Applying Consumer Theory

Chapter 5
Applying
Consumer Theory
Topics
1. Deriving Demand Curves.
2. How Changes in Income Shift Demand

Curves.
3. Effects of a Price Change.
4. Cost-of-Living Adjustments.
5. Deriving Labor Supply Curves.
Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-2

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

12.0
Figure 5.1 Deriving

an Individual’s
Demand Curve e1
2.8
Budget Line, L L1 (pb = $12) I1
0 26.7 Beer (b), Gallons per year
Y - Pb b
(b) Demand Curve
Initial optimal bundle of
W=
Pw
p b, $ per unit
Pw beer and wine
Initial Values
12.0 E1
Pb = price of beer = $12

Pw = price of wine = $35
Y = Income = $419.
Beer (b), Gallons per year
0 26.7


12.0
Figure 5.1 Deriving

an Individual’s e2
Demand Curve 4.3

e1
2.8 I2
Budget Line, L L1 (p b = $12) I1 L2 (p b = $6)
Y - Pb b
0 26.7 44.5 Beer (b), Gallons per year
W= Pw Pw (b) Demand Curve
p b , $ per unit
New Values
12.0 E1
E2
Y = Income = $419. 6.0
Price of beer goes down!

0 26.7 44.5 Beer (b), Gallons per year


12.0
Figure 5.1 Deriving Price-consumption curve

an Individual’s 5.2
e2
e3
Demand Curve 4.3
2.8
e1 I3
I2
Budget Line, L L1 (pb = $12) I1 L2 (pb = $6) L3 (p b = $4)
0 26.7 44.5 58.9 Beer (b), Gallons per year
Y - Pb b
W= Pw
(b) Demand Curve
Pw
p b, $ per unit
New Values 12.0 E1
Pw = price of wine = $35 6.0
E2
Y = Income = $419. 4.0

E3
D1, Demand for Beer
Price of beer goes down 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
• 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
5.1: Answer

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.

Wine, Gallons per year
L1
Figure 5.2 Effect of a

Budget Increase on an 2.8 e1
I1
Individual’s Demand
0 26.7 Beer, Gallons per year
Curve
Price of beer, $ per unit

Budget Line, L 12
E1
Y - Pb b
W= P
w Pw
D1
Initial Values 0 26.7 Beer, Gallons per year

Y, Budget
$628
Y = Income = $419.
Y 1 = $419 E 1*
Income goes up! 0 26.7 Beer, Gallons per year

Figure 5.2 Effect of a
Budget Increase on an L2
Individual’s Demand L1
Curve 4.8 e2
2.8 e1
I2
I1
0 26.7 38.2 Beer, Gallons per year
Budget Line, L

Y - Pb
W= b 12
E1 E2
PW PW
Initial Values D2
D1
Y, Budget
PW = price of wine = $35
$628
Y = Income = $419.
Y 2 = $628 E 2*
Y 1 = $419 E 1*
Income goes up!

Figure 5.2 Effect of

L3
a Budget Increase L2
on an Individual’s L1
e3
Income-consumption curve
Demand Curve
7.1
4.8 e2
2.8 e1 I3
I2
I1
0 26.7 38.2 49.1 Beer, Gallons per year
Budget Line, L

Y - Pb E1 E2 E3
b
12
W=
PW PW
D3
D2
Initial Values 0 26.7 38.2 49.1

D1
Beer, Gallons per year
Y, Budget
PW = price of wine = $35
Engel curve for beer
Y = Income = $837. Y 3 = $837
Y 2 = $628 E 2*
E 3*
Y 1 = $419 E 1*
Income goes up again! 0 26.7 38.2 49.1 Beer, Gallons per year

Solved Problem 5.2
• 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
5.2: Answer

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% increase
in quantity demanded, the income elasticity of
demand is x = 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
constraint shifts
L2
ICC 1
to the right.
a – The income
Food normal, elasticities
housing normal depend on where
ICC 2 on the new
L1 b budget constraint
the new optimal
consumption
e
bundle will be.
c
Food normal,
ICC 3 housing inferior
I
Food, Pounds peryear

Application: (a) Indifference Curves and Budget Constraints
All other goods per year

Fast-food Engel Y3 L3
Curve Y2 L2
Income-consumption curve
e3
• When Gail was poor
and her income
1
Y1 L I3
e2
increased she bought

more hamburger.
e1 I2
I1
Hamburger peryear
(b) Engel Curve
• But as she became
Y, Income
wealthier and her Y3 E3
income rose she Y2 E2

bought less Engel curve
hamburger and more Y1

E1
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 5.4 Substitution and
Income Effects with Normal
Goods

Solved Problem 5.3
• Kathy views apple pie and vanilla ice cream

as perfect complements. At the initial prices,
she consumed two pieces of pie per week.
After the price of pie rises, she chooses to
consume only one piece of pie. In a graph
similar to Figure 5.4, show the substitution,
income, and total effects of the price
change.

Solved Problem 5.3: Answer

Solved Problem 5.4
• Next to its plant, a manufacturer of dinner

plates has an outlet store that sells plates of
both first quality (perfect plates) and second
quality (plates with slight blemishes). The
outlet store sells a relatively large share of
seconds. At its regular stores elsewhere, the
firm sells many more first-quality plates
than second-quality plates. Why?

• Determine how the relative prices of plates

differ between the two types of stores.
• Use the relative price difference to explain
why relatively more seconds are bought at
the factory outlet.

Income and Substitution Effects
with an Inferior Good
• If a good is inferior, the income effect and
the substitution effect move in opposite
directions.
• For most inferior goods, the income effect is
smaller than the substitution effect.
• If the income effect more than offsets the
substitution effect, we have a Giffen good,
for which a decrease in its price causes the
quantity demanded to fall.

Solved Problem 5.5
• Ximing spends his money on rice, a Giffen

good, and all other goods. Show that when
the price of rice falls, Ximing buys less rice.
Decompose this total effect of a price
change on his rice consumption into a
substitution effect and an income effect.


Compensating Variation and
Equivalent Variation
• Compensating variation (CV): the
amount of money one would have to give a
consumer to offset completely the harm
from a price increase.
• Equivalent variation (EV): the amount of
money one would have to take from a
consumer to harm the consumer by as much
as the price increase.

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 2013 dollars, the real price of a hamburger

in 1955 was:
CPI for 2013 231.5

 price of a burger  15 ¢  $1.30
CPI for 1995 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 5.5 The Consumer Price
Index
C, Units of clothing pe year
The firm ensures

Y1 /pC1 that Klaas can buy
the same bundle of
Y2 /pC2 goods in the second
year that he chose
e1
in the first year…
C1
e2
C2
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
C, Units of clothing per year
Y1/pC1
Y2 /pC2
Y*/pC2
e1
C1
e2
C2
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

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%.

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.
• Her total income, Y, is her earned income plus

her unearned income, Y*:
Y = wH + Y*.

(a) Indifference Curves and Constraints
Figure 5.6 Time constraint
Y, Goods per day

Demand 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

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

I2 Time constraint
Demand for L2
Leisure (cont.) –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 5.7 Supply Curve of
Labor

Figure 5.8 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 N 2 24 N, Leisure hours per d ay

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

Solved Problem 5.6
• 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?


Figure 5.9 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 H 3 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 5.10 The Relationship of U.S. Tax
Revenue to the Marginal Tax Rate

Per-Hour Versus Lump-Sum
Child Care Subsidies

Applying Consumer Theory

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Chapter 5

1. Deriving Demand Curves.

2. How Changes in Income Shift Demand

3. Effects of a Price Change.

5. Deriving Labor Supply Curves.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-2

Wine, (W), Gallons per year

Figure 5.1 Deriving

Budget Line, L L1 (pb = $12) I1

0 26.7 Beer (b), Gallons per year

Pb = price of beer = $12

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-3

Wine, (W), Gallons per year

Figure 5.1 Deriving

Demand Curve 4.3

Budget Line, L L1 (p b = $12) I1 L2 (p b = $6)

Price of beer goes down!

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-4

Wine, (W), Gallons per year

Figure 5.1 Deriving Price-consumption curve

Demand Curve 4.3

Budget Line, L L1 (pb = $12) I1 L2 (pb = $6) L3 (p b = $4)

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

Y = Income = $419. 4.0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-5

• A line through optimal bundles at each price

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-6

• Mahdu views Coke, q, and Pepsi as perfect

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-7

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-8

• Engel curve - the relationship between the

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-9

Figure 5.2 Effect of a

Price of beer, $ per unit

Initial Values 0 26.7 Beer, Gallons per year

Pb = price of beer = $12

Income goes up! 0 26.7 Beer, Gallons per year

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-10

Price of beer, $ per unit

Pb = price of beer = $12

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-11

Wine, Gallons per year

Price of beer, $ per unit

Initial Values 0 26.7 38.2 49.1

Pb = price of beer = $12

Y = Income = $837. Y 3 = $837

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-12

• Mahdu views Coke and Pepsi as perfect

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• Inferior good - a commodity of which less

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Food, Pounds peryear

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All other goods per year

increased she bought

income rose she Y2 E2

hamburger and more Y1

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-18

• Substitution effect - the change in the

• Income effect - the change in the quantity

Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-19