Perloff 6e ch05

Chapter 5
Applying
Consumer
theory
Topics
• Deriving Demand Curves.
• How Changes in Income Shift Demand

Curves.
• Effects of a Price Change.
• Cost-of-Living Adjustments.
• Deriving Labor Supply Curves.
5-2 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Figure 5.1 Deriving
(a) Indifference Curves and Budget Constraints
Wine, (W), Gallons per year

12.0
an Individual’s
Demand Curve
Budget Line, L
e1
Y - Pb 2.8
W= b
PW PW L1 (pb = $12) I1
0 26.7 Beer (b), Gallons per year
Initial Values (b) Demand Curve

Initial optimal bundle of
p b, $ per unit
beer and wine
Pb = price of beer = $12
PW = price of wine = $35 12.0 E1
Y = Income = $419.
Beer (b), Gallons per year

0 26.7

Figure 5.1 Deriving

12.0
an Individual’s
Demand Curve
Budget Line, L e2
4.3
e1
Y - Pb 2.8 I2
W= b
PW PW L1 (p b = $12) I1 L2 (p b = $6)
0 26.7 44.5 Beer (b), Gallons per year
New Values (b) Demand Curve
p b, $ per unit
Y = Income = $419.
E2
6.0
Price of beer goes down!

0 26.7 44.5 Beer (b), Gallons per year

Figure 5.1 Deriving

12.0
an Individual’s
Demand Curve
Price-consumption curve
Budget Line, L 5.2
e2
e3
4.3
e1 I3
Y - Pb 2.8 I2
W= b
PW PW L1 (pb = $12) I1 L2 (pb = $6) L3 (p b = $4)
0 26.7 44.5 58.9 Beer (b), Gallons per year
New Values (b) Demand Curve
p b, $ per unit
Y = Income = $419.
E2
6.0
Price of beer goes down 4.0

E3
D1, Demand for Beer
again!
0 26.7 44.5 58.9 Beer (b), Gallons per year

Price-Consumption Curve
• A line through optimal bundles at each

price of one good (beer) when the price of
the other good (wine) and the budget are
held constant.
• The demand curve corresponds to the
price-consumption curve.

Solved Problem 5.1
• In Figure 5.1, how does Mimi’s utility at E1

on D1 compare to that at E2?
• Answer:
 Use the relationship between the points in
panels a and b of Figure 5.1 to determine
how Mimi’s utility varies across these points
on the demand curve.

Solved Problem 5.2
• Mahdu views Coke, q, and Pepsi as

perfect substitutes: He is indifferent as to
which one he drinks. The price of a 12-
ounce can of Coke is p, the price of a 12-
ounce can of Pepsi is p* and his weekly
cola budget is Y. Derive Mahdu’s demand
curve for Coke using the method
illustrated in Figure 5.1.

Solved Problem 5.2
(cont.)

Effects of a Rise in Income
• Engel curve - the relationship between

the quantity demanded of a single good
and income, holding prices constant.
• Income-consumption curve shows how
consumption of both goods changes when
income changes, while prices are held
constant.
5 - 10 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Wine, Gallons per year
Figure 5.2 Effect of a
Budget Increase on an
Individual’s Demand Curve
L1
2.8 e1
Budget Line, L
I1
0 26.7 Beer, Gallons per year
Price of beer, $ per unit

Y - Pb
W= b
PW PW 12
E1
Initial Values
D1
Pb = price of beer = $12 0 26.7 Beer, Gallons per year
PW = price of wine = $35
Y, Budget
$628
Y = Income = $419.
Income goes up! Y 1 = $419 E 1*
0 26.7 Beer, Gallons per year

Figure 5.2 Effect of a
Budget Increase on an
L2
Individual’s Demand Curve

L1
4.8 e2
2.8 e1
I2
Budget Line, L
I1
0 26.7 38.2 Beer, Gallons per year

Y - Pb
W= b
PW PW 12
E1 E2
Initial Values D2
D1
Pb = price of beer = $12 0 26.7 38.2 Beer, Gallons per year
Y, Budget
$628
Y = Income = $419.
Y 2 = $628 E 2*
Income goes up! Y 1 = $419 E 1*
0 26.7 38.2 Beer, Gallons per year

Figure 5.2 Effect of a L3
Budget Increase on an L2
Individual’s Demand Curve 7.1

L1
e3
Income-consumption curve
4.8 e2
2.8 e1 I3
I2
Budget Line, L
I1
0 26.7 38.2 49.1 Beer, Gallons per year

Y - Pb
W= b
PW PW 12
E1 E2 E3
Initial Values D3
D2
D1
Pb = price of beer = $12 0 26.7 38.2 49.1 Beer, Gallons per year
Y, Budget
Engel curve for beer
Y = Income = $837.
Y 3 = $837 E3*
Y 2 = $628 E 2*
Income goes up again! Y 1 = $419 E 1*
0 26.7 38.2 49.1 Beer, Gallons per year

Solved Problem 5.3
• Mahdu views Coke and Pepsi as perfect

substitutes. The price of a 12-ounce can
of Coke, p, is less than the price of a 12-
ounce can of Pepsi, p*. What does
Mahdu’s Engel curve for Coke look like?
How much does his weekly cola budget
have to rise for Mahdu to buy one more
can of Coke per week?

Solved
Problem 5.3

Consumer Theory and Income Elasticities
• Formally,
Q
%Q Q Q Y
  
%Y Y Y Q
Y
 where Y stands for income.
• Example
 If a 1% increase in income results in a 3% decrease in
quantity demanded, the income elasticity of demand is
 = -3%/1% = -3.

Consumer Theory and Income Elasticities
(cont.)
• Normal good - a commodity of which as

much or more is demanded as income
rises.
 Positive income elasticity.
• Inferior good - a commodity of which less

is demanded as income rises.
 Negative income elasticity.

Figure 5.3 Income-Consumption
Curves and Income Elasticities
• As income rises
Housing, Squarefeet per year
Food inferior,
housing normal the budget
ICC 1
constraint shifts to
L2
a
the right.
 The income
Food normal,
housing normal
elasticities depend
on….
ICC 2
b
• …where on the new
L1
budget constraint
the new optimal
consumption bundle
e will be
c
Food normal,
ICC 3 housing inferior
I
Food, Pounds per year

Figure 5.4 A Good (a) Indifference Curves and Budget Constraints
All other goods per year

That Is Both Inferior Y3 L3
and Normal Y2 L2
Income-consumption curve
e3
• When Gail was poor Y1 L

1
I3
and her income e2
increased.. e1 I2
 …she bought more I1
hamburger (b) Engel Curve

Hamburger peryear
• But as she became
Y, Income
Y3 E3
wealthier and her Y2

income rose…
E2
Engel curve
 ….she bought less Y1

E1
hamburger and more
steak. Hamburger peryear

Effects of a Price Change
• Substitution effect - the change in the

quantity of a good that a consumer
demands when the good’s price changes,
holding other prices and the consumer’s
utility constant.
• Income effect - the change in the

quantity of a good a consumer demands
because of a change in income, holding
prices constant.
Figure 5.5 Substitution and Income
Effects with Normal Goods
Budget Line, L1
1
Y1 PF
C= - 1
F
1
PC PC
Budget Line, L2 (increase in salary)
2
Y2 PF
C= 2
- 2
F
PC PC
1 1
 PC   PF

Figure 5.6
Giffen Good
Basketball, Tickets per year
When the price of movie tickets

L2
decreases the budget constraint
rotates out…
L1 e2
I2
e1 allowing the consumer to

increase her utility.
I1
Total effect Movies, Tickets per year
Nevertheless, the total effect is negative. WHY?
Figure 5.6
Giffen Good
Basketball, Tickets per year
• Even though the substitution
L2
effect is positive….
 …the income effect is larger
L1 e2
and negative (since this is an
inferior good).
L* I2
e1
e*
I1
Total effect Substitution effect Movies, Tickets per year
Income effect

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?

Inflation Indexes (cont.)
• Consumer Price Index (CPI) – measure the cost of a

standard bundle of goods for use in comparing prices
over time.
 We can use the CPI to calculate the real price of a

hamburger over time.
 In terms of 2008 dollars, the real price of a hamburger in

1955 was:
CPI for 2008 211.1

 price of a burger   15  1.18
CPI for 2005 26.8

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.
• Question: what is the difference between using the

CPI to adjust the long-term contract and using a true
cost-of-living adjustment, which holds utility constant?

Figure 5.7 The Consumer Price
Index
Budget Line, L1
C, Units of clothing pe year
But
Thesince
firm Klaas is
ensures 1
Y1 PF
Y1/pC1 better off, the
that Klaas canCPI
buy C= - 1
F
adjustment
the same bundle of PC
1
Pc
Y2 /pC2 overcompensates
goods in the second Budget Line, L2 (increase in salary)
for thethat
year change in
he chose 2
inflation
in the first year… Y2 PF
C1
e1 C= 2
- 2
F
PC Pc
e2 1 1
C2  PC   PF
I2
I1
L1 L2
F1 F2 Y1/pF1 Y2/pF2
F, Units offood peryear

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?

True Cost-of-Living Adjustment
Budget Line, L1
C, Units of clothing per year
1
Y1 PF
Y1/pC1 C= - 1
F
1
PC Pc
Y2 /pC2 Budget Line, L2 (increase in salary)
2
Y*/pC2 Y2 PF
C1
e1 C= 2
- 2
F
PC Pc
1 1
C2
e2  PC   PF
e*
I2
I1
L1 L* L2
F1 F2 Y1/p1F Y2* /pF2 Y2/pF2

F, Units of food per year

Table 5.1 Cost-of-Living
Adjustments

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.

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.

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.
• And her total income, Y, is her earned income plus her unearned
income, Y*:
Y = wH + Y*.

(a) Indifference Curves and Constraints
Time constraint
Figure 5.8 Demand
Y, Goods per day

for Leisure
I1
Budget Line, L1
L1
Y = w1H –w1
1 e1
Y1
0 N1 = 16 24 N, Leisure hours per day
Y = w1(24 − N). 24
(b) Demand Curve
H1 = 8 0 H, Work hours per day
Each extra hour of leisure w, Wage per hour
she consumes costs her w1

goods.
w1 E1
0 N1 = 16 N, Leisure hours per day

H1 = 8 H, Work hours per day

(a) Indifference Curves and Constraints
Y, Goods per day

I2 Time constraint
Figure 5.8 Demand L2
for Leisure –w2

1
I1
e2
Y2
Budget Line, L1
L1
Y = w1H –w1
1 e1
Y1
0 N2 = 12 N1 = 16 24 N, Leisure hours per day
Y = w1(24 − N). 24
(b) Demand Curve
H2 = 12 H1 = 8 0 H, Work hours per day
w, Wage per hour

Budget Line, L2
E2
w2
Y = w2H
Y = w2(24 − N). w1 E1
Demand for leisure
w2 > w1 0 N2 = 12
H2 = 12
N1 = 16
H1 = 8
N, Leisure hours per day
H, Work hours per day

Figure 5.9 Supply Curve of Labor

Figure 5.10 Income and Substitution
Y, Goods per d ay Effects of a Wage Change
I2 Time constraint
L2
Since income effect is

I1
positive, leisure is a normal
good.
L* e2
e*
L1 e1
0 N* N1 N 2 24 N, Leisure hours per d ay

24 H* H1 H 2 0 H, Work hours per d ay
Substitution effect Total effect
Income effect

Solved Problem 5.5
• 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?

Solved Problem 5.5 (cont.)

Figure 5.11 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….

Figure 5.12 The Relationship of U.S. Tax
Revenue and the Marginal Tax Rate

Figure 5.13 Per-Unit Versus Lump-
Sum Child Care Subsidies

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Chapter 5

• Deriving Demand Curves.

• How Changes in Income Shift Demand

• Effects of a Price Change.

• Deriving Labor Supply Curves.

5-2 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Wine, (W), Gallons per year

0 26.7 Beer (b), Gallons per year

Initial Values (b) Demand Curve

Beer (b), Gallons per year

5-3 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Wine, (W), Gallons per year

0 26.7 44.5 Beer (b), Gallons per year

New Values (b) Demand Curve

Price of beer goes down!

5-4 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Wine, (W), Gallons per year

0 26.7 44.5 58.9 Beer (b), Gallons per year

New Values (b) Demand Curve

Price of beer goes down 4.0

5-5 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• A line through optimal bundles at each

5-6 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• In Figure 5.1, how does Mimi’s utility at E1

5-7 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Mahdu views Coke, q, and Pepsi as

5-8 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

5-9 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Engel curve - the relationship between

5 - 10 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Price of beer, $ per unit

Pb = price of beer = $12 0 26.7 Beer, Gallons per year

PW = price of wine = $35

Income goes up! Y 1 = $419 E 1*

0 26.7 Beer, Gallons per year

5 - 11 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Individual’s Demand Curve

Price of beer, $ per unit

Pb = price of beer = $12 0 26.7 38.2 Beer, Gallons per year

PW = price of wine = $35

0 26.7 38.2 Beer, Gallons per year

5 - 12 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Individual’s Demand Curve 7.1

Price of beer, $ per unit

PW = price of wine = $35

0 26.7 38.2 49.1 Beer, Gallons per year

5 - 13 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Mahdu views Coke and Pepsi as perfect

5 - 14 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

5 - 15 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

5 - 16 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

• Normal good - a commodity of which as

• Inferior good - a commodity of which less

5 - 17 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Food, Pounds per year

5 - 18 Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

All other goods per year

• When Gail was poor Y1 L

 …she bought more I1

hamburger (b) Engel Curve

• But as she became

wealthier and her Y2

 ….she bought less Y1