of Rational Choice and Demand TheoriesIn the story of the housing price changes, the consumer takes advantage of pricechanges in either direction by substituting between income and housing in ways that makeher better off. It is important to realize that the initial bundle of housing and income isavailable in both cases because the house is already owned by you and so your potentialincome will always be at least the value of the home.A price index like the CPI indicates the amount of income increase that must be ob-tained in order to "keep up with inflation." However, it uses the same market basket fromyear to year, thereby eliminating the possibility that the consumer can fight off inflation bysubstitution within the market basket. If the consumer substitutes away from the inflateditems in the basket, it takes a smaller income increase to maintain the earlier welfare level.Thus the CPI overestimates the true effect of inflation on consumer welfare. Product qual-ity increases also make it difficult for the CPI to measure true cost of living changes.This chapter includes several examples of the relevance of price elasticity. The AtlantaTransport Authority case shows how elasticity can be calculated when price changes resultin changes in total revenue. The price elasticity of alcohol turned out to be considerablymore elastic in a Philip Cook study than was often assumed by policy makers because theincome effect of alcohol price increases was significant since alcoholics usually do nothave big incomes. The final topic in this chapter concerns issues of time in consumer choice. Manychoices in life depend on how one views the future. For example, after your clothing is allneatly washed and hung in the closet, do you wear the best first or save it for later? If youchoose to save the best for last you have a negative time preference because a unit of plea-sure in the future is worth more than a unit of pleasure now. These preferences of the con-sumer can be illustrated by an indifference curve showing the tradeoffs that the consumeris willing to make between present and future options. The characteristics of diminishingmarginal utility, more is better than less, and transitivity apply to these curves as they do toall normal indifference curves. A patient person will have a flat indifference curve with re-spect to present consumption while an impatient person will have a steep curve with re-spect to the same axis.Using these tools of analysis, it is possible to illustrate how a consumer will optimizesubject to the income constraint and become either a saver or a borrower. An increase inthe interest rate will cause future consumption to rise and present consumption to fall.An example of this allocation of resources over time from the macroeconomics area isthe lifetime income hypothesis. This hypothesis states that people who have irregular in-come tend to allocate income over time in ways that keep consumption fairly stable fromone time period to the next. Saving occurs in high-income years and borrowing takes placewhen income is below the norm.Many things impact a person's intertemporal indifference curve. A pessimist about thefuture will have a positive time preference, whereas someone who is optimistic that enor-mous opportunity is coming may possibly have a negative time preference, saving largeamounts for the coming opportunities. The intensity of anticipation of a good or a bad willinfluence how choices are allocated between the present and future. If there is truth to thestatement that anticipation of something good is greater than reality, then a postponed real-ity brings enhanced pleasure. 5-2Chapter 05 - Applications of