Transcript Chapter 6

Chapter 6
From Demand to Welfare
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Main Topics
Dissecting the effects of a price change
Measuring changes in consumer welfare
using demand curves
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Dissecting the Effects of a
Price 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 falls
Economists have learned a lot about
consumer demand and welfare from
thinking about price changes this way
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Dissecting the Effects of a
Price 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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if M=10, PB=0.25, then,
★if Ps=0.5, then choose A
★if Ps=1, purchasing power declines, L2,
and choose B
As P increases, consumer is worse off b/c
purchasing power is less
how much $ would need to give consumer
to compensate him for the higher P?
 if M=15 now, then L3 and C.
note that A~C
from L2-L3: the effect of compensation on
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BL
L1-L2: uncompensated price change:
price change with no change in M
L1-L3: Compensated price change:
price change and M change to leave the
consumer unaffected
What about a reduction of Ps?
the consumer is better off
L1-L3: compensated price change
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Compensated Price Effects
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Substitution and Income Effects
If we assume that the good is normal,
then the increase in price will result in a
fall in the quantity demanded.
This is for two reasons; the IE(have a
limited budget, therefore can purchase
lower quantities of the good) and the SE
(swap with alternative goods that are
cheaper).
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Due to the price of good x increasing, the
budget line has pivoted from B1 to B2
and the consumption point has moved.
The decrease in the quantity demanded
can be divided into two effects;
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1. SE: when the consumer switches
consumption due to the price change alone
but remains on the same indifference curve.
To identify the SE, a new BL needs to be
constructed. The BL B1* is added, this
budget line needs to be parallel with the BL
B2 and tangent to I1.
Therefore, the movement from Q1 to Q2 is
purely due to the SE
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2. IE: consumption changes due to the having
a change in purchasing power as a result of
the price change.
The higher price means BL is B2, hence the
optimum consumption point is Q2.
 This point is on a lower indifference curve
(I2).
Thus, in the case of a normal good, the IE
and SE work to reinforce each other.
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Direction of Substitution Effect
Substitution effect of price increase is:
Negative for price increase
Positive for price decrease
Consumer substitutes away from the
good that becomes relatively more
expensive
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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 power
Consumer 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 good
Positive for inferior good
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IE: an increase in P will reduce purchasing
power
this will reduce Q if good is normal and
increase Q if good is inferior
IE<0 if good is normal
IE>0 if good is inferior
Normal good: IE and SE move in same
direction, both are (-) if P increases and both
are (+) if P falls
inferior: IE and SE move in opposite direction:
when P increases, IE increases Q while SE
reduces it.
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Substitution & Income Effects for
Inferior Goods
IE and SE work in opposite directions
with inferior goods.
As the price of X rises there is a
decrease in real income. You can see
that point A is the original point for X* and
Y* on the original Budget Constraint .
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The price of X (inferior good) increased
therefore decreasing the real income
which caused the budget constraint to
rotate inward because the X intercept
changes as the price of X changes.
Since the price of X increased the SE
sets in as X is substituted by Y as shown
by the movement A-B.
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However, since X is an inferior good,
demand for X increases as income
decreases therefore countering the SE.
The IE is shown by the movement from
B-C.
C is where the combination of the
substitution effect and the income effect
settles.
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Why Do Demand Curves Slope
Downward?
The Law of Demand states that demand
curves slope downward
SE is always consistent with Law of Demand
For normal goods,IE reinforces substitution
effect
Normal goods always obey the Law of Demand
Theoretically, if IE for an inferior good is large
enough to offset substitution effect, could
violate Law of Demand
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A drop in the price of inferior good would
raise the purchasing power, making the
consumer better off: she will consume more
of the other goods and less of the inferior
good.
Extreme Inferiority: Giffen Goods
IE>SE
and D curve slopes upward
Giffen goods are inferior, and the amount
purchased increases as the price rises
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Giffen goods are hard to find b/c:
1. most goods are normal
2.if spending on a good is a small fraction
of M, a large increase in good’s P will not
affect M significantly
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Compensating Variation
How can a consumer measure economics gains and
losses in monetary terms? a common measure is
compensating variation
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
Example: if CV for road improvement =$100, then
the consumer is better off as long as his contribution
is <$100
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b/c 5$ fully compensate consumer from
an increase in P from 0.5 to 1, the
compensating variation for this P
increase is $5
the compensating variation for P
reduction is -$3.75
worked-out problem 6.2
in-text-exercise 6.2
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Compensated Price Effects
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Consumer Surplus
Consumer surplus is the net benefit a
consume receives from participating in the
market for some good
and, the amount of money that would
compensate the consumer for losing access to
the market, compensating variation
Consumer’s D curve measures the gross
benefit of consuming a good
Consumer surplus is area below the D curve
and above a horizontal line at the price
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if Q=1, the highest P the consumer is
willing to pay is $4000, but Q=0 if P is
higher.
Willingness to pay 1st and 2nd =$3000
and $2000 for 3 units and so on
the consumer’s net benefit is is the
difference between his gross benefit and
the amount he pays
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if P=$1500, the consumer will buy 3
units: he is:
willing to pay $4000 for the first, pays
$1500 and enjoys $2500
his net benefit from 2nd unit: $1500
net benefit from the 3rd =$500
his consumer surplus: 2500+1500+500
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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 $80
Must 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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