Transcript Lecture 9
PPA 723: Managerial Economics Lecture 9: Applications of Consumer Choice Managerial Economics, Lecture 9: Applications of Consumer Choice Outline The Labor-Leisure Choice Application to welfare programs Measuring Consumer Welfare The concept of consumer surplus Managerial Economics, Lecture 9: Applications of Consumer Choice Deriving Labor Supply Curves Use consumer-maximization diagram with income (= all goods consumed) on the vertical axis and leisure (= nonwork) on the horizonal axis. Income equals the wage times hours worked. The wage rate is the price of leisure. Managerial Economics: Consumer Choice (a) Indifference Curves and Constraints Y, Goods per day Time constraint I2 L2 –w2 I1 Figure 5.8 Demand for Leisure 1 e2 Y2 L1 –w 1 1 e1 Y1 0 24 N 2 = 12 H2 = 12 N1 = 16 H1 = 8 24 0 N, Leisure hours per day H, Work hours per day (b) Demand Curve w, Wage per hour E2 w2 E1 w1 Demand for leisure 0 N2 = 12 H2 = 12 N 1 = 16 H1 = 8 N, Leisure hours per day H, Work hours per day Managerial Economics, Lecture 9: Applications of Consumer Choice Supply Curve of Labor The supply curve of hours worked (labor) is the “mirror image” the of demand curve for leisure: Every extra hour of leisure implies one fewer hours of work. Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 5.9 Supply Curve of Labor (a) Leisure Demand w, Wage per hour w2 w1 0 (b) Labor Supply Demand for leisure E2 E1 12 16 N, Leisure hours per day Supply of work hours w, Wage per hour w2 e2 e1 w1 0 8 12 H, Work hours per day Managerial Economics, Lecture 9: Applications of Consumer Choice Income and Substitution Effects A wage increase causes both income and substitution effects that alter an individual's demand for leisure and supply of hours worked. The substitution effect leads to more work. The income effect leads to more leisure. Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 5.10 Income and Substitution Effects of a Wage Change Y, Goods per day Time constraint I2 L2 I1 L* e2 e* L1 0 24 e1 N* H* N1 N 2 H1 H 2 Substitution effect Total effect Income effect 24 0 N, Leisure hours per day H, Work hours per day Managerial Economics, Lecture 9: Applications of Consumer Choice Leisure Choice with a Welfare Guarantee Time Constraint Goods per Day, Y -wage 1 0 L1 Guarantee L2 Leisure Hours per Day, L Work Hours per Day Managerial Economics, Lecture 9: Applications of Consumer Choice Leisure Choice with a Welfare Guarantee and “Tax” Rate Goods per Day, Y Time Constraint Slope = -w(1-t) Substitution Effect 0 Guarantee L1 Income Effect L2 L3 Leisure Hours per Day, L Work Hours per Day Managerial Economics, Lecture 9: Applications of Consumer Choice Leisure Choice with an EITC Goods per Day, Y Time Constraint Substitution Effect 0 L3 Income Effect Slope = -w(1+e) L1 L2 Leisure Hours per Day, L Work Hours per Day Managerial Economics, Lecture 9: Applications of Consumer Choice Gross Income vs. Earned Income Source: Clifford F. Thies on the mises.org blog. Managerial Economics, Lecture 9: Applications of Consumer Choice Implicit Marginal Tax Rates Source: Clifford F. Thies on the mises.org blog Managerial Economics, Lecture 9: Applications of Consumer Choice Welfare Programs: Lessons Income guarantees raise recipients’ utility but decrease their work effort. Income guarantees with benefit reduction rates decrease work effort even more. Training programs, child care credits, and the EITC raise utility while boosting work effort. Managerial Economics, Lecture 9: Applications of Consumer Choice Consumers’ Welfare Measuring welfare with utility functions is not practical for 2 reasons: we don't know individuals' utility functions we cannot compare utilities across individuals Instead, we measure consumer welfare in dollars of willingness to pay easier to measure than utility can compare dollars across individuals Managerial Economics, Lecture 9: Applications of Consumer Choice Measuring Consumer Welfare Consumer surplus (CS) from a good = benefit a consumer gets from consuming it (in $'s) minus its price how much more you'd be willing to pay than you did pay for a good A demand curve contains this information. A demand curve reflects a consumer's marginal benefit= the amount a consumer is willing to pay for an extra unit. Managerial Economics, Lecture 9: Applications of Consumer Choice Graphing an Individual's CS For each quantity, the consumer surplus is the difference between willingness to pay for another unit (the individual’s demand curve) and actual payment (the price) Total consumer surplus is the sum of these differences across all quantities consumed. Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 9.1a Consumer Surplus p, $ per magazine 5 (a) David’s Consumer Surplus a b 4 CS1 = $2 CS2 = $1 c 3 Price = $3 2 E 1 = $3 E2 = $3 E 3 = $3 Demand 1 0 1 2 3 4 5 q, Magazines per week Managerial Economics, Lecture 9: Applications of Consumer Choice Graphing Total CS in a Market For each quantity, the consumer surplus is the difference between willingness to pay for another unit (the market demand curve) and the market price Total consumer surplus is the sum of these differences across all quantities consumed. Managerial Economics, Lecture 9: Applications of Consumer Choice ’ Figure 9.1b Consumer Surplus p, $ per trading card Consumer surplus, CS p1 Expenditure, E Demand Marginal willingness to pay for the last unit of output q1 q, Trading cards per year Managerial Economics, Lecture 9: Applications of Consumer Choice Concluding Comment on CS As we will see, consumer surplus is a key concept in policy economics. It forms the basis for benefit-cost analysis. CS is used to determine whether a policy is efficient and to measure the distortion in behavior caused by a tax. Managerial Economics, Lecture 9: Applications of Consumer Choice Producer Surplus Suppliers’ gain from participating in a market, too. Their surplus is the difference between the amount for which a good sells and minimum amount necessary for the seller to produce that good. Managerial Economics, Lecture 9: Applications of Consumer Choice Measuring PS Using the Supply Curve Producer surplus for a competitive firm or market is: the area above supply curve (which, as we will later learn, is the MC curve) and below price line up to quantity sold Managerial Economics, Lecture 9: Applications of Consumer Choice Figure 9.3 Producer Surplus (a) A Firm’s Producer Surplus Supply p , Price per unit (b) Market Producer Surplus p, $ per unit Market supply curve 4 p PS1 = $3 PS 2 = $2 PS 3 = $1 Market price 3 p* 2 Producer surplus, PS 1 MC1 = $1 MC2 = $2 MC3 = $3 MC4 = $4 0 1 2 3 4 q, Units per week Variable cost, VC Q* Q, Units per year Managerial Economics, Lecture 9: Applications of Consumer Choice Producer Surplus and Social Welfare Some analysts define social welfare as consumer surplus plus producer surplus. Others focus exclusively on consumer surplus. This is an issue in normative analysis, that is, it involves value judgments.