Transcript week8-2 - GEOCITIES.ws

Chapter 5
Consumer surplus
Household choice in input markets
Consumer Surplus
• The difference between the maximum
amount a person is willing to pay for a good
and its current market price
Example - Consider consumer surplus in the
market for hamburgers...
Price ($)
$5.00
A
B
C
Demand
E
$2.50
1 2 3
7
Millions of hamburgers per
month
Example - Consider consumer surplus in
the market for hamburgers...
Price ($)
Price ($)
Total consumer surplus
A
$5.00
B
$5.00
C
Demand
E
$2.50
1 2 3
7
Demand
E
$2.50
1 2 3
Millions of hamburgers per month
7
Diamond/water paradox
• Water:
– greatest value in use, little value in exchange
– Plentiful supply
– Each of us enjoys an enormous consumer
surplus
• Diamond
– Greatest value in exchange, little value in use
Household Choice in Input Markets
• Households must sell land, labor, and
capital in markets for inputs in order to earn
the income that they spend on goods and
services.
• We will focus on the labor supply decision...
Labor supply
• In labor markets, households must decide:
– Whether to work
– How much to work
– What kind of a job to take
• These decisions are affected by:
– The availability of jobs
– Market wage rates
– The skill possessed by the household
Labor or Leisure?
• The labor supply decision involves a choice
between consuming “labor” or “leisure”.
• Labor is defined as working in exchange for
a wage.
• Leisure is defined as time spent doing
nonmarket activities.
Example-Suppose Sally’s market wage
is $10 per hour.
Income per day
• Consider Sally. She has 24
hours per day to allocate
between labor and leisure.
• If Sally chooses no hours of
leisure per day, she will earn 24
times her hourly wage. (A)
• If Sally chooses no hours of
work per day, she will earn no
income but will enjoy 24 hours
of leisure.(B)
24w A
0
B
24
Hours of leisure per day
Example-Suppose Sally’s market wage
is $10 per hour.
Income per day
$240
$80
0
A
C
16
• Sally could choose to work
24 hours per day and earn
$240. (A)
• Sally could choose to work
no hours and earn no income.
(B)
• Sally could choose to work 8
hours per day, earn $80, and
“buy” 16 hours of leisure. (C)
• The “price” of leisure is $10
per hour.
B
24
Hours of leisure per day
Example-suppose sally’s wage is $12 now
Income per day
$288
$240
A
C’
C
$96
$80
0
16
• Suppose Sally’s
market wage rises
from $10 per hour
to $12 per hour
• Does she work
MORE, or LESS?
• Depends
B
24
Hours of leisure per day
What if wages increase?
• Consider the household’s response to an
increase in wages.
– The income effect says that the household can
now afford to buy more leisure,
however,
– the substitution effect says that the opportunity
cost of leisure is now higher; given the law of
demand, the household will buy less leisure.
Labor Supply Curve
• A diagram that shows the quantity of labor
supplied as a function of the wage rate
• Its shape depends on the income and
substitution effects of a wage change.
Labor supply curve
• Since either of these effects can dominate, the labor
supply curve can have several different shapes.
Income effect > Substitution effect
Substitution effect > Income effect
Wage rate
Wage rate $/hour
$12
$10
Units of labor
Units of labor
Saving and Borrowing: Present
vs. Future Consumption
• Households can use present income to
finance future spending (i.e., save), or they
can use future funds to finance present
spending (i.e., borrow).
Interest
• Interest = the opportunity cost of present
spending.
• When interest rates rise, present spending
becomes more expensive.
Changes in interest rates have
income and substitution effects.
• SUPPOSE INTEREST RATES RISE:
• Income effect: Households will now earn
more on all previous savings, so they will
save less
• Substitution effect: The opportunity cost of
present consumption is now higher; given
the law of demand, the household will save
more.
Financial capital market
• The complex set of institutions in which
suppliers of capital (households that save)
and the demand for capital (business firms
wanting to invest) interact.
• We won’t discuss in detail in our class.
Chapter Summary
• A household’s opportunity set describes what can
be purchased; along with utility theory, it helps to
describe what will be purchased.
• A household’s utility maximizing bundle of
outputs has equal marginal utility per dollar spent
on each good.
• The labor supply curve can be upsloping or
backward bending, depending upon the relative
strength of income and substitution effects.
• Saving and borrowing decisions depend on
interest rates.