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Applications of Consumer Theory

Applications of Consumer Theory. Derivation of Demand; Income and Substitution Effects; In Kind vs Cash Transfers; Labor/leisure Tradeoff; CPI. Indifference Curves Describe Tastes of Individual Consumer. Derivation of demand. Individual Demand. P Q 2.5 40 5 20 10 10 .

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Applications of Consumer Theory

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  1. Applications of Consumer Theory Derivation of Demand; Income and Substitution Effects; In Kind vs Cash Transfers; Labor/leisure Tradeoff; CPI

  2. Indifference Curves Describe Tastes of Individual Consumer

  3. Derivation of demand

  4. Individual Demand PQ 2.5 40 5 20 10 10

  5. Income and Substitution Effects XN X0 Xs

  6. In-Kind vs Cash Transfers • Examples of In-Kind Transfers • Medicaid and Medicare • Distribution of Free Food • Housing Subsidies/vouchers • Is a Gift of 10 units of Good X (purchased at $5 per unit) equivalent to $50 in cash?

  7. Budget with Gift of 10 Units of X

  8. Consumer Indifferent Between In-Kind Transfer and Cash

  9. Consumer Better Off With Cash

  10. Summary • Cash transfers are more efficient than in-kind transfers (in this model) • Why are in-kind transfers popular? • Interdependent utility • Interest groups -- ex., agricultural lobby and food stamps

  11. The Labor Supply Decision • Two goods -- leisure and food (Y) • Wage rate fixed -- w • No non - labor income • Price of good Y=1 (Y is numeraire.)

  12. Labor/Leisure Trade Off

  13. Derivation of Labor Supply

  14. Example: Substitution Effect is Offset by Income Effect, Hours Worked Stay Same Intercept is w0T X0-Xs is substitution effect Xs to X1 is income effect New intercept is w1T Wage rate decreases Xs X0=X1

  15. Applications • What happens if there is non - labor income? • Budget line will have a vertical segment. Consumer can spend 16 hours at leisure and still consume NL of good Y. • Additional income will lead consumer to consume more of all normal goods -- including leisure. • Hours worked will decrease. • What is the effect of income tax on hours worked? • Slope of budget line will change to -w(1-t). • Substitution effect leads consumer to spend more time at leisure because it has become relatively cheaper. • Income effect leads consumer to buy less of normal goods -- including leisure.

  16. Problems with the CPI Does the CPI overstate Inflation?

  17. Problems with the CPI Income needed to be as happy as before. Income needed to buy old bundle

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