Chapter 5: Applying consumer theory

5 topics:
-Deriving demand curves
-How changes in income shift demand curves
-Effect of price change
-Cost-of-living adjustment
-Deriving labor supply curves

5.1-Deriving demand curves:

By deriving demand curve  relationship between consumer taste and shape of demand curve and summarized by
elasticity of demand.

Indifference curves and a rotating budget line:

If the price of a good drops (holding her budget and other goods constant) then consumer will get more and more
satisfaction and utility from consuming more  going on a higher indifference curve

Price-Consumption Price:
Price-consumption curve  line through the optimal bundles
Price-consumption curves can have different forms: flat, upward slopping
or downward slopping etc.

The demand curve corresponds to the price-consumption curve:

-From the price-consumption curve, possible to draw DCurve:

5.2-How changes in income shift demand curve:

Engel curve  relationship between the quantity demanded of a single good and income, holding prices constant
A change in income will shift the DCurve to the right meaning that the consumer can get more of both goods, meaning
that the ICurves will also shift outward creating an income-consumption curve

Consumer theory and income elasticities:

Income elasticity can be used to summarize the shape of Engel curve, shape of income-consumption curve or the
movement in demand curves when income increases
Let’s recall:
∆𝑄𝑄 𝑌𝑌
𝜉𝜉 = ; where ΔQ is the change in quantity and ΔY the change in income
∆𝑌𝑌 𝑄𝑄

Normal good  commodity of which ≥ is demanded as income rises  ξ ≥ 0

Inferior good  commodity of which < is demanded as income rises  ξ < 0
Income-consumption curves and income elasticities:
-Slope of income-consumption curves tells us of the elasticities for both goods is positive or negative

ICC1  Housing is a normal good because as the income

rises, consumer spends more on housing than in food, an
inferior good
ICC2  Housing is normal and food is normal meaning
that as the income rises, consumer spends equally on both
ICC3  Food is normal because as the income rises,
consumer spends more on food than in housing, an inferior
good

Some goods must be normal:

-Two goods cannot be inferior  both can be normal, one can be normal and the other inferior
-If despite rise in income, consumption of both goods does not change then money is saved (saving is normal good)
-In the case of fast-food  consumption differs depending on the level of income = more income you have, less fast-food
you consume  Engel curve is backward bending
5.3-Effects of a price change:
Substitution effect  change in the quantity of a good that a consumer demands when that good’s price rises,
holding other prices and the consumer’s utility constant
Income effect  change in quantity of a good that a consumer demands because of a change in income, holding
prices constant
Total effect can be broken up in 2 components  substitution effect and income effect: Total Effect = SEffect + IEffect
• Possible to counter the effect of price change by giving extra income

-Substitution effect causes a movement along an ICurve  consumer will get more of a less expensive good and will get
less of a less expensive one (will always be negative)
-Income effects’ sign will depend on the elasticity of income (positive or negative)

In the situation of perfect complements, no substitution effect but only income effect (SP 5.3)

-If a good is inferior, the income effect and the substitution effects move in opposite directions
-For most goods, IEffect is smaller than SEffect so TEffect moves in the same direction as SEffect but will be smaller

Income and substitution effects with an inferior good:

Giffen good: commodity for which a decrease in its price causes the quantity demanded to fall  very few real life
examples of such goods (Potato famine in Ireland in 19th century)

-Theoretically possible for the demand curve to be upward slopping but so rare that it is seen as a general statement 
when price of a good decreases then the consumer will consume less of this good to consume more of the others

Compensating variation and equivalent variation:

Compensating variation (CV)  amount of money one would ae to give a consumer to offset completely the harm
from a price increase or take from the consumer to offset the benefit from a price increase

Equivalent variation (EV)  amount of money one would have to take from a consumer to harm the consumer by
as much as the price increase or give to a consumer to benefit the consumer by as much as a price increase

5.4-Cost of living adjustments:

Inflation indexes  Overall rise of prices known as inflation:
Real versus Nominal prices:

Real price of a good  nominal

Price adjusted to inflation  real price

Consumer Price Index (CPI):

𝑪𝑪𝑪𝑪𝑪𝑪𝒇𝒇
𝑪𝑪𝑪𝑪𝑪𝑪𝒔𝒔
×𝒑𝒑𝟏𝟏 = real price; where CPIf is the most recent CPI, CPIs the oldest CPI and p1 the price of a good at given time

CPI  364 individuals goods and services  average of the price rises

Where Y1 and Y2 are the income on 2 different years

Effects of inflation adjustments:
CPI adjustment:
-Salaries that rise automatically with the rise of the CPI and if one good’s price rises more than the other from one year
to another then the consumer will be better off the second year because he will go on a higher ICurve 
overcompensated for the increase in prices
• One good (the one that didn’t rise as much) is relatively less expensive than the other  can be any of the two
goods because in both cases, he is overcompensated for the rise of the prices

True cost-of-living adjustment:

CPI adjustment overcompensates for inflation (automatic rise of salary)

-If there was no CPI adjustment but still a rise in price then consumers would lose in utility but the adjustment
overcompensates them meaning that they get more utility

Size of the CPI substitution bias:

CPI has an upward bias = individual’s utility rises if his income rises by as much as the CPI  substitution bias

To calculate the substitution bias:

; where Y*/Y1 is rise in true cost of living and Y2/Y* is the substitution bias

The term Y2/Y* will always be greater than 1 so will CPI overestimates true cost of living by X%

Faster some prices rise relative to others, the more pronounced is upward sloping

5.5-Deriving Labor Supply Curves:

Labor-Leisure choices:

-Either work more to get more money to > consumption of G&S or > leisure but gain less (forgone earnings)
-The more you gain, the more costly leisure is:

-We derive the function  higher

wage=less leisure and vice-versa
-The demand for leisure is the mirror
curve of the supply for work

Income and substitution effects:

-Rise in wage causes both income and substitution effects
-When wage rises but still works same amount of hours = higher income
-Leisure/work can be both inferior (not the 2 at the same time) or normal goods

Shape of the labor supply curve:

-People with higher income tend to work less

which is not rational because it means that
they gain less money but have more leisure
time

Income tax rates and labor supply:

-Increase in income tax may have consequences especially if the demand for L is upward slopping  people will not
want to have additional hours of work if most of the earnings are taken by the State then reduces tax revenue
-No economists have found that tax cuts would increase tax revenue  despite that, many politicians believe that it would
motivate individuals to work longer
-There is an optimum level of income tax which will give the State a maximum of tax revenue without bankrupting the
workers and still motivates them to work more hours

First part of the curve: individuals still willing to substitute leisure for more
work hours as to increase their revenue but if government taxes them too
heavily they will refuse to work more and will substitute work for more
leisure because it is not worth the effort