Microeconomics

SAIS Johns Hopkins Bologna Center (PreTerm 2010)

Lecture 3: Consumer Behavior and Welfare

Professor: David Cheong

Lecture Outline
Case Study: Food Stamps Individual Demand Case Study: A Two-Part Tariff Income and Substitution Effects Case Study: Labor Supply

Measuring the Welfare of Consumers

Case Study: The US Sugar Import Quota

Case Study: Food Stamps

Using the consumer-choice framework: The Budget Line I Is household money income PF and PA are prices of food and all other goods S is amount of food stamps. Each stamp is redeemable for 1 unit of food. Stamps cannot be exchanged for cash. Preferences Typical downward-sloping indifference curves. What does the model predict regarding:
1. The change in food consumption given foods stamps? 2. Whether a household prefers foods stamps or an equivalent cash transfer?

Case Study: Food Stamps

All Other Goods (units) R CCASH FKIND
What happens to the budget line given food stamps, S? What is the consumers new optimal choice?

What happens to the budget line given a cashequivalent transfer of S*PF? Optimal choice?
Consider a different consumer who has more of a preference for other goods than food. How do the effects of food stamps differ from the cashequivalent transfer?

A2 A1

FCASH FKIND F1

F2

Food (units)

Individual Demand or The Effects of Price Changes on Quantity

Clothing

10

Assume: I = $20 PC = $2 PF = $2, $1, $0.50

A
U1

6
5 4

D B

Each price leads to different amounts of food purchased

U3

U2
Food (units per month)

12

20

Individual Demand or The Effects of Price Changes on Quantity

Clothing

10

Assume: I = $20 PC = $2 PF = $2, $1, $0.50

A
U1

6
5 4

D B

Each price leads to different amounts of food purchased

U3

U2
Food (units per month)

12

20

Effect of a Price Change

By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individual From the previous example:
Demand Schedule P $2.00 $1.00 $0.50 Q 4 12 20

Effect of a Price Change

Price of Food

$2.00

Individual Demand relates the quantity of a good that a consumer will buy to the price of that good.

G
$1.00

Demand Curve
$.50 H
Food (units per month)

12

20

The Cobb-Douglas Utility Function

A widely-used mathematical representation of consumer preferences. Fulfils the 3 assumptions of rationality. On a graph, this utility function comes out as indifference curves that are convex to the origin In general, the Cobb-Douglas utility function is: U(X,Y) = CXaYb , where a, b, and C are positive constants. If a + b = 1, then one special property of this function is that the consumer will always spend the same share of her budget on a good regardless of income level or prices.

An Example of a Cobb-Douglas Utility Function

Suppose that a consumers utility function is U(X,Y) = X0.6Y0.4
MUX = (U/ X) = 0.6X-0.4Y0.4 MUY = (U/ Y) = 0.4Y-0.6X0.6 Therefore, the MRS = 0.6X-0.4Y0.4/ 0.4Y-0.6X0.6 = 3Y/2X

At the optimal choice, MRS = Px/Py

3Y/2X = Px/Py

The optimal choice must also be on the budget line, i.e. PxX+PyY = I or Y=(I PxX)/Py Substitute for Y in the eq. above to get: PxX = 3 I/5 = 0.6I Note the share of income spent on X is constant.

An Example of a Cobb-Douglas Utility Function

Rearranging the previous equation, the optimal choice of X is: X = 0.6I/Px Suppose the consumers income is $1000, then the consumers demand for good X is X = 600/Px Note the consumers demand for good X does not involve the price of Y.
600

500

400 Price

300

200

100

0 0 50 Quantity 100 150

Estimating a Cobb-Douglas Utility Function Given Observed Expenditure Shares

Suppose we observe that a consumer spends 40% of his income on mobile communication and the rest on other goods. Assuming that the consumers preferences can be represented by a Cobb-Douglas utility function with parameters that sum to 1, what is the consumers utility function?

Case Study: A Two-Part Tariff

There are many goods (e.g. phone plans, health clubs, bars with cover charges) for which a consumer must pay a fixed access(or entry) charge and a unit charge for each unit bought. Consider phone plans. Suppose: (i) plan A has no access charge but a unit charge of $0.05 while plan B has a certain fixed access charge (F) and a unit charge of $0.01. If a firm had information about a consumers demand, the firm could extract the maximum fixed access charge. How would it do so? Suppose (i) Other goods cost $1 per unit, (ii) The consumer has $1000 as income, and (iii) The consumers utility function is U(M,G) = M0.4G0.6 Solving for the optimal choice under plan A, M = 0.4*1000/0.05 = 8,000 and G = 0.6*1000/1 = 600 This bundle yields a total utility of 8,0000.46000.6 = 673

Computing the Maximum Fixed Fee in a Two-Part Tariff

The maximum access fee that can be imposed for plan B is when the consumer is indifferent between plan A and plan B (i.e., total utility must be the same). If the consumer prefers plan B to A, then the access fee can be increased. If the consumer prefers plan A to B, then the access fee is too much. As computed, utility under plan A is 673 Solving for the optimal choice under plan B,
M = 0.4*(1000-F)/0.01 = 40,000-40F and G = 0.6*(1000F)/1= 600 0.6F

Plugging these into the consumers utility function and setting it equal to 673 yields M0.4G0.6 = (40,000-40F)0.4(600 0.6F )0.6 = 673 This is a scary equation in F. So, well use Excel to help us solve for F.

Computing the Maximum Fixed Fee in a Two-Part Tariff

Fixed $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Fee 786 787 788 789 790 791 792 793 794 795 796 797 798 799 800 Utility 689 686 682 679 676 673 670 666 663 660 657 653 650 647 644

Excel Formula ((40000-40*F)^0.4)*((600 -0.6*F)^0.6)

Income and Substitution Effects

A change in the price of a good has two effects:
Substitution Effect Income Effect

Income and Substitution Effects

Substitution Effect
The substitution effect is the change in an items consumption associated with a change in the price of the item, with the level of utility held constant When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good

Income and Substitution Effects

Income Effect
The income effect is the change in an items consumption brought about by the increase in purchasing power, with the price of the item held constant When a persons real income increases, the quantity demanded for the product may increase or decrease

Income and Substitution Effects: Normal Good

Clothing (units per month) R
When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B. The substitution effect, F1E, (from point A to D), changes the relative prices but keeps utility constant. The income effect, EF2, (from D to B) keeps relative prices constant but increases purchasing power.

C1

D
C2
Substitution Effect

U2 U1
E S F2
Income Effect

F1

Total Effect

Food (units per month)

Income and Substitution Effects: Inferior Good

Clothing (units per month) R
Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect.

A B

U2

Substitution Effect

U1
F2 E S T
Food (units per month)
Income Effect

F1
Total Effect

Income and Substitution Effects

A Special Case: The Giffen Good
The income effect may theoretically be large enough to cause the demand curve for a good to slope upward This rarely occurs and is of little practical interest

The Lump Sum Principle

Lump-sum principle holds that taxes imposed on income will have smaller welfare costs than taxes imposed on commodities.

Suppose an individual initially has I0 dollars to spend and chooses to consume F0 and C0 , yielding U0 utility.
Tax on Food raises its price, resulting in a pivoted budget line I1 and consumption reduced to F1, C1 and utility level U1. An income tax that generates same total tax revenue is represented by budget constraint I2 that must goes though F1, C1. With an income tax, the consumers optimal choice is F2, C2.

Lump-Sum Principle
Clothing (units per month) R Assume: Food and Clothing are Normal Goods

C1

C0 C2
Substitution Effect

A C

U1
F2 F0

U2

U0
Food (units per month)

F1

Total Effect

Income Effect

The Lump Sum Principle

Intuitive explanation of lump-sum principle: singlecommodity tax affects consumers in two ways:
Reduces purchasing power, Directs consumption away from good being taxed.

The lump-sum tax only has first of these two effects.

Therefore, the consumer is better off with the lumpsum tax rather than the commodity tax.

Case Study: Labor Supply

For most households, the most important source of income is from work. The work decision is a choice of how to allocate time between labor and leisure (and/or household production). We can use the consumption choice framework to analyze this decision: The consumer chooses a stylized bundle that contains consumptions goods (C) and leisure hours (N). To simplify, the price of a unit of C is $1. Let the hourly wage be w per hour. Recall that the budget equation makes total expenditure equal total income. The consumers total expenditure on consumption is simply C. Total income depends on the number of hours worked. Suppose that the consumer has 16*7=112 hours in a week to allocate between labor and leisure. So, the consumers total income is (112-N)w. The budget line equation: C = w(112-N) or 1C + wN = w*112

Case Study: Labor Supply

From previous slide, the budget-line equation: C = w(112-N) or 1C + wN = w*112 The second equation shows us:
The price of an hour of leisure is the opportunity cost, which is the hourly wage, w. The total cost of the consumers chosen bundle of consumption and leisure must equal the value of his/her time endowment (which is the product of the wage rate and the total hours to be allocated between labor and leisure).

The consumers preferences over consumption goods and leisure can be represented by downward-sloping indifference curves that are convex to the origin (i.e., the typical indifference curves that we have used so far). We assume that leisure and consumption goods are normal goods.

Case Study: Labor Supply

Consumption Goods (units) R
The slope of the budget line = -W/1. Suppose that the wage rate rises, what happens to the budget line? What happens to the optimal choice of leisure hours? Work hours? Suppose that the wage rate rises again, what happens to the budget line? What happens to the optimal choice of leisure hours? Work hours?

C3 C2
C1

N2 N3 N1

T=112

Leisure (hours in a week)

The Decision Not to Work is a Corner Solution

Consumption Goods (units) R
Note the shape of the indifference curves. What does this imply about the consumers marginal rate of substitution between consumption goods and leisure? At a corner solution like the one in the diagram, the MRS is not equal to the price ratio. What is the relationship between the two? How do we interpret this relationship?

T=112

Leisure (hours in a week)

Case Study: Aid to Families with Dependent Children (AFDC)

Consumption Goods (units) R
These programs provide cash to families with dependent children and an absent or incapacitated parent. They have been used in the US, Europe, and other countries. In the US version, the aid recipient would get a grant, say $10, but the grant would be reduced by $1 for each $1 earned by working. How do we draw the consumers budget under this program? What are the work incentives of this program?

CG 10 CR1

NG

102

NR1

T=112

Leisure (hours in a week)

Price Changes and Consumer Welfare

We have seen that price changes take the consumer from one indifference curve to another Can we say something quantitative about the effect of a given price change on the consumers welfare?

Consumer Welfare
Can we measure in monetary terms the effect of a price change on the consumers utility (wellbeing)? Economists use three concepts:
Compensating variation: what change in income would restore the consumers utility to what it was before the price change Equivalent variation: what change in the consumers income would have an equal effect on the consumers utility as the price change Change in consumer surplus

Quantifying A Change in Welfare: The Problem

y

U0

U'

Suppose the consumer's optimal choice is now A let the Price of good X fall... after a price fall, the consumer is better off at B, but by how much?

B
How do we quantify this gap?

The Compensating Variation (CV)

The Price of good x falls

U0

The original utility level is the reference point

CV is reduction in income to make consumer just as well off as before price fall
C

B
Original prices New price

CV

The Equivalent Variation (EV)

The Price of good x falls

U1
EV

The new utility level is now the reference point EV is increase in income that raises utility to as much as the price fall would have.

E A

B
Original prices New price

Consumer Surplus
It can be shown that, given a change in price, the monetary measure of a change in consumer surplus is between the measures of compensating and equivalent variations. As such, consumer surplus is an approximate measure of changes in consumer welfare but useful because it is easily applied. To apply it, all we need to have is the demand function whereas with CV and EV we would need individual consumer preferences.

Consumer Surplus
On each unit of the good, there is a surplus that is the difference between the maximum amount a consumer is willing to pay for that unit and the amount actually paid (i.e. market price). Consumer Surplus is thus calculated as the area under the demand curve and above the market price. What is consumer surplus if the market price is $9? $7?

Price ($/unit)

15

11
9 7

An Individuals Demand

10

15

20

Quantity (units)

The concept also applies in the same way to market demand

Case Study: The US Sugar Import Quota

1. Consider a supply and demand model of the US market for raw sugar. Draw one supply curve involving only domestic supply and another supply curve that combines both domestic supply and imports of 1.2 million metric tons under the quota. To simplify, ignore above-quota imports and non-quota imports from Mexico. The articles states that the US price of raw sugar is about 35 cents per pound. 1 metric ton corresponds to 2204.6 lbs. So, the US price of raw sugar is about $772 per metric ton. Indicate this price in your diagram in (1). 85% of the US raw sugar market is supplied by domestic producers with the other 15% imported. Suppose that the 15% corresponds to the 1.2 million metric tons of imported sugar (i.e., ignore above-quota and non-quota imports). This implies that the total quantity traded of raw sugar in the US is 8 million metric tons with US producers supplying 6.8 million metric tons. Indicate the total quantity traded, the quantity supplied by only US producers, and the quantity imported in your diagram in (1).

2.

3.

Case Study: The US Sugar Import Quota

4. The global price of sugar is at about 20 cents per pound, which corresponds to $441 per metric ton. If US raw sugar consumers faced the global price instead of the domestic price, show the quantity demanded of raw sugar on your diagram. Does this exceed the current quantity traded?

5. The article states that, Imperial Sugar Co., the nation's second largest buyer of sugar behind Domino Foods Inc., wants the government to almost double the quota to 2.2 million tons. Suppose that US demand for raw sugar has an insignificant effect on the global price. What effect will an increase in the import quota have on the domestic price of raw sugar in the US?
6. What effect will an increase in the sugar import quota have on domestic sugar production?

Case Study: The US Sugar Import Quota

7. Suppose that the new quota requested by Imperial Sugar Co. results in a quantity supplied (combining domestic supply and imports) that equals quantity demanded at the global price. Why must this market equilibrium quantity be less than 9.2 million tons? 8. Suppose that the market equilibrium quantity is 9 million tons. Indicate this in your diagram in (1) and compute the increase in consumer surplus. 9. Given the assumptions in (4) and (6) above, will relaxing the sugar import quota to allow more than 2.2 million tons of imports have an effect on the US market for raw sugar?