Chapter 5 Applying Consumer Theory Key issues 1 deriving demand curves 2 income effect 3 effects of a price change 4 CPI bias 5 labor supply curve Questions 1 What would happen if a consumer behaved randomly 2 Do we measure incomes in developing countries accurately 3 What are the effects of overtime laws 4 What are the effects on hours of work of tax cuts 5 Can a flat tax be progressive 1 Deriving Demand Curves trace out the demand curve by holding income and the price of wine constant and varying the price of beer example estimated set of indifference curves for the typical American consumer are bowed away from origin so beer and wine are imperfect substitutions Figure 5 1 Deriving an Individual s Demand Curve a Indifference Curves and Budget Constraints Wine Gallons per year 12 0 e3 5 2 4 3 2 8 I3 I2 I1 L 1 pb 12 0 Price consumption curve e2 e1 26 7 44 5 L2 pb 6 58 9 L 3 pb 4 Beer Gallons per year b Demand Curve p b per unit 12 0 E1 E2 6 0 E3 4 0 0 D1 Demand for beer 26 7 44 5 58 9 Beer Gallons per year Price consumption curve shows how the optimal pairs of beer and wine vary as the relative price varies 2 How income changes shift demand curves hold prices fixed and vary income increase in income causes shift of the demand curve movement along income consumption curve movement along the Engel curve Figure 5 2 Effect of a Budget Increase on an Individual s Demand Curve a Indifference Curves and Budget Constraints Wine Gallons per year L3 L2 Income consumption curve L1 e3 7 1 4 8 2 8 0 b Demand Curves e2 e1 I1 26 7 38 2 49 1 I2 I3 Beer Gallons per year Price of beer per unit E1 12 E2 E3 D3 D2 D1 0 c Engel Curve 26 7 38 2 49 1 Beer Gallons per year Y Budget Engel curve for beer Y3 837 E3 Y2 628 E2 Y1 419 0 E 1 26 7 38 2 49 1 Beer Gallons per year Income elasticities income elasticity percentage change in quantity demanded percentage change in income Q Q Y Y normal good 0 inferior good 0 3 Mimi s income elasticities beer b 0 88 wine w 1 38 both are normal goods Are children inferior mother with relative little education 0 18 mother relatively well educated 0 044 Income consumption curves and income elasticities shape of income consumption curve for 2 goods tells us sign of income elasticities some goods must be normal not all goods can be inferior 4 Figure 5 3 Income Consumption Curves and Income Elasticities Housing Square feet per year Food inferior housing normal L2 ICC 1 a Food normal housing normal ICC 2 b L1 e c ICC 3 Food normal housing inferior I Food Pounds per year Income elasticities may vary with income Gail may view hamburger as a normal good at a low income an inferior good at a high income Figure 5 4 A Good That Is Both Inferior and Normal a Indifference Curves and Budget Constraints All other goods per year 3 Y3 L Income consumption curve 2 Y2 L Y1 e3 L1 I3 e2 e1 I2 I1 Hamburger per year b Engel Curve Y Income Y3 E3 Y2 E2 Engel curve Y1 E1 Hamburger per year 5 Quality and income elasticities when their incomes rise some people buy higher quality goods rather than more of what they re currently buying examples fancier cars fancier foods designer clothing Effects of a price change as price of one good goes up all else the same there are two effects a substitution effect an income effect Substitution effect consumers substitute other now relatively cheaper goods for the one whose price rose direction of the effect is unambiguous 6 Income effect price increase consumers buying power falls reducing income opportunity set so consumer buys less of at least some goods direction of income effect depends on income elasticity of each good Income and substitution effects price rise substitution effect income effect normal good negative negative inferior good negative positive Figure 5 5 Substitution and Income Effects with Normal Goods Wine Gallons per year 12 0 L2 L1 e2 5 5 L I2 e1 e I1 0 26 7 30 6 58 9 Substitution Income effect effect Total effect Beer Gallons per year 7 Income and substitution effect with an inferior good substitution effect opposite of price movement income effect same direction as price movement Giffen good good for which a decrease in its price causes the quantity demanded to fall potatoes in Ireland quinine water for lab rats Figure 5 6 Giffen Good Basketball Tickets per year L2 e2 L1 I2 L e1 e Total effect Substitution effect I1 Movies Tickets per year Income effect Solved problem dinner plate manufacturer sells first quality perfect second quality slight color defects dinner plates manufacturer has an outlet store located next to its manufacturing plant assume tastes same everywhere cost of shipping each plate from factory to distant stores is s 8 Solved problem cont compared to sales at other stores does the outlet store sell A a relatively large share of seconds B the same ratio of first and second quality plates C a relatively small share of seconds Answer relative prices at outlet store ps p f relative prices elsewhere ps s pf s relative price of seconds rises causing substitution away from seconds presumably the income effect is small Shipping the Good Stuff Away expect larger share of higher quality goods shipped greater per unit shipping fee Hummels and Skiba 2002 examined shipments between 6 000 country pairs for more than 5 000 goods 9 Results doubling per unit shipping costs results in a 70 to 143 increase in average price excluding cost of shipping larger share of top quality products shipped farther apart are trading countries greater the cost of shipping may explain relatively high quality of Japanese goods Results cont ad valorem tariff raises relative price of higherquality goods given that there is also a per unit shipping fee doubling ad valorem tariff decreases average price three to four fold as average quality falls thus using an ad valorem rather than a specific per unit tariff reduces quality of imported goods Inflation because of inflation prices today are not directly comparable to past prices inflation harms people on fixed incomes net lenders and others 10 Cost of living adjustments many long term contracts include cost ofliving adjustments COLAs general business contracts rental alimony payments salaries pensions Consumer Price Index CPI many governments report a cost of living measure CPI measure of inflation overall rise in prices over time CPI overestimates how true cost of living changes over time overestimate hurts you if your landlord increases rent on your apartment using CPI Real vs nominal prices nominal price
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