Key issues

1. Key issues 1. deriving demand curves 2. income effect 3. effects of a price change 4. CPI bias 5. labor supply curve

2. trace out the demand curve by holding income and the price of wine constant, and varying the price of beer example: estimated set of indifference curves for the typical American consumer are bowed away from origin, so beer and wine are imperfect substitutions Deriving Demand Curves

4. Deriving an Individual’sDemand Curve

5. Price-consumption curve shows how the optimal pairs of beer and wine vary as the relative price varies

6. How income changes shift demand curves • hold prices fixed and vary income • increase in income causes • shift of the demand curve • movement along income-consumption curve • movement along the Engel curve

7. Effect of a Budget Increase on an Individual’s Demand Curve

8. Income elasticities • income elasticity: • normal good: EI> 0 • inferior good: EI 0

9. Mimi's income elasticities • beer: Eb = 0.88 • wine: Ew = 1.38 • both are normal goods

10. Are children inferior? • mother with relative little education: EI = -0.18 • mother relatively well educated: EI = 0.044

11. Income-consumption curves and income elasticities • shape of income-consumption curve for 2 goods tells us sign of income elasticities • some goods must be normal: not all goods can be inferior

12. Income-Consumption Curves and Income Elasticities

13. Income elasticities may vary with income Gail may view hamburger as • a normal good at a low income • an inferior good at a high income

14. A Good That Is Both Inferior and Normal

15. Quality and income elasticities • when their incomes rise, some people buy higher quality goods rather than more of what they’re currently buying • examples: • fancier cars • fancier foods • designer clothing

16. Effects of a price change as price of one good goes up (all else the same), there are two effects: • a substitution effect • an income effect

17. Substitution effect • consumers substitute other, now relatively cheaper, goods for the one whose price rose • direction of the effect is unambiguous

18. Income effect • price increase  consumers' buying power falls, reducing “income” (opportunity set) • so consumer buys less of at least some goods • direction of income effect depends on income elasticity of each good

19. Income and substitution effects

20. Substitution and Income Effects with Normal Goods

21. Income and substitution effect with an inferior good • substitution effect: opposite of price movement • income effect: same direction as price movement • Giffen good: good for which a decrease in its price causes the quantity demanded to fall • potatoes in Ireland? • quinine water for lab rats

22. Giffen Good

23. Inflation • because of inflation, prices today are not directly comparable to past prices • inflation harms people on fixed incomes, net lenders, and others

26. Cost-of-living adjustments many long-term contracts include cost-of-living adjustments (COLAs): • general business contracts • rental • alimony payments • salaries • pensions

28. Consumer Price Index (CPI) • many governments report a cost-of-living measure: CPI • measure of inflation: overall rise in prices over time • CPI overestimates how true cost-of-living changes over time • overestimate hurts you if your landlord increases rent on your apartment using CPI

29. Real vs. nominal prices • nominal price = “current dollars” price • real price = “constant dollar” price (adjusted for inflation) • real price = nominal price divided by CPI

30. Government collects prices on 364 individual goods and services, such as: • housing • dental services • watch and jewelry repairs • college tuition fees • taxi fares • women's hair pieces and wigs • hearing aids • slip covers and decorative pillows • bananas • funeral expenses

31. Summary statistics • if government reports all price increases separately, information is overwhelming • instead use a single summary statistic, CPI: how prices rose on average

32. Averaging • one way to average price increases: weight the good equally • but do we really want to weight price increase of skateboards as much as that of automobiles?

33. CPI approach • give a larger weight to price change of a good, the larger its budget share • example: suppose CPI consists of only clothing (C) and food (F)

34. Price of bundles

35. Calculate rate of inflation

36. CPI adjustment • we assume price of clothing rose more rapidly than that of food • CPI overcompensates (upward bias) • utility rises because consumer substitutes toward the relatively cheaper good

37. The Consumer Price Index

38. Source of Bias

39. Total CPI bias CPI Commission concluded that CPI has a total upward bias of about 1.1 percentage points per year: • substitution bias: 0.4 percentage points per year • failure to take proper account of spread of discount stores: 0.1 percentage point • failure to account fully for quality improvements and new products (drugs, computers): 0.6 percentage point

40. USPS • in 2002, a typical union employee earned $59,900 (including benefits) • Substitution bias of 0.5% a year costs USPS $300 extra per employee • multiplied by 860,000 employees: substitution bias costs USPS over $257 million per year (and benefits its employees by same amount)

42. Federal Government • CPI Commission concluded CPI is fourth largest "federal program" after Social Security, health care, defense • $634 billion of national debt would be eliminated in 5 years if CPI rose 1% less rapidly per year • gain to government would largely be at expense of Social Security recipients

43. How rich are developing countries? • commonly used measure of income understates third-world country incomes relative to those of industrial nations • problem: ignores substitution effects (as with CPI)

44. International Monetary Fund • IMF used to report country’s income by converting native currency into dollars at market exchange rate • IMF switched to using purchasing-power parities (PPP), which take account of international differences in prices • used to report how much Chinese could buy at high US prices, now use lower Chinese prices

45. Result IMF now reports that third world's share of world's income went from • 18% to 34% for developing countries • 9% to 11% for Eastern Europe and the former Soviet Union • 7% to 18% for Asia • 73% to 54% for industrialized countries

47. More plausible • old system: China's total income < Canada's; its income per person only slightly > India • improbable • China has a high daily food consumption • 70% of Chinese urban households have color TVs • 81% have washing machines • new Chinese av. income is $1,950 • China's share of the world income rose from 2% to 6%, making it third-biggest economy behind U.S. (22.5%) and Japan (7.6%)

48. 1999 U.S. income distribution (solid) 2001 China income distribution (dashes)

49. Deriving labor supply curves • use consumer-theory model to derive supply curve of labor by deriving demand curve for time spent not working • time constraint: H = 24 - N • H = hours of work in a day • N = hours of leisure or nonwork in a day

50. Price of leisure foregone earnings are greater for a lawyer who earns $500 an hour than for someone who works for minimum wage