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Chapters 5: Using Consumer Choice Theory 1 Returning to the Concept of Consumer Surplus • Consumer surplus is a dollar measure of the extent to which a consumer (or many) benefits from participating in a transaction – Assuming that transactions occur voluntarily (implying that those engaging in them are better off than had the transactions not occurred), consumer surplus represents the difference in what one was willing to pay for a product/service and what one actually had to pay to obtain that product/service • The concept of consumer surplus is key to evaluating public policies such as taxation/subsidization, price ceilings/floors, etc. 2 Consumer Surplus P Consumer’s surplus P* Q 3 Algebra of Consumer Surplus 20 12 10 8 10 Consumer surplus before tax = 12 (20 10) 10 50 Consumer surplus after tax = 1 (20 12) 8 32 2 Change in C.S. after tax = 50 32 [(12 10) 8] [1/2 (12 10) (8 10)] 18 4 Price Elasticity and Consumer Surplus S1 S0 Loss in C.S. for inelastic demand Loss in C.S. for elastic demand Elastic Demand Inelastic Demand 5 Calculating Loss in Consumer Surplus Supply1 P Supply0 P Demand Q Q Q • Loss inConsumer Surplus (P Q) .5(P Q) 6 Taxation P ST S Deadweight Loss Loss in C.S. Tax Revenue Loss in P.S. D Q 7 Taxation on the Supply Side S2 S1 Pc Pno tax Pp A B F G E D C • Lost P.S. = FCDE • Lost C.S. = ABCF • Tax Revenue = ABDE • Deadweight Loss = BCD • Tax Paid By Consumer=ABFG • Tax Paid By Producer = FGDE D1 Pc = Price paid by consumer Pp = Price received by producer 8 Taxation on the Demand Side S Pc A Pno tax F Pp E • Lost P.S. = FCDE • Lost C.S. = ABCF • Tax Revenue = ABDE • Deadweight Loss = BCD • Tax Paid By Consumer=ABFG • Tax Paid By Producer = FGDE B G C D D2 D1 Pc = Price paid by consumer Pp = Price received by producer 9 Algebraic Example of Taxation QD 10,040 10P Q 6000 1000P S Supply and Demand Before Tax • The government imposes a $0.404/pack cigarette tax – What is the total amount of the tax? $0.404 9,996 $4030.38 – What percentage of the tax is paid by the consumers? $0.409,996 $3,998.4 99% of Tax – What percentage of the tax is paid by the producers? $0.004 9,996 $39.98 1% of Tax – What is the total deadweight loss of the tax? .5 ($0.404 4) $0.81 10 Burden of Taxation: Elastic Demand P ST S Loss in C.S. Loss in P.S. D Q 11 Burden of Taxation: Inelastic Demand ST P S Loss in C.S. Loss in P.S. D Q 12 Algebra of Taxation: Elastic and Inelastic Demand • Two demand curves (elastic & inelastic) have the same initial equilibrium price and quantity Supply : QS 850 P Elastic Demand : Qd (e ) 1450 5P P * 100, Q* 950 Inelastic Demand : Qd (i) 1000 .5P • Government imposes tax of $60 Supply Tax : QS T 790 P Elastic Demand : P eT 110, QeT 900 C.S. 9250 Inelastic Demand : P iT =140, QiT 930 C.S. 38,400 13 Bias in Consumer Price Index • Substitution Bias: The CPI does not take into account the fact that consumers will change their consumption basket as relative prices change. (Substitution Effect) • Quality Change: The CPI holds a basket of goods as fixed, when in fact the quality of some of the goods may be changing dramatically over time (e.g. the efficacy of pharmaceuticals) 14 CAFÉ Standards for Automobiles • Justification for government intervention – Imperfect information about long-term benefits – Imperfect capital markets – Externalities (pollution and national security) - estimated to be 12 cents per gallon • Government solution - regulations governing average fleet mileage – Fines imposed on those who don’t meet government standard • (Possible) consequences – Increased lobbying expenditure – Increased fleet sales – “Rebound Effect” 15 Graphical Depiction of CAFÉ Standards Supply with CAFÉ Standards Marginal Social Cost (MSC) Price of Automobiles Supply without CAFÉ Standards PC PE Demand for automobiles QC QE Quantity of Automobiles 16 Alternative Way to Meet Objective: Tax and Rebate $ Amount of rebate 17 Gasoline Strip Club Moratorium • Justification for government intervention: negative externalities • Government solution - restrict the number of strip clubs in Seattle to 4 (existing) clubs • (Possible) consequences – Higher prices – Economic profits – Possible loss of consumer surplus 18 Graphical Depiction of Strip Club Moratorium Regulated Regulated Supply = S1 Supply = S2 market supply Price Ps PE market demand QS QE Quantity of strip clubs 19 Intertemporal Choice • Just as consumers make decisions over the purchase of different combinations of goods, they make decisions about whether to purchase goods today or in the future • We can examine consumer preferences over intertemporal choice using the tradition IC framework – Intertemporal ICs show combinations of current/future consumption for which consumers are indifferent – The marginal rate of time preference (MRTP), which is the slope of the Intertemporal IC, shows the rate at which the consumer is willing to trade off consumption today versus consumption tomorrow – Consumers may exhibit positive, negative, or neutral time preference (most exhibit positive) 20 Factors Affecting Time Preferences • Inidividual preferences • Uncertainty about future events • Value of anticipated future utility/disutility • Preferences for a rising consumption standard 21 Graphical Illustration of Time Preferences C2 C2 C2 C1 Impatience C1 Neutrality C1 Patience 22 Intertemporal Budget Constraint • The intertemporal budget constraint is determined by r, the interest rate • Assuming consumers can borrow freely, the intertemporal budget constraint is represented by: C2 Y2 C1 Y1 1 r 1 r 23 Intertemporal Optimality C2 Y1 (1+r) + Y2 C2* C1* Y1+Y2(1+r)-1 C1 24 Changes in the Interest Rate and Optimality Y1 (1+r0) + Y2 • Interest rate begins at r0 • Interest rate falls from r0 to r1 Y1 (1+r1) + Y2 Y1+Y2(1+r0)-1 Y1+Y2(1+r1)-1 25 Algebraic Example of Intertemporal Choice If James earns $50,000 this year and will earn $60,000 next year, what is the maximum interest rate that would allow him to spend $100,000 this year? $50,000 $60,000 $100,000 1 r r .2 What is the minimum interest rate that would allow him to spend $115,000 next year? $50,000(1 r) $60,000 $115,000 r .1 26 Homo Economicus? • Some people may function as perfect examples of Homo Economicus, but most only approximate this behavior – We are satisfiers not maximizers, but this is rational! • Limitations of rationality – Asymmetric treatment of gains and losses (K-T value function) – Failure to appropriately ignore sunk costs – Judgmental heuristics and biases • Availability • Representativeness • Anchoring and adjustment • So long as people practice “bounded rationality” economic theory 27 is useful Kahneman-Tversky Value Function Value V(gain) loss Losses Gains gain V(loss) V(gain) V(loss) 28 Sunk Costs • James and AJ have the same preferences for movies. They’re both eager to see the latest summer blockbuster but work different schedules: James can only attend the matinee ($3.50) and AJ can only attend the evening show ($9.00). Halfway through the movie they both realize they hate it. Which is more likely to walk out? • K-T value function helps explain failure to ignore sunk costs! 29 K-T Value Function and the Market • Sellers, gift givers, etc. can “manipulate” consumers by: – Segregating gains (e.g. separate lottery wins) – Combining losses (e.g. state and fed tax delinquency notices) – Offsetting small loss with a larger gain (e.g. lottery and ink drop) – Segregating small gains from large losses (e.g. car rebate) • We see examples of all of these practices above in the marketplace 30 Graphical Depiction of K-T Practices A manufacturer offers a $1000 rebate on a car purchase 1000 1000 31 Judgmental Heuristics (Rules of Thumb) • Availability - memory research shows that it is easier to recall an event the more vivid, sensational, or recent it is – As a consequence, we often put too much weight on these type of events (e.g. murders and suicides in NYC, “r” as first or third letter) • Representativeness - we often overstate the importance of representative events – Judgments about muggings – Regression to the mean – Sophomore/SI jinx • Anchoring and adjustment - we often overstate the importance of the anchor (e.g. which is larger 1x2x3…x9 or 9x8x7…1) 32