bài giảng kinh tế vi mô tiếng anh ch5 applying consumer theory

• trace out the demand curve by holding income and the price of wine constant, and varying the price of beer • example: estimated set of indifference curves for the typical American cons

Chapter 5

Applying Consumer Theory

Key issues

1 deriving demand curves

2 income effect

3 effects of a price change

4 CPI bias

5 labor supply curve

Questions

1.What would happen if a consumer behaved

randomly?

2 Do we measure incomes in developing

countries accurately?

3 What are the effects of overtime laws?

4 What are the effects on hours of work of

tax cuts?

5 Can a flat tax be progressive?

• trace out the demand curve by holding income and the price of wine constant, and varying the price of beer

• example: estimated set of indifference curves for the typical American consumer are bowed away from origin, so beer and wine are imperfect substitutions

Deriving Demand Curves

Individual’s Demand Curve

4.3 12.0

2.8

12.0

6.0 4.0

26.7

L1(p b= $12)

p b, $ per unit

L2(p b= $6) L3( p b= $4)

26.7

e3

e2

e1

E3

E2

E1

I1

I2

I3

Beer, Gallons per year

Beer, Gallons per year

D1 , Demand for beer

Price-consumption curve

Wine, Gallons per year (a) Indifference Curves and Budget Constraints

(b) Demand Curve

Price-consumption curve

shows how the optimal pairs of beer and wine vary as the relative price varies

How income changes shift

demand curves

• hold prices fixed and vary income

• increase in income causes

• shift of the demand curve

• movement along income-consumption curve

• movement along the Engel curve

Increase on an Individual’s Demand Curve

per year

Income-consumption curve

Engel curve for beer

0 2.8 7.1

49.1 38.2 26.7 Beer, Gallons per year

0 12

0

49.1 38.2 26.7 Beer, Gallons per year

49.1 38.2 26.7 Beer, Gallons per year

I2 I3

I1

Price of beer,

$ per unit (b) Demand Curves

Y, Budget

(c) Engel Curve

e2

e3

E3

E1E2

Y1 = $419

Y2= $628

Y3 = $837

L3

L2

L1

e1

D D D1 2 3

E1 *

E2 *

E3 * Wine, Gallons

Income elasticities

• income elasticity:

• normal good: ξ > 0

• inferior good: ξ ≤ 0

percentage change in quantity demanded

percentage change in income

/

/

Q Q

Y Y

ξ=

∆

=

∆

Mimi's income elasticities

• beer: ξb = 0.88

• wine: ξw = 1.38

• both are normal goods

Are children inferior?

• mother with relative little education:

ξ = -0.18

• mother relatively well educated:

ξ = 0.044

Income-consumption curves and

income elasticities

• shape of income-consumption curve for 2 goods tells us sign of income elasticities

• some goods must be normal: not all goods can be inferior

Figure 5.3 Income-Consumption Curves and Income Elasticities

Housing, Square feet

per year

Food, Pounds per year

Food normal, housing normal

Food inferior,

housing normal

Food normal, housing inferior

b

c e

a

L1

L2

I

ICC2

ICC1

ICC3

Income elasticities may vary with

income

Gail may view hamburger as

• a normal good at a low income

• an inferior good at a high income

Is Both Inferior and Normal

Y2

Y1

Y1

Y2

Y3

Y3

L1

Y, Income

L2

L3

e2

e3

e1

E2

E3

E1

I1

I2

I3

Hamburger per year Income-consumption curve

Hamburger per year

All other goods per year (a) Indifference Curves and Budget Constraints

(b) Engel Curve

Engel curve

Quality and income elasticities

• when their incomes rise, some people buy higher quality goods rather than more of what they’re currently buying

• examples:

• fancier cars

• fancier foods

• designer clothing

Effects of a price change

as price of one good goes up (all else the

same), there are two effects:

• a substitution effect

• an income effect

Substitution effect

• consumers substitute other, now relatively cheaper, goods for the one whose price rose

• direction of the effect is unambiguous

Income effect

• price increase ⇒ consumers' buying power

falls, reducing “income” (opportunity set)

• so consumer buys less of at least some

goods

• direction of income effect depends on

income elasticity of each good

Income and substitution effects

positive negative

inferior good

negative negative

normal good

income effect substitution effect

price rise

Wine, Gallons

per year

12.0

5.5

0 26.7 30.6 58.9

Substitution effect Total effect Income effect

Beer, Gallons per year

I2

I1

L*

L2

L1

e2

e1

e *

Income and substitution effect with an inferior good

• substitution effect: opposite of price movement

• income effect: same direction as price movement

• Giffen good: good for which a decrease in its price causes the quantity demanded to fall

• potatoes in Ireland?

• quinine water for lab rats

Basketball,

Tickets per year

Movies, Tickets per year

L1

L*

Total effect

Income effect Substitution effect

L2

e1

e2

e*

I1

I2

Solved problem

• dinner plate manufacturer sells

• first-quality (perfect)

• second-quality (slight color defects) dinner plates

• manufacturer has an outlet store located next to its manufacturing plant

• [assume tastes same everywhere; cost of shipping

each plate from factory to distant stores is s]

Solved problem (cont.)

compared to sales at other stores, does the

outlet store sell

A a relatively large share of seconds

B the same ratio of first and second quality

plates

C a relatively small share of seconds?

Answer

• relative prices at outlet store:

• relative prices elsewhere:

•

• relative price of seconds rises—causing substitution away from seconds

• presumably the income effect is small

/

p p s

f

+ +

Shipping the Good Stuff Away

• expect larger share of higher-quality goods

shipped, greater per-unit shipping fee

• Hummels and Skiba (2002) examined

shipments between 6,000 country pairs for

more than 5,000 goods

Results

• doubling per unit shipping costs results in a

70 to 143% increase in average price (excluding cost of shipping) — larger share

of top-quality products shipped

• farther apart are trading countries, greater the cost of shipping—may explain relatively high-quality of Japanese goods

Results (cont.)

• ad valorem tariff raises relative price of

higher-quality goods (given that there is also a per unit

shipping fee)

• doubling ad valorem tariff decreases average price

three to four fold, as average quality falls

• thus, using an ad valorem rather than a specific

(per unit) tariff reduces quality of imported goods

Inflation

• because of inflation, prices today are not directly comparable to past prices

• inflation harms people on fixed incomes, net lenders, and others

Cost-of-living adjustments

many long-term contracts include

cost-of-living adjustments (COLAs):

• general business contracts

• rental

• alimony payments

• salaries

• pensions

Consumer Price Index (CPI)

• many governments report a cost-of-living measure: CPI

• measure of inflation: overall rise in prices over time

• CPI overestimates how true cost-of-living changes over time

• overestimate hurts you if your landlord increases rent on your apartment using CPI

Real vs nominal prices

• nominal price = “current dollars” price

• real price = “constant dollar” price (adjusted

for inflation)

•

• real price = nominal price divided by CPI

Government collects prices

on 364 individual goods and services, such as:

• housing

• dental services

• watch and jewelry repairs

• college tuition fees

• taxi fares

• women's hair pieces and wigs

• hearing aids

• slip covers and decorative pillows

• bananas

• funeral expenses

Summary statistics

• if government reports all price increases

separately, information is overwhelming

• instead use a single summary statistic, CPI:

how prices rose on average

Averaging

• one way to average price increases: weight the good equally

• but do we really want to weight price increase of skateboards as much as that of automobiles?

CPI approach

• give a larger weight to price change of a

good, the larger its budget share

• example: suppose CPI consists of only

clothing (C) and food (F)

Price of bundles

• CPI in Year 1:

• cost of buying first year’s bundle in second year is:

• how much income would have to rise to buy first year’s bundle in second year:

Y = p C +p F

+

= +

Calculate rate of inflation

Y2/Y1shows average price rise

1

CPI adjustment

• we assume price of clothing rose more rapidly than that of food

• CPI overcompensates (upward bias)

• utility rises because consumer substitutes toward the relatively cheaper good

C2

C1

C, Units of clothing

per year

e2

e1

I1

L1

e*

L* L2

I2

F, Units of food per year

Y2*/p2

F

Y1/p1

F

Y1/p1

C

Y */p2

C

F2

F

Y2/p2

C

Source of Bias

• CPI calculates price increase as Y2/Y1 We can rewrite this expression as

• Y*/Y1 = increase in true cost of living

• Y2/Y* = substitution bias in CPI (> 1 because Y2> Y*)

*

2 2

*

1 1

Y Y Y

Y =Y Y

Total CPI bias

CPI Commission concluded that CPI has a total

upward bias of about 1.1 percentage points per

year:

• substitution bias: 0.4 percentage points per year

• failure to take proper account of spread of

discount stores: 0.1 percentage point

• failure to account fully for quality improvements

and new products (drugs, computers): 0.6

percentage point

USPS

• in 2002, a typical union employee earned

$59,900 (including benefits)

• Substitution bias of 0.5% a year costs USPS

$300 extra per employee

• multiplied by 860,000 employees:

substitution bias costs USPS over

$257 million per year (and benefits its employees by same amount)

Federal Government

• CPI Commission concluded CPI is fourth

largest "federal program" after Social

Security, health care, defense

• $634 billion of national debt would be

eliminated in 5 years if CPI rose 1% less

rapidly per year

• gain to government would largely be at

expense of Social Security recipients

How rich are developing

countries?

• commonly used measure of income understates third-world country incomes relative to those of industrial nations

• problem: ignores substitution effects (as with CPI)

International Monetary Fund

• IMF used to report country’s income by

converting native currency into dollars at market

exchange rate

• IMF switched to using purchasing-power parities

(PPP), which take account of international

differences in prices

• used to report how much Chinese could buy at

high US prices, now use lower Chinese prices

Result

IMF now reports that third world's share of world's income went from

• 18% to 34% for developing countries

• 9% to 11% for Eastern Europe and the former Soviet Union

• 7% to 18% for Asia

• 73% to 54% for industrialized countries

More plausible

• old system: China's total income < Canada's; its

income per person only slightly > India

• improbable

• China has a high daily food consumption

• 70% of Chinese urban households have color TVs

• 81% have washing machines

• new Chinese av income is $1,950

• China's share of the world income rose from 2% to

6%, making it third-biggest economy behind U.S

(22.5%) and Japan (7.6%)

income

1999 U.S income distribution (solid)

2001 China income distribution (dashes)

Deriving labor supply curves

• use consumer-theory model to derive supply

curve of labor by deriving demand curve for

time spent not working

• time constraint:

H = 24 - N

Price of leisure

foregone earnings are greater for a lawyer who earns $250 an hour than for someone who works for minimum wage

Utility

• Jackie's utility,

U(Y, N)

• depends on

• goods she consumes, represented by her

Budget constraint

• her total income is:

Y = wH + Y*

• where

Time constraint

ƒ can’t increase hours in a day

ƒ vertical constraint at 24 hours of leisure

Figure 5.8

Demand for Leisure Y, Goodsper day

Time constraint

H2= 12 H1= 8

N2= 12 N1= 16

H, Work hours per day

N, Leisure hours per day

H2 = 12 H1 = 8

N2 = 12 N1 = 16 0

H, Work hours per day

N, Leisure hours per day

Demand for leisure

I2

I1 1

–w2

L1

L2

w, Wage

per hour (b) Demand Curve

–w1 1

e2

Y2

Y1

w1

w2

e1

E2

E1

Supply curve of labor

• her supply curve of hours worked (labor) is

“mirror image” of demand curve for leisure:

H = 24 - N

• for every extra hour of leisure she

consumes, she works one fewer hour

w, Wage

per hour

(a) Leisure Demand

Demand for leisure

w1 w2

16 12 0

N, Leisure hours per day

E1

E2

w, Wage

per hour

(b) Labor Supply

Supply of work hours

w1 w2

0

H, Work hours per day

e2

e1

Solved problem

• Mark’s utility function is

• his budget constraint is:

• How many hours a day does he chose to

work if the wage is w?

( , )

U U Y N= =YN

Y = wH

Answer

• substitute Mark’s budget constraint and his hours

2

U YN wH N w N N

w wN N wN wN

Income and substitution effects

increase in wage causes both income and

substitution effects that alter an individual's

demand for leisure and supply of hours

worked

Y, Goods

per day Time constraint

H2

H * H1

N2

N * N1

Substitution effect Income effect Total effect

H, Work hours per day

N, Leisure hours per day

I2

I1

L2

L*

L1

e2

e1 e*

Estimated labor supply curves

• typical British male

• slightly backward-sloping supply curve

• labor supply elasticity between –0.2 and –0.05

• American male workers

• vertical supply curve

• elasticity between –0.2 and 0.15 (best estimates is 0)

• unmarried women

• upward sloping

• elasticity between 0 and 4

Married women's supply curves

• slightly backward bending in Canada and U.S

• slightly forward sloping in U.K and Germany

Do animals make rational

choices?

• animals have to make choices between

scarce resources, as do humans

• income-leisure choices of pigeons

• “job”: pecking a response key for a 3

second access to a food hopper containing

mixed pigeon grains

• (I assume they used adult pigeons - so far as

I know, no one has ever seen a baby pigeon)

Wages and income

• wages could be altered by varying number of pecks required for a payoff from about 12 to 400

• income varied by providing free access for 3 seconds to food hopper at regular intervals

• by varying both wage rate and income, experimenters could determined pure (compensated) substitution effect of a wage change and income effect

Researchers found

• compensated substitution effect for leisure > 0: as

price of leisure falls and pigeons compensated

with more income, consumed more leisure

• leisure normal good: as pigeons' income increased

(food without working), pigeons consumed more

leisure by spending less time pecking

• pigeons' supply curve of labor is backward

bending

Rational pigeons

• if pigeons use arbitrary rule (such as working constant percent of time), would not respond to wage and income changes in this systematic, nonconstant manner

• apparently pigeons are rational enough to react consistently to variations in a price and income

Income tax rates and labor supply

• why care about shape of labor supply curves?

• if supply curves are upward sloping, income tax

causes

• people to work fewer hours

• reducing goods produced

• raising fewer tax revenues

• if supply curves slope backward, a small increase

in income tax rate may increase tax revenues and

increase total production

Bush tax cut

“I want all Americans to study my tax cut proposal.” – President George W Bush, February 6, 2001

Tax cuts

• Presidents John Kennedy and Ronald

Reagan argued that cutting marginal tax rate

would stimulate people to work more

• Reagan also claimed that, due to extra work,

tax receipts would increase

• because tax rates have adjusted substantially

over time, we have a natural experiment to

test this hypothesis

Tax rates

• Kennedy tax cuts: lowered top personal marginal tax rate from 91% to 70%

• rate fell over the next couple of decades