Microeconomics

Eighth Edition, Global Edition

Chapter 5
Applying
Consumer Theory
Part B

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Learning Objectives
5.1 Deriving Demand Curves. ✓
5.2 How Changes in Income Shift Demand Curves. ✓
5.3 Effects of a Price Change. ✓
5.4 Cost-of-Living Adjustments.
5.5 Deriving Labor Supply Curves.

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Inflation Indexes
• Inflation - the increase in the overall price level over
time.
– nominal price - the actual price of a good.
– real price - the price adjusted for inflation.
• How do we adjust for inflation to calculate the real
price?

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Inflation Indexes
• Consumer Price Index (CPI) – measure the cost of a
standard bundle of goods for use in comparing
prices over time (Base year: 1982-84 is 100)
– We can use the CPI to calculate the real price of a
hamburger over time.
– In terms of 2016 dollars, the real price of a
hamburger in 1955 was:

CPI for 2016 240.2

× price of a burger = × 15 ¢ = $1.34
CPI for 1955 26.8

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Effects of Inflation Adjustments
• Scenario: Klaas signed a long-term contract when
he was hired. According to the COLA clause in his
contract, his employer increases his salary each
year by the same percentage as that by which the
CPI increases. If the CPI this year is 5% higher
than the CPI last year, Klaas’s salary rises
automatically by 5% over last year’s.

• CPI adjustment can make Klaas better off if price

ratios change

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Cost-of-Living Adjustment
(COLA)
• If a person’s income
increases automatically
with the CPI, he can afford
to buy the first year’s
bundle in the second year,
but chooses not to.
– Better off in the second
year because the CPI-
based COLA
overcompensates in the
sense that utility
increases.
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True Cost-of-Living Adjustment
• True cost-of-living index - an inflation index that
holds utility constant over time.
• Question: how big an increase in Klaas’s salary would
leave him exactly as well off in the second year as in
the first?

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Cost-of-Living Adjustments
Assume U = 20C0.5F0.5

Utility,
blank pC pF Income, Y Clothing Food
U
First year $1 $4 Y1 = $400 200 50 2,000
Second year $2 $5 blank blank blank blank
No adjustment blank blank Y1 = $400 100 40  1,265
CPI
blank blank Y2 = $650 162.5 65  2,055
adjustment
True COLA blank blank Y* $632.50  158.1  63.2 2,000

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Cost-of-Living Adjustments
CPI adjustment = (650 – 400)/400 = 0.625 or 62.5%

True COLA = (632.50 – 400)/400 = 0.581 or 58.1%

Utility,
blank pC pF Income, Y Clothing Food
U
First year $1 $4 Y1 = $400 200 50 2,000
Second year $2 $5 blank blank blank blank
No adjustment blank blank Y1 = $400 100 40  1,265
CPI
blank blank Y2 = $650 162.5 65  2,055
adjustment
True COLA blank blank Y* $632.50  158.1  63.2 2,000

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Size of the CPI Substitution Bias
• Income adjustments based on CPI suffer from an
upward bias.
• The CPI-based adjustment suffers from substitution
bias – it ignores that consumers may substitute
toward the relatively inexpensive good when prices
change disproportionately.
• A number of studies estimate that the U.S. substitution
bias is at least 0.5%.

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Labor-Leisure Choice
• Leisure - all time spent not working.
• The number of hours worked per day, H, equals 24
minus the hours of leisure or nonwork, N, in a day:
H = 24 − N.
– The price of leisure is forgone earnings.
▪ The higher your wage, the more an hour of leisure costs
you.

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Labor-Leisure Choice: Example
• Jackie spends her total income, Y, on various goods.
– The price of these goods is $1 per unit.
• Her utility, U, depends on how many goods and how
much leisure she consumes:
U = U (Y , N ) .
• Jackie’s earned income equal: wH.
• Her total income, Y, is her earned income plus her
unearned income, Y*:

Y = WH + Y * .

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Demand for Leisure
Budget line, L1
Y1 = w1H = w1(24-N)

Budget line, L2
Y2 = w2H = w2(24-N)

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Supply Curve of Labor

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Income and Substitution Effects of a
Wage Change
Y , Goods per d ay

I2 Time const raint

L2

Since income effect is positive,

I1
leisure is a normal good.

L* e2
e*

L1 e1

0 N* N1 N2 24 N, Leisure hours per d ay

24 H* H1 H2 0 H , Work hours per d ay
Substitution effect Total effect
Income effect

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Effect of Unearned Income
• Enrico receives a no-strings-attached scholarship that
pays him an extra Y * per day.
How does this scholarship affect the number of hours
he wants to work? Does his utility increase?

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Effect of Unearned Income

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Effect of Unearned Income: Lotteries
• Massachusetts Megabucks lottery
– Average winner: 55K per year over 20 years
• Labour earnings fell by $1877 per year
• Consumption and savings increased
• Effects three times as large for 55 to 65 year olds than
for younger workers.

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Labor Supply Curve That Slopes Upward
and Then Bends Backward
(a) Labor-Leisure Choice (b) Supply Curve of Labor

Supply curve of labor

Y , Goods per d ay

w, Wage per hour

L3 I3 Time const raint E3

I2
E2
I1
e3
L2
e2 E1

L1 e1

24 H2 H H1 0 0 H1 H3 H2 24
3
H , Work hours per d ay H , Work hours per d ay

butlow
At at high
wages,
wages,
an increase
an increase
in the
in the
wage causes the worker to work
more….
less….
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Income Tax Rates and Labor Supply
• How does an increase in income tax rate affect
government tax revenue?
• If labour supply is upward sloping increases in taxes
will reduce hours worked
– May reduce tax revenue
• If labour supply is downward sloping (backward
bending) increases in taxes will increase hours
worked
– Increase tax revenue

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The Relationship of U.S. Tax Revenue
to the Marginal Tax Rate

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Per-Hour Versus Lump-Sum Child Care
Subsidies
Lump-Sum Subsidy makes
individuals better off than a per-
hour subsidy

Individuals substitute away from

child-care and into other goods

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MCQ
The CPI substitution bias is least likely to exist for an
individual with:
a) Cobb-Douglas utility
b) Perfect complement utility
c) Quasi-linear utility
d) Perfect substitute utility

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MCQ
Y , Goods per d ay

I2 Time const raint

L2

This figure shows that leisure is:

I1
a) Inferior
b) Normal
c) Cannot say

L* e2
e*

L1 e1

0 N* N1 N2 24 N, Leisure hours per d ay

24 H* H1 H2 0 H , Work hours per d ay
Substitution effect Total effect
Income effect

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MCQ
A true cost of living index:
a) Holds utility constant at its original level
b) Holds income constant at its original level
c) Ensures that the individual can afford the original
bundle

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MCQ
This figure suggests that:
a) Leisure is normal and Y is normal
b) Leisure is inferior and Y is inferior
c) Leisure is inferior and Y is normal
d) Leisure is normal and Y is inferior

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