Upload
mira
View
33
Download
0
Tags:
Embed Size (px)
DESCRIPTION
Chapter 6. From Demand to Welfare. 1. Main Topics. Dissecting the effects of a price change Measuring changes in consumer welfare using demand curves Labor supply and the demand for leisure. 2. Dissecting the Effects of a Price Change. When a price increases two things happen: - PowerPoint PPT Presentation
Citation preview
1
Chapter 6
From Demand to Welfare
Main Topics
Dissecting the effects of a price changeMeasuring changes in consumer welfare
using demand curves
2
3
Dissecting the Effects of aPrice Change
When a price increases two things happen:That good becomes expensive relative to
others; consumers shift their purchases away from the more expensive good
Consumers’ purchasing power fallsEconomists have learned a lot about
consumer demand and welfare from thinking about price changes this way
4
Dissecting the Effects of aPrice Change
As the price of a good changes, the consumer’s well-being varies
An uncompensated price change is one with no change in income
A compensated price change is a price change and an income change that together leave the consumer’s well-being unaffected
5
if M=10, PB=0.25, then, ★if Ps=0.5, then choose A★if Ps=1, purchasing power declines, L2, and
choose BAs P increases, consumer is worse off b/c
purchasing power is lesshow much $ would need to give consumer
to compensate him for the higher P? if M=15 now, then L3 and C.note that A~Cfrom L2-L3: the effect of compensation on
BL
6
L1-L2: uncompensated price change: price change with no change in M
L1-L3: Compensated price change:price change and M change to leave the consumer unaffected
What about a reduction of Ps?the consumer is better offL1-L3: compensated price change
7
Compensated Price Effects
If we assume that the good is normal, then the increase in price will result in a fall in the quantity demanded.
This is for two reasons; the IE(have a limited budget, therefore can purchase lower quantities of the good) and the SE (swap with alternative goods that are cheaper).
8
Substitution and Income Effects
Due to the price of good x increasing, the budget line has pivoted from B1 to B2 and the consumption point has moved.
The decrease in the quantity demanded can be divided into two effects;
9
1. SE: when the consumer switches consumption due to the price change alone but remains on the same indifference curve. To identify the SE, a new BL needs to be constructed. The BL B1* is added, this budget line needs to be parallel with the BL B2 and tangent to I1.Therefore, the movement from Q1 to Q2 is purely due to the SE
10
2. IE: consumption changes due to the having a change in purchasing power as a result of the price change. The higher price means BL is B2, hence the optimum consumption point is Q2. This point is on a lower indifference curve (I2).Thus, in the case of a normal good, the IE and SE work to reinforce each other.
11
12
13
Direction of Substitution Effect
Substitution effect of price increase is:Negative for price increasePositive for price decrease
Consumer substitutes away from the good that becomes relatively more expensive
14
14
Direction of Income Effect
Direction of income effect depends on whether the good is normal or inferior
Increase in the good’s price reduces the consumer’s purchasing powerConsumer will buy less of the good if it is normal,
but more if it is inferiorIncome effect of a price increase is:
Negative for normal goodPositive for inferior good
15
15
IE: an increase in P will reduce purchasing power
this will reduce Q if good is normal and increase Q if good is inferior
IE<0 if good is normalIE>0 if good is inferiorNormal good: IE and SE move in same same
directiondirection, both are (-) if P increases and both are (+) if P falls
inferior: IE and SE move in opposite directionopposite direction: when P increases, IE increases Q while SE reduces it.
16
Substitution & Income Effects for Inferior Goods
IE and SE work in opposite directions with inferior goods.
As the price of X rises there is a decrease in real income. You can see that point A is the original point for X* and Y* on the original Budget Constraint .
16
The price of X (inferior good) increased therefore decreasing the real income which caused the budget constraint to rotate inward because the X intercept changes as the price of X changes.
Since the price of X increased the SE sets in as X is substituted by Y as shown by the movement A-B.
17
18
However, since X is an inferior good, demand for X increases as income decreases therefore countering the SE.
The IE is shown by the movement from B-C.
C is where the combination of the substitution effect and the income effect settles.
19
20
Why Do Demand Curves Slope Downward?
The Law of Demand states that demand curves slope downward
SE is always consistent with Law of DemandFor normal goods,IE reinforces substitution
effectNormal goods always obey the Law of Demand
Theoretically, if IE for an inferior good is large enough to offset substitution effect, could violate Law of Demand
19
A drop in the price of inferior good would raise the purchasing power, making the consumer better off: she will consume more of the other goods and less of the inferior good.
Extreme Inferiority: Giffen GoodsIE>SEand D curve slopes upwardGiffen goods are inferior, and the amount
purchased increases as the price rises
21
22
23
Giffen goods are hard to find b/c:1. most goods are normal2.if spending on a good is a small fraction
of M, a large increase in good’s P will not affect M significantly
24
Compensating VariationHow can a consumer measure economics gains and
losses in monetary terms? a common measure is compensating variation
Compensating variation: the amount of money that exactly compensates the consumer for a change in circumstances
Example: If the compensating variation for a gasoline tax is $50, then the consumer is better off with the tax as long as he receives a rebate for more than $50
Example: if CV for road improvement =$100, then the consumer is better off as long as his contribution is <$100
25
b/c 5$ fully compensate consumer from an increase in P from 0.5 to 1, the compensating variation for this P increase is $5
the compensating variation for P reduction is -$3.75
worked-out problem 6.2in-text-exercise 6.2
24
26
Compensated Price Effects
27
Consumer SurplusConsumer surplus is the net benefit a
consume receives from participating in the market for some good
and, the amount of money that would compensate the consumer for losing access to the market, compensating variation
Consumer’s D curve measures the gross benefit of consuming a good
Consumer surplus is area below the D curve and above a horizontal line at the price
28
if Q=1, the highest P the consumer is willing to pay is $4000, but Q=0 if P is higher.
Willingness to pay 1st and 2nd =$3000 and $2000 for 3 units and so on
the consumer’s net benefit is is the difference between his gross benefit and the amount he pays
29
if P=$1500, the consumer will buy 3 units: he is:
willing to pay $4000 for the first, pays $1500 and enjoys $2500
his net benefit from 2nd unit: $1500net benefit from the 3rd =$500 his consumer surplus: 2500+1500+500
30
Figure 6.6: Consumer Surplus
31
Using Consumer Surplus to Measure Changes in Welfare
Some public policies alter prices and amounts of traded goods
Consumer surplus is useful, allows us to measure change in net economic benefit from the policy
This is another way to describe compensating variation for the policy
Example:Policy reduces consumer surplus from $100 to $80Must provide her with $20 to compensate fully for
the policy’s effects
6-2030
32
Figure 6.7: Change in Consumer Surplus
When price = $2, consumer surplus is grey and brown shaded areas
When price = $4, consumer surplus is grey area
Brown area is change in consumer surplus