Lecture 5

Lecture 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 ©2016 Pearson Education, Ltd. All rights reserved. 5-2

(a) Indifference Curves and Budget
Constraints
year
12.0
, Gallons
) per
Figure 5.1 Deriving
Wine, (W
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 Cu
rve
Initial optimal bundle of
W=
p,b $ per unit

Pw 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

(a) Indifference Curves and Budget
Constraints
year
12.0
, Gallons per
Figure 5.1 Deriving
Wine, (W )
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 Cu
rve
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

(a) Indif
erence
f Cu
es
rv and Budget Const
raints
year
12.0
, Gallons
) per
Figure 5.1 Deriving
Wine, (W
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= (b) Demand Cu
rve
p,b $ per unit

Pw Pw
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.

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.

, Gallons peryear
Wine
L1
Figure 5.2 Effect of a

Budget Increase on an 2.8 e1
I1
Individual’s Demand
0 26.7 Bee
,rGallons peryear
,r$ per unit

Curve
ice of bee
Budget Line, L 12
E1
Y - Pb
Pr
W= P b
w Pw
D1
Initial Values 0 26.7 Bee

,rGallons peryear

Y, Budget
$628
Y = Income = $419.
Y 1= $419 E1*
Income goes up! 0 26.7 Bee

,rGallons peryear

, Gallons peryear
Figure 5.2 Effect of a
Budget Increase on an L2
Individual’s Demand
Wine
L1
Curve 4.8 e2
2.8 e1
I2
I1
0 26.7 38.2 Bee
,rGallons peryear
Budget Line, L
,r$ per unit

Y - Pb
ice of bee
W= b 12
E1 E2
PW PW
Pr
Initial Values D2
D1
0 26.7 38.2 Bee
,rGallons peryear
Y, Budget
PW = price of wine = $35
$628
Y = Income = $419.
Y2= $628 E2*
Y1= $419 E1*
Income goes up!
0 26.7 38.2 Bee
,rGallons peryear

Figure 5.2 Effect of
, Gallons peryear
L3
a Budget Increase L2
Wine
on an Individual’s L1
e3
Income-consumption curve
Demand Curve
7.1
4.8 e2
e1 I3
2.8 I2
I1
0 26.7 38.2 49.1 Bee
,rGallons peryear
Budget Line, L
,r$ per unit

ice of bee
Y - Pb E1 E2 E3
b
12
W=
PW PW
Pr
D3
D2
Initial Values 0 26.7 38.2 49.1 Bee

D1
,rGallons peryear
Y, Budget
PW = price of wine = $35
Engel curve for beer
Y = Income = $837. Y 3= $837
Y 2= $628 E2*
E3*
Y 1= $419 E1*
Income goes up again! 0 26.7 38.2 49.1 Bee

,rGallons peryear

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.

Application: erence
(a) Indif
f Curves
and Budget Const
raints
year
Fast-food Engel Y3 L3
All other goods per

Curve Y2 L2
Income-consumption rve
cu
e3
• When Yaa was poor
and her income
1
Y1 L I3
e2
increased she bought

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

bought less Engel cu
rve
hamburger and more Y1

E1
steak.
Hamb
urger 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. It
describes how consumption is impacted
by changing relative income and prices.
• Income effect - the change in the quantity of
a good a consumer demands because of a
change in income, holding prices constant. It
expresses the impact of changed in
purchasing power on consumption

Figure 5.4 Substitution and
Income Effects with Normal
Goods

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. It is the adjustment in income that
returns the consumer to the original utility after an
economic change has occurred.
• In the case of a positive economic change (such as a fall in

price of a good), CV is often referred to as the maximum a
consumer is willing to pay in order to have the economic
change happen.
• When there is a negative economic change, CV is the

minimum the consumer needs in order to accept the
economic change.

• 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.
• It is the adjustment in income that changes the consumer’s utility

equal to the level that would occur IF the event had happened.
• In the case of a positive economic change, such as a fall in price,

EV would be the increase in income that would give the consumer
the same additional utility that would happen if a price did fall.
• In the case of a negative economic change, EV would be the

amount of income that would be taken away to lower the
consumer’s utility to the level that would happen if the change had
occurred.

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
, Units of
F of od per
year

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

, Units
F 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
Figure 5.6
Constraints
Time constraint
Y, Goods per
Demand for
day
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 Work hours per day
H,
Each extra hour of leisure age per hour
she consumes costs her w1

w, W
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
,YGoods per day

I2 Time raint
const
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). (b) Demand Curve

24 H2 = 12 H1 = 8 0 Work hours per day
H,
age per hour

Budget Line, L2
E2
w2
w, W
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
ay
Effects of a Wage Change
I2 Time const
raint
, Goods per d
L2
Since income effect is positive,

I1 leisure is a normal good.
Y
L* e2
e*
L1 e1
0 N* N1 N2 24 ,NLeisure hours per ay

d
24 H* H1 H2 0 H, Wor
k 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?

Solved Problem 5.6: Answer

Figure 5.9 Labor Supply Curve That Slopes
Upward and Then Bends Backward
(a) Labor-Leisure Choice (b) Supply Cu

rv
e of Labor
age per hour

Supply curve of labor
ay
, Goods per d
L3 I3 Time const
raint E3
w, W
I2
Y
E2
I1
e3
L2
e2 E1
L1 e1
24 H2 H H1 0 0 H1 H3 H2 24
3
H, Wor
k hours per d
ay H, Wor
k hours per d
ay
but
At low
at high
wages,
wages,
an increase
an increase
in the
in the
wage causes the worker to work
less….
more….
Figure 5.10 The Relationship of U.S. Tax
Revenue to the Marginal Tax Rate
The marginal tax rate is the

tax rate you pay on an
additional dollar of income.
Under a marginal tax rate,
taxpayers are most often
divided into tax brackets or
ranges, which determine the
rate applied to the taxable
income of the tax filer. As
income increases, the last
dollar earned will be taxed at
a higher rate than the first
dollar earned.

Lecture 5 - Application of Consumer Choice

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1. Deriving Demand Curves.

2. How Changes in Income Shift Demand

3. Effects of a Price Change.

5. Deriving Labor Supply Curves.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-2

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

0 26.7 Beer (b), Gallons per year

p,b $ per unit

Pb = price of beer = $12

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-3

Demand Curve 4.3

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

Price of beer goes down!

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-4

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

p,b $ per unit

Y = Income = $419. 4.0

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-5

• A line through optimal bundles at each price

• The demand curve corresponds to the price-

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-6

• Engel curve - the relationship between the

• Income-consumption curve shows how

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-7

Figure 5.2 Effect of a

,r$ per unit

Initial Values 0 26.7 Bee

Pb = price of beer = $12

Income goes up! 0 26.7 Bee

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-8

,r$ per unit

Pb = price of beer = $12

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-9

,r$ per unit

Initial Values 0 26.7 38.2 49.1 Bee

Pb = price of beer = $12

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

Income goes up again! 0 26.7 38.2 49.1 Bee

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-10

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-11

All other goods per

increased she bought

income rose she Y2 E2

hamburger and more Y1

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-12

• Substitution effect - the change in the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-13

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-14

• In the case of a positive economic change (such as a fall in

• When there is a negative economic change, CV is the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-15

• It is the adjustment in income that changes the consumer’s utility

• In the case of a positive economic change, such as a fall in price,

• In the case of a negative economic change, EV would be the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-16

• Inflation - the increase in the overall price

• How do we adjust for inflation to calculate

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 5-17

• Consumer Price Index (CPI) – measure the cost

– We can use the CPI to calculate the real price of a

– In terms of 2013 dollars, the real price of a hamburger