Chapter 6

From Demand to Welfare

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics

Dissecting the effects of a price changeMeasuring changes in consumer welfare

using demand curvesMeasuring changes in consumer welfare

using cost-of-living indexesLabor supply and the demand for leisure

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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

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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

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Figure 6.1: Compensated Price Effects

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Substitution and Income Effects

Uncompensated price change has two parts:Substitution effect: the effect of a

compensated price change, causing the consumer to substitute one good for another

Income effect: the effect on consumption of removing the compensation, affecting the consumer’s purchasing power

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Substitution and Income Effects

Substitution effect involves:Movement along an indifference curveTo a point where the slope is the same as

the new budget line

Income effect involves:Parallel shift in the budget constraint

Toward the origin for a price increaseAway from the origin for a price decrease

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Figure 6.2: Substitution and Income Effects

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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

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Figure 6.3: Direction of the Substitution Effect for a Price Increase

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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 inferior

Income effect of a price increase is:Negative for normal goodPositive for inferior good

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Figure 6.4: Direction of the Income Effect for a Price Increase

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Direction of Income and Substitution Effects

Substitution effect is:Negative for a price increasePositive for a price reduction

For a normal good, the income effect reinforces the substitution effect:Negative for a price increasePositive for a price reduction

For an inferior good, the income effect opposes the substitution effect:Positive for a price increaseNegative for a price reduction

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Why Do Demand Curves Slope Downward?

The Law of Demand states that demand curves slope downward

Substitution effect is always consistent with Law of Demand

For normal goods, income effect reinforces substitution effectNormal goods always obey the Law of Demand

Theoretically, if income effect for an inferior good is large enough to offset substitution effect, could violate Law of Demand

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Figure 6.5: Giffen Good

Giffen goods are inferior, and the amount purchased increases as the price rises

Income effect is larger than the substitution effect

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Compensating Variation

How can a consumer measure economics gains and losses in monetary terms?

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

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Consumer Surplus

Consumer surplus is the net benefit a consume receives from participating in the market for some good

Amount of money that would compensate the consumer for losing access to the market, compensating variation

Consumer’s demand curve measures the gross benefit of consuming a good

Consumer surplus is area below the demand curve and above a horizontal line at the price

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Figure 6.6: Consumer Surplus

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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

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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

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Measuring Changes in Consumer Welfare Using Cost-of-Living Indexes

A cost-of-living index measures the relative cost of achieving a fixed standard of living in different situations

Commonly used to measure changes in the cost of living over time

Can be used to measure changes in consumer well-being due to public policies that alter prices or income

Example: Consumer Price Index

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Cost-of-Living Indexes: Basics

Base value of one during some specific periodLevel of index in the base period is

unimportantAll that matters is percentage change in the

indexExample: Value of index in 1998 is 1; value in 2006

is 1.2, then cost of living has risen by 20%Ideally should allow us to quickly evaluate

changes in consumer well-being following changes in prices and income

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Cost-of-Living Indexes: Basics

Use to convert nominal income into real income

If real income has risen, then: Nominal income has grown more rapidly than then cost of

living Consumer should be better off

Ideally, change in real income should measure the change in the consumer’s well-being

Difficult to construct a good cost-of-living index because different prices change by different proportions

index living-of-cost of Value

income Nominal income Real

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Fixed-Weight Price Indexes

Select a consumption bundle and measure its cost in multiple time periods, using prices at which the goods were available

Fixed-weight price index: measures percentage change in the cost of a fixed consumption bundle

Easy to calculate, requires no information about consumer preferences

But what consumption bundle is appropriate?Example: Laspeyres price index

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Labor Supply

Consumer buy goods and servicesMany are also sellers (e.g., sell their

work effort)Labor supply refers to the sale of a

consumer’s time and effort to an employer

To study labor supply, economists often study demand for leisure

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Labor-Leisure Choice:An Example

Javier’s possible income sources:Allowance of $30 per day (no strings attached!)Job that pays $5 per hour

14 hours per day available to allocate toward work and leisure

Assume all money spent on foodDecision about how many hours of leisure to

enjoy (and thus how many to work) depends on his preferences

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Figure 6.10: Labor-Leisure Choice

With the dark red preferences, Javier chooses 8 hours of leisure (6 hours of work) per day

With the light red preferences, Javier chooses not to work

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Effect of Wages on Hours of Work

How does a change in wage affect a consumer’s budget line?

In Javier’s case, he will have $30 to spend on food regardless of his wage

Wage change rotates his budget line, getting steeper with higher hourly wages

Points of tangency between indifference curves and budget lines form a price-consumption path

This leads to Javier’s leisure demand curve in Figure 6.11(b)

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Figure 6.11: Leisure Demand and Labor Supply Curves

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Labor Demand Curves

Do labor demand curves obey the Law of Demand?

Some people may have backward bending labor supply curves

Increase in wage reduces the supply of labor for some range of wages

Due to income effects:People own more time than they consumeIncrease in wage rate raises their purchasing powerIncreases their consumption of leisure, a normal

good

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Figure 6.12: Effects of Increase in Wage Rate

Increase in wage rate leads to opposing income and substitution effects

Income effect overwhelms substitution effect

Wage increase results in reduced number of labor hours

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Effect of Wages on Labor Force Participation

Given that backward bending labor supply curves exist:Can a wage reduction cause someone who

would not otherwise work to enter the labor market?NO!

Can a wage increase drive someone who would otherwise work out of the labor market?NO!

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Figure 6.13: Effect of Wage Rate on Labor Force Participation

A wage lower than the wage represented on the black budget line cannot lead Javier to enter the labor force

A wage increase rotates the budget line upward and can entice him to choose to work (e.g., by selecting bundle G)

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