MicroEconomics theory and application 12th by browning an zupan chapter 05

 Develop an intertemporal model that illuminates the consumer’s choice to save or borrow and shows how changes in endowment and the interest rate affect that choice.. All rights reserve

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By Edgar K Browning & Mark A Zupan

John Wiley & Sons, Inc.

Chapter 5: Using Consumer Choice Theory

MICROECONOMICS: Theory & Applications

Prepared by Dr Della Lee Sue, Marist College

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 Analyze how a voucher program would affect the quantity

of educational services chosen by parents for their children

(continued)

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Learning Objectives (continued)

 Explore the impact of per-bag charges versus a fixed annual fee on the amount of trash generated by a community,

recycling, and household welfare

 Develop an intertemporal model that illuminates the

consumer’s choice to save or borrow and shows how

changes in endowment and the interest rate affect that

choice

 Understand how the theory of consumer choice can explain what types of financial assets an individual intent on saving

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5.1 EXCISE SUBSIDIES, HEALTH

CARE, AND CONSUMER WELFARE

Determine how an excise subsidy affects consumer welfare and why it results in a deadweight loss.

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Excise Subsidies, Health Care, and

Consumer Welfare

Excise subsidy – a form of subsidy in which the government

pays part of the per-unit price of a good and allows

consumers to purchase as many units as desired at the

subsidized price

 Example: tax credit for a expenditures on a specific good or service

 Lowers the price to the consumer or taxpayer

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Figure 5.1 - Excise versus Lump-Sum

Subsidy

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The Relative Effectiveness of a

Lump-Sum Transfer

 Lump-sum transfer – a form of subsidy in which the

government gives the consumer a cash grant to be spent in any way the recipient wants

 Cash transfer: has an income effect

 Excise subsidy: has both an income effect and a substitution effect

 Consequently, consumers prefer a cash grant but they do not necessarily purchase more of an otherwise subsidized good

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Using the Consumer Surplus Approach

 Implication – The consumer could be better off with an

alternative subsidy of the same cost to the government

 Deadweight loss – a measure of the aggregate loss in

well-being resulting from output not well-being at the efficient level

 It does NOT mean that the consumer is worse off under the excise subsidy than with no subsidy at all

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Figure 5.2 – Excise Subsidy Using

Consumer Surplus

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Subsidizing Consumption

 The government has two ways to subsidize consumption:

 Reduce the price

 Provide a particular quantity of the good or service at a price below the market price

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5.2 SUBSIDIZING HEALTH

INSURANCE: OBAMACARE

Examine how the public provision of a certain quantity of a good such as education may lead to less consumption of the good.

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Subsidizing Health Insurance: Obamacare

 Patient Protection and Affordable Care Act, enacted March

23, 2011

 Major goal: reduce the number of people without health insurance

 Program components:

 subsidization of individual health insurance purchases (discussed here)

 Expansion of existing government welfare programs

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The Basics of Obamacare

 Health insurance policy offering specific coverage

(determined by the government) to those eligible for the subsidy

 Regressive (subsidy decreases as income increases)

 Following slides: application of consumer choice theory to examine the effects of subsidization

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Figure 5.3 – Health Insurance Subsidy’s Effect on the Budget Line

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Bringing in Preferences

 Two alternatives

 Subsidy – uninsured recipient is left equally well off with subsidy

 Unrestricted cash transfer – recipient is better off with monetarily equivalent cash

transfer

 Outcome: deadweight loss (inefficiency)

 Considerations in ObamaCare legislation

 Mandate to require health insurance policy

 Pay a fine instead of participation in program

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Figure 5.4 – The Optimal Consumption

Choice and the Resultant Deadweight Loss

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Figure 5.5 - A Case Where Mandated

Insurance Harms Subsidy Recipients

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5.3 PUBLIC SCHOOLS AND THE

VOUCHER PROPOSAL

Analyze how a voucher program would affect the quantity of educational services chosen by parents for their children.

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Public Schools and the Voucher

Proposal

 Alternative form of subsidy: government offers a specific quantity of a good at a cost that is below market price

 Example: public school voucher

 Voucher program: a subsidy in which parents receive

vouchers that can be used to purchase education at any school of their choice

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Using Consumer Choice Theory to

Analyze Voucher Proposals

 Expected outcomes

 Some families purchase a larger quantity of educational services.

 Some families purchase a type of education that they view as superior.

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Figure 5.6 – Fixed-Quantity Subsidy:

Education

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5.4 PAYING FOR GARBAGE

Explore the impact of per-bag charges versus a fixed annual fee on the amount of trash generated by a community, recycling, and household welfare.

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Paying for Garbage

 Original trash collection plan: residents pay a fixed annual

price for pick up

 Those with less garbage subsidized those with more garbage

 New plan: residents purchase garbage collection bags at a

price that exceeds their cost, which generates a net revenue that is used to finance garbage collection services

 Each household pays cost of own trash disposal.

 Everyone has an incentive to reduce amount of trash generated.

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Figure 5.7 - Consumer Choice: Garbage Disposal

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Does Everyone Benefit?

Price-per-bag system:

 Each household has an incentive to reduce the amount of garbage generated so

everyone gains.

 Households with less than the average amount of trash gain

 BUT since the subsidy to the heavy users is removed, those who generate more than the average amount of trash lose.

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Figure 5.8 - Trash Disposal: The Bag

System

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5.5 THE CONSUMER’S CHOICE TO

SAVE OR BORROW

Develop an intertemporal model that illuminates the consumer’s choice to save or borrow and shows how changes in the consumer’s endowment and the interest rate affect that choice.

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The Consumer’s Choice to Save or

Borrow

 Decision to save (or borrow): a decision to rearrange

consumption between various time periods

 What factors influence decisions to save or borrow?

 Current income

 Future income

 Interest rate

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Endowment Point

 Endowment point: the consumption mix available to the

individual if no saving or borrowing takes place

 By saving or borrowing, the consumer can choose a

different market basket

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Figure 5.9 –

Consumer Choice over Two Time Periods

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A Change in Endowment

Endowment Point can change due to

 Change in current income

 Change in future income

 Change in interest rate

 Circumstances in intertemporal choice between saving and borrowing

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Figure 5.10 - An Income Change and

Intertemporal Choice

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Figure 5.11 - Social Security and Saving

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Figure 5.12 - A Change in Interest Rate

on Saving or Borrowing

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5.6 INVESTOR CHOICE

Understand how the theory of consumer choice can explain what types of financial assets an individual intent on saving for the future should invest

in, or purchase.

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Investor Choice - Terminology

 Two characteristics of financial assets:

 return

 risk

 Tradeoff between return and risk

 Expected return – the summed value of each possible rate

of return weighted by its probability

 Expected utility – the summed value of each possible

utility weighted by its probability

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Risk: Attitude and Utility

prospect that generates the same expected return

as from an uncertain prospect generating the same expected return

from an uncertain prospect generating the same expected return

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Figure 5.13 - The Return-Risk Tradeoff

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Figure 5.14 - Differences in Individuals’ Risk-Return Preferences

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Figure 5.15 - Investor Preferences and

Risk

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Minimizing Exposure to Risk

 Insurance – an arrangement by which the consumer pays a

premium in return for the promise that the insurer will

provide compensation for losses due to misfortune

 Diversification – investing a given amount of resources in

numerous independent projects instead of a single project in order to minimize exposure to risk

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Figure 5.16 – Pricing Insurance

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