Chapter 5

1. Chapter 5 Consumer surplus Household choice in input markets

2. Consumer Surplus • The difference between the maximum amount a person is willing to pay for a good and its current market price

3. Example - Consider consumer surplus in the market for hamburgers... Price ($) A $5.00 B C Demand E $2.50 1 2 3 7 Millions of hamburgers per month

4. Example - Consider consumer surplus in the market for hamburgers... Price ($) Price ($) Total consumer surplus A $5.00 B $5.00 C Demand Demand E E $2.50 $2.50 1 2 3 7 1 2 3 7 Millions of hamburgers per month

5. 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

6. 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...

7. 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

8. 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.

9. 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) A 24w B 0 24 Hours of leisure per day

10. Example-Suppose Sally’s market wage is $10 per hour. Income per day • 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. A $240 C $80 B 0 16 24 Hours of leisure per day

11. Example-suppose sally’s wage is $12 now Income per day • Suppose Sally’s market wage rises from $10 per hour to $12 per hour • Does she work MORE, or LESS? • Depends $288 A $240 $96 C’ $80 C B 0 16 24 Hours of leisure per day

12. 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.

13. 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.

14. 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

15. 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).

16. Interest • Interest = the opportunity cost of present spending. • When interest rates rise, present spending becomes more expensive.

17. 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.

18. 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.

19. 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.