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**ECON 212 Lecture 7 Tianyi Wang
**

Queen’ s Univerisity

Winter 2013

Tianyi Wang (Queen’ s Univerisity)

Lecture 7

Winter 2013

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Intro

Note: Quiz 1 can be picked up at Distribution Center. Second Quiz covers: Preferences, Budget and Optimal Choices. Core of theory of demand: how does demand change in di¤erent enviroments. Can have many directions. We will look at:

I I

e¤ect of changes in price, and e¤ect of changes in income.

Tianyi Wang (Queen’ s Univerisity)

Lecture 7

Winter 2013

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E¤ect of Changes in Price

What happens to optimal choices when price changes. Derive demand function from consumer’ s optimal choices.

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Lecture 7

Winter 2013

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Tianyi Wang (Queen’ s Univerisity)

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Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 5 / 46 .

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 6 / 46 .

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 7 / 46 .

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demand curve derived from de…nition: letting Px changes while holding others constant. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 11 / 46 . See class notes for examples.Demand Function Note.

or willing to sacri…ce Px unites of y. To translate into value.Demand Function (Cont’ d) Demand curve is also a "willingness to pay curve" I I I I MRS says willness to substitute. Py Willing to pay Px for additional unit of x . Px . MRS = Py Py Px Py = Px . Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 12 / 46 .

E¤ect of Changes in Income Income Consumption Curve (ICC): traces out optimal bundles on X-Y space as income changes. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 13 / 46 .

Engel curve (EC): depicts optimal choices on I-X space. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 13 / 46 .E¤ect of Changes in Income Income Consumption Curve (ICC): traces out optimal bundles on X-Y space as income changes.

Engel curve (EC): depicts optimal choices on I-X space.S . Inferior good. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 13 / 46 . Normal good V .E¤ect of Changes in Income Income Consumption Curve (ICC): traces out optimal bundles on X-Y space as income changes.

I Normal: positive slope for both ICC and EC Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 13 / 46 . Engel curve (EC): depicts optimal choices on I-X space.S .E¤ect of Changes in Income Income Consumption Curve (ICC): traces out optimal bundles on X-Y space as income changes. Inferior good. Normal good V .

E¤ect of Changes in Income Income Consumption Curve (ICC): traces out optimal bundles on X-Y space as income changes. Normal good V .S . I I Normal: positive slope for both ICC and EC Inferior: negative slope for both ICC and EC Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 13 / 46 . Inferior good. Engel curve (EC): depicts optimal choices on I-X space.

I I Normal: positive slope for both ICC and EC Inferior: negative slope for both ICC and EC With Quasilinear utility function. Engel curve (EC): depicts optimal choices on I-X space.E¤ect of Changes in Income Income Consumption Curve (ICC): traces out optimal bundles on X-Y space as income changes. both are vertical line. (Math and intuition?) Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 13 / 46 . Inferior good. Normal good V .S .

Usually assume identical individuals. See class notes for examples. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 14 / 46 .Market Demand Horizontal summation of individual demand.

Income and Substitution E¤ect Does price increase always decreases demand (Gi¤en good)? Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 15 / 46 .

buy more. – richer.Income and Substitution E¤ect Does price increase always decreases demand (Gi¤en good)? Decrease (increase) in price can have ambiguous e¤ect. – relatively cheaper. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 15 / 46 . buy less (inferior good).

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 15 / 46 . These ambiguities include: – the e¤ect of wage rates on labor supply. – richer.Income and Substitution E¤ect Does price increase always decreases demand (Gi¤en good)? Decrease (increase) in price can have ambiguous e¤ect. – the e¤ect of interest rates on savings. buy less (inferior good). – relatively cheaper. buy more.

buy less (inferior good). buy more. Purchasing power increased. – the e¤ect of interest rates on savings. Price changes involve two seperate e¤ects: – Substitution e¤ect: good 1 becomes cheaper. – relatively cheaper.Income and Substitution E¤ect Does price increase always decreases demand (Gi¤en good)? Decrease (increase) in price can have ambiguous e¤ect. These ambiguities include: – the e¤ect of wage rates on labor supply. cost changes) – Income e¤ect: b/c good 1 is cheaper. more attractive than good 2 (opp. can buy more of it with a given amount of income. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 15 / 46 . – richer.

Substitution E¤ect How to seperate? Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 16 / 46 .

…xed.Substitution E¤ect How to seperate? 1 keep relative price changes. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 16 / 46 . take away (grant) money to keep sth.

take away (grant) money to keep sth. reimburse and hold the relative prices. …xed.Substitution E¤ect How to seperate? 1 2 keep relative price changes. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 16 / 46 .

Substitution E¤ect How to seperate? 1 2 keep relative price changes. …xed. take away (grant) money to keep sth. reimburse and hold the relative prices. Hicks Decomposition: …x (initial) utility level. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 16 / 46 .

…xed. Hicks Decomposition: …x (initial) utility level. reimburse and hold the relative prices. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 16 / 46 .Substitution E¤ect How to seperate? 1 2 keep relative price changes. Slutsky Decomposition: …x purchasing power (not income). take away (grant) money to keep sth.

Substitution E¤ect How to seperate? 1 2 keep relative price changes. – how much consumer would require in payment to accept a change. reimburse and hold the relative prices. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 16 / 46 . take away (grant) money to keep sth. Hicks Decomposition: …x (initial) utility level. …xed. Slutsky Decomposition: …x purchasing power (not income). We will use Hicks below (clean intuition).

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Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 22 / 46 .Point A is original optimizing bundle.

Point A is original optimizing bundle. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 22 / 46 . and new optimal bundle is C. Decrease in price of X rotate budget line outward.

– Note the hypothetic budget at B is smaller than that at A (why?). e¤ect.Point A is original optimizing bundle. Decrease in price of X rotate budget line outward. Point B is the optimal bundle. that if we reduce the income just enough so that the consumer could just obtain the original utility level. e¤ect out by taking away implicit income changes. and new optimal bundle is C. – We seperate sub. – this is the sub. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 22 / 46 . at di¤erent relative prices.

Decrease in price of X rotate budget line outward. – this is the inc. – shift the hypothetic BC back to get implied changes in consumption. – Note the hypothetic budget at B is smaller than that at A (why?). e¤ect out by taking away implicit income changes. – this is the sub.Point A is original optimizing bundle. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 22 / 46 . e¤ect. Point C is the optimal bundle. that if we reduce the income just enough so that the consumer could just obtain the original utility level. Point B is the optimal bundle. – We seperate sub. e¤ect. and new optimal bundle is C. at di¤erent relative prices. that if we hold the new relative prices and add back the income that we took away.

that if we reduce the income just enough so that the consumer could just obtain the original utility level. – Note the hypothetic budget at B is smaller than that at A (why?).Point A is original optimizing bundle. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 22 / 46 . e¤ect. that if we hold the new relative prices and add back the income that we took away. Point B is the optimal bundle. – We seperate sub. – this is the inc. e¤ect. Decrease in price of X rotate budget line outward. e¤ect out by taking away implicit income changes. – shift the hypothetic BC back to get implied changes in consumption. See class note for examples. Point C is the optimal bundle. and new optimal bundle is C. at di¤erent relative prices. – this is the sub.

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 23 / 46 . – consumers are compensated just enough to obtain the original utiliy.Hicks substitution e¤ect also know as Compensated Demand Curve.

– consumers are compensated just enough to obtain the original utiliy. Note sign of substitution e¤ect must be negative Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 23 / 46 .Hicks substitution e¤ect also know as Compensated Demand Curve.

– consumers are compensated just enough to obtain the original utiliy.Hicks substitution e¤ect also know as Compensated Demand Curve.s. Note sign of substitution e¤ect must be negative Sign of income e¤ect can be positive or negative (normal v. inferior) Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 23 / 46 .

inferior) Therefore Gi¤en good must be inferior good. Note sign of substitution e¤ect must be negative Sign of income e¤ect can be positive or negative (normal v. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 23 / 46 .s.Hicks substitution e¤ect also know as Compensated Demand Curve. – consumers are compensated just enough to obtain the original utiliy.

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 24 / 46 .

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 25 / 46 . I I both original BC and hypothetical BC go through A.Slustsky de…nes substitution e¤ect by keeping purchasing power constant. Note incomes are di¤erent.

consumer earn it by supplying labour. instead of taking income as given.Application: Consumption and Leisure Choice In practice. Assume: Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 26 / 46 .

Assume: I Consumer’ s endowment of time T = 24 hours .Application: Consumption and Leisure Choice In practice. instead of taking income as given. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 26 / 46 . consumer earn it by supplying labour.

Application: Consumption and Leisure Choice In practice. Time can be used in labour (L) and leisure (R ). instead of taking income as given. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 26 / 46 . Assume: I I Consumer’ s endowment of time T = 24 hours . consumer earn it by supplying labour.

Time can be used in labour (L) and leisure (R ). instead of taking income as given. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 26 / 46 .Application: Consumption and Leisure Choice In practice. Assume: I I I Consumer’ s endowment of time T = 24 hours . consumer earn it by supplying labour. earn wage (w ) on each working hour.

Application: Consumption and Leisure Choice In practice. max U (C . R ). Consumer values consumption (C ) and leisure (R ). Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 26 / 46 . instead of taking income as given. Time can be used in labour (L) and leisure (R ). earn wage (w ) on each working hour. Assume: I I I I Consumer’ s endowment of time T = 24 hours . consumer earn it by supplying labour.

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 26 / 46 . Consumer values consumption (C ) and leisure (R ). max U (C . Need to use wages to buy consumption good.Application: Consumption and Leisure Choice In practice. R ). Price = 1. Assume: I I I I I Consumer’ s endowment of time T = 24 hours . Time can be used in labour (L) and leisure (R ). consumer earn it by supplying labour. earn wage (w ) on each working hour. instead of taking income as given.

max U (C .Application: Consumption and Leisure Choice In practice. consumer earn it by supplying labour. Time can be used in labour (L) and leisure (R ). Formulate consumer’ s problem. R ). Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 26 / 46 . Price = 1. Need to use wages to buy consumption good. earn wage (w ) on each working hour. instead of taking income as given. see class notes for example. Assume: I I I I I Consumer’ s endowment of time T = 24 hours . Consumer values consumption (C ) and leisure (R ).

Since: supply of labour + demand for leisure = 24 hours. by varying wage rate (see graph below). (See graph below). L=T R .Backward bending labour supply We can …nd demand for leisure from optimal choices. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 27 / 46 .

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Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 36 / 46 .

Substitution e¤ect makes an hour of leisure more expensive. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 37 / 46 .

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 37 / 46 . Income e¤ect increases your overall endowment.Substitution e¤ect makes an hour of leisure more expensive.

e¤ect if negative. Income e¤ect increases your overall endowment. Sub.Substitution e¤ect makes an hour of leisure more expensive. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 37 / 46 .

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 37 / 46 . — Income e¤ect is positive. — Inc. Income e¤ect increases your overall endowment. e¤ect. consume more when income raises. If leisure is normal good. Sub. e¤ect counteracts sub.Substitution e¤ect makes an hour of leisure more expensive. e¤ect if negative.

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 37 / 46 . — Inc. If leisure is normal good.Substitution e¤ect makes an hour of leisure more expensive. Income e¤ect increases your overall endowment. e¤ect if negative. Labour supply curve bends baceward. — Income e¤ect is positive. Sub. consume more when income raises. e¤ect counteracts sub. e¤ect.

Compensating Variation and Equivalent Variation Two ways to measure consumer welfare. I I Price changes result in welfare change. Rather than describe welfare in utility terms. (utility level drops): Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 38 / 46 . Suppose price of X increases . we would like to describe it in terms of dollars.

at the new price. Suppose price of X increases . we would like to describe it in terms of dollars. — This is Compensating Variation.Compensating Variation and Equivalent Variation Two ways to measure consumer welfare. (utility level drops): 1 Ask how much money to compensate a consumer. such that she obtains her initial utility level. I I Price changes result in welfare change. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 38 / 46 . Rather than describe welfare in utility terms.

Suppose price of X increases . — This is Compensating Variation. we would like to describe it in terms of dollars. at the new price.Compensating Variation and Equivalent Variation Two ways to measure consumer welfare. (utility level drops): 1 Ask how much money to compensate a consumer. such that the e¤ect is equivalent to the price change. Ask how much money to take away from a consumer. — This is Equivalent Variation. at the initial price. 2 Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 38 / 46 . such that she obtains her initial utility level. I I Price changes result in welfare change. Rather than describe welfare in utility terms.

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 39 / 46 .

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Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 44 / 46 .

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 45 / 46 .

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 46 / 46 .Note: these are pure income e¤ects.

Note: Change in consumer surplus includes both inc. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 46 / 46 . e¤ect. e¤ect and sub.Note: these are pure income e¤ects.

Note: Change in consumer surplus includes both inc. Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 46 / 46 . e¤ect and sub.Note: these are pure income e¤ects. e¤ect. Which measure is higher depends on income elasticity.

Tianyi Wang (Queen’ s Univerisity) Lecture 7 Winter 2013 46 / 46 . e¤ect. e¤ect and sub. Note: Change in consumer surplus includes both inc. they are virtually identical.Note: these are pure income e¤ects. However as the budget share of most goods are small. Which measure is higher depends on income elasticity.

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