Ch5 Applying Consumer Theory

Price-consumption curve

Optimal bundles as one price changes

Reading a demand point off budget lines

Price = income ÷ intercept; quantity at that line's optimum

Income $20, snacks intercept 10, optimum 5 snacks. Demand point?

P = $2, Q = 5

Juice costs $4, juice intercept 20. Income?

$80

Income $80, snacks intercept 40. Price of snacks?

$2

Income-consumption curve

Optimal bundles as income changes

Engel curve

Quantity of a good plotted against income

Upward-sloping Engel curve

Normal good: quantity rises with income

Downward-sloping Engel curve

Inferior good: quantity falls as income rises

Can both goods be inferior?

No; the optimum would sit inside the budget line

Income elasticity formula

%ΔQ ÷ %ΔY

Income elasticity above 0

Normal good (quantity moves with income)

Income elasticity below 0

Inferior good (quantity moves against income)

Income elasticity above 1

Luxury: quantity rises faster than income

Quantity +4%, income −2%. Income elasticity?

−2 (inferior)

Price elasticity formula

(ΔQ/ΔP)·(P/Q)

Linear demand Q = a − bP: elasticity

−b·P/Q

Q = 8 − 0.1P at P = 30. Elasticity?

−0.6 (inelastic)

|ε| below 1

Inelastic: quantity changes less than proportionally to price

|ε| above 1

Elastic: quantity changes more than proportionally to price

Substitution effect

Quantity change from the relative price change, utility constant

Substitution effect direction

Always opposite to the price change

Income effect

Quantity change from the change in purchasing power

Normal good: income and substitution effects

Same direction

Inferior good: income and substitution effects

Opposite; substitution effect wins

Giffen good: income and substitution effects

Opposite; income effect wins

Giffen good's price falls: quantity

Falls, because the income effect outweighs substitution

Every Giffen good is...

Inferior, since only an opposing income effect can reverse demand

Isolating the substitution effect on a graph

New price slope tangent to the original indifference curve

E1 to E*

Substitution effect

E* to E2

Income effect

Tracks: 24 to 16 (E*) to 12. Substitution and income effects?

−8 and −4

Perfect complements: substitution effect

Zero: the compensated bundle stays at the same kink

Interest rate rises and Tom saves more

Substitution effect beats income effect

Nominal price

Price in current dollars

Real price

Price adjusted for inflation

Old price in today's dollars

P_old × CPI_new ÷ CPI_old

Under inflation, nominal prices are...

Higher than real prices

$20 at CPI 200, $25 at CPI 280. Real price?

Fell ($28 > $25)

What the CPI measures

Cost of a fixed typical-household basket

Does the CPI measure each person's inflation?

No; it uses typical household weights

Substitution bias

The CPI overstates cost-of-living increases

Price of leisure

The wage

Backward-bending labour supply

At high wages the income effect beats the substitution effect

Beer gets cheaper and wine consumption rises

Beer and wine are complements

Why wine demand can't be derived when only beer's price varies

Wine has only one price point

Possible Engel curve shapes

Straight, through the origin, even vertical

Vertical Engel curve: example

Life-saving drug at a fixed dose

Hamburgers as income rises

Normal at low income, inferior at high income

Recovering income from a bundle

Sum of price × quantity

Giffen good: example

Rice for very poor households

Compensating variation

Money after a price rise that restores original utility

Equivalent variation

Money taken at old prices causing the same utility loss

Core CPI

CPI excluding volatile items such as gasoline

COLA

Pay rise linked to CPI inflation

Effect of substitution bias on a COLA

Slightly overcompensates

True cost-of-living index

Holds utility constant and allows substitution

15¢ burger in 1955 (CPI 26.45) in 2016 dollars (CPI 240.2)

About $1.36

Goods with falling real prices

TVs, electronics, clothing, furniture

Goods with rising real prices

Tuition, healthcare, childcare

Labour-leisure income

wH + non-labour income

Higher wage: labour-leisure budget line

Steeper

Backward-bending labour supply: examples

Senior doctors, pilots, high-earning musicians

Consumer surplus

Area under the demand curve above the price paid