Microeconomics for EOR

Lecture Week 2

Pim Heijnen

1/63

Agenda
1. Recap: Choice and Demand
2. Slutsky equation (Chapter 8)
3. Buying and selling (Chapter 9)
4. Consumer surplus (Chapter 14)

2/63

Optimal choice

3/63

Optimal choice
If
preferences are well-behaved
there exists a consumption bundle for which M RS =

p1
p2

then
this consumption bundle maximizes utility.

4/63

This week well dig deeper

What does the model of rational choice predict about consumer behavior? (Chapter 8)
What happens when consumers have an initial endowment of
goods? (Chapter 9)
Can we quantify how much a consumer is hurt by a price
change? (Chapter 14)

5/63

A primer on the philosophy of science

Karl Popper (1934)s concept of falsifiability
Theories make predictions
Theory of gravity and the return of Haleys comet
Why is this a scientific theory?

6/63

A primer on the philosophy of science

Not because it correctly predicted the return of Haleys comet!
Falsifiability states that there needs to be set of outcomes for
which we would have rejected the theory of gravity
For instance, the comet did not return or it returned at the
wrong time
Is economic theory falsifiable?

7/63

Preferences and observed choices

Prices and choices are observable, but preferences are not.
Suppose we observe an individual making repeated purchases
(at different prices)
Is there always a preference relationship that rationalizes these
choices?
The answer has to be NO, otherwise not a scientific theory
The law of demand is a restriction on preferences.

8/63

Slutsky equation
What happens to the demand for good 1 when the price of good 1
decreases?
Relative price changes (substitution towards good 1)
More bundles are affordable (feels like more income)
Can we decompose the effect of price change into a substitution
effect and a income effect?

9/63

The situation
Focus on the demand for good 1: x1 (p1 , m)
Price of good 1 decreases: p1 p01
p1 p01 p1 < 0
Slutsky equation:
x1 =
|{z}
Total

xs
|{z}1

Substitution

+ xn1
|{z}

Income

10/63

x2

Substitution vs. income effect

x1
11/63

x2

Substitution vs. income effect

Total

x1
11/63

Substitution vs. income effect

x2

Consume more of x1!

x1
11/63

x2

Substitution vs. income effect

Sub Inc

x1
11/63

x2

Substitution vs. income effect

Total

x1
11/63

Substitution vs. income effect

Compensate for a price change by changing the income level
Extra income allows you to buy your old choice:
m = m0 m = p1 x1 (p1 , m)
Price ratio has changed = choose something else
After a price decrease (with compensated income), you always
buy more of good 1
After a price increase (with compensated income), you always
buy less of good 1
12/63

Slutsky equation
The compensated income is
m0 = m + p1 x1 (p1 , m)
The substitution effect is
xs1 = x1 (p01 , m0 ) x1 (p1 , m)
and the income effect is
xn1 = x1 (p01 , m) x1 (p01 , m0 )

13/63

Slutsky equation
Note that
x1 = x1 (p01 , m) x1 (p1 , m)
(Change is new demand minus old demand)
Then
x =
|{z}1
Total

xs
|{z}1

Substitution

+ xn1
|{z}

Income

14/63

Example
Sams demand for good 1 is given by
x1 (p1 , m) =

m
2p1

Suppose Sams income is 1000, the old price of good 1 is 2 and the
new price of good 1 is 1. Calculate the total effect on demand of
this price change, the substitution effect and the income effect.

15/63

Example
Demand at the old price
x1 (p1 , m) = x1 (2, 1000) =

1000
= 250
4

and demand at the new price

x1 (p01 , m) = x1 (1, 1000) =

1000
= 500
2

The total effect is

x1 = x1 (p01 , m) x1 (p1 , m) = 500 250 = 250
16/63

Example
Sams compensated income is
m0 = m + p1 x1 (p1 , m) = 1000 + (1 2) 250 = 750
The substitution effect is
xs1 = x1 (p01 , m0 ) x1 (p1 , m) = 375 250 = 125
and the income effect is
xn1 = x1 (p01 , m) x1 (p01 , m0 ) = 500 375 = 125

17/63

Another version of the Slutsky equation

Observe that the income effect is defined as
xn1 = x1 (p01 , m) x1 (p01 , m0 )
This is old minus new and inconsistent with our definition of xs1
and x1 . Hence
n
0
0
0
xm
1 = x1 = x1 (p1 , m ) x1 (p1 , m)

18/63

Another version of the Slutsky equation

The Slutsky equation rewritten as:
x1
xs1 xm
1
=

p1
p1
p1
Use m = p1 x1 (p1 , m) to get:
x1
xs1
xm
1
=
x1 (p1 , m)
p1
p1
m

19/63

Another version of the Slutsky equation

x1
=
p1

xs1
p
| {z1}

Always ()

x1 (p1 , m)

xm
1
m
| {z }

Slope of Engel curve

20/63

Law of demand
If the demand for a good increases when income increases, then the
demand for the good must decrease when its price increases.
Normal good = ordinary good
Giffen good = inferior good
Theory of rational choice provides a link between how consumers
respond to income changes and how consumers respond to price
change.

21/63

Do Giffen goods exist?

A Giffen good is an inferior good (but not vice versa).
A very inferior good: basic food items for households near the
subsistence threshold
Original example: potatoes during the Irish famine of the
1840s
Actual evidence: rice in the Hunan province of China (Jensen
and Miller, 2008)

22/63

A short look at the Hicksian substitution effect instead of the Marshallian substitution effect

23/63

The effect of a tax on unhealthy food

Why should the government tax unhealthy foods?
Bad behavior should be punished
Economic reason: unhealthy people spend more time in hospitals
than healthy people
In most of the Western world, sick people only pay a fraction
of the cost of medical care
Public good, that is overused by people with an unhealthy
lifestyle
Externality
24/63

Fat tax
Suppose that unhealthy food is 1 euro per unit, and healthy food is
2 euro per unit. The average consumer spends 1000 euro per month
on food.
Introduce a 100% fat tax
Price of unhealthy food increases to 2 euro.

25/63

Without a tax

Healthy food

500

166.7

666.7

1000

Unhealthy food
26/63

Effect of a fat tax: inward rotation of budget line

Healthy food

500

166.7

500

666.7

1000

Unhealthy food
26/63

Effect of a fat tax

Healthy food

500

250

166.7

250

500

666.7

1000

Unhealthy food
26/63

Effect of a fat tax

Healthy food

500

250

166.7

416.7

250

500

666.7

1000

Unhealthy food
26/63

Effect of a fat tax

Demand for unhealthy food decreases by

666.7250 = 416.7 units

Healthy food

500

250

166.7

416.7

250

500

666.7

1000

Unhealthy food
26/63

Effect of a fat tax

Huge decrease in demand for unhealthy food
Substitution towards healthy food
But consumers are worse off
Why not compensate consumers?
Take the tax revenue from the fat tax
Redistribute using a tax rebate (lump-sum)

27/63

The effect of a rebate

Healthy food

500

375

250

166.7

250

375

500

666.7

1000

Unhealthy food
28/63

The effect of a rebate

Tax rebate shifts the

budget line outward

Healthy food

500

375

250

166.7

250

375

500

666.7

1000

Unhealthy food
28/63

The effect of a rebate

Healthy food

500

375

250

166.7

Total effect = 416.7

250

375

500

666.7

1000

Unhealthy food
28/63

Substitution effect

Healthy food

500

375

250

Substitution effect =
375 666.7 =291.7

166.7

250

375

500

666.7

1000

Unhealthy food
28/63

Income effect

Healthy food

500

375

250

Income effect = Total effect

Substitution effect = 125

166.7

250

375

500

666.7

1000

Unhealthy food
28/63

Income and substitution effect

Substitution effect is always negative: fat tax will have the desired
effect
With the tax rebate, the consumer is no worse off after the tax has
been introduced.

29/63

Buying and selling

Income (so far) is manna from the heaven. In reality people work
(or sell goods) to provide income.
Initial endowment of goods, which consumers can buy and sell at
the market price.
Labor supply as an important application: tradeoff between consuming material goods and enjoying leisure time.

30/63

Endowment
A consumer has an initial endowment = (1 , 2 )
He owns 1 units of good 1 and 2 units of of good 2
. . . and access to a market where he can either sell good 1 at
price p1 or buy additional units at the same price
(idem for good 2)

31/63

Income
Budget equation where net expenditure is zero
p1 (x1 1 ) + p2 (x2 2 ) = 0 = p1 x1 + p2 x2 = p1 1 + p2 2
Sell entire endowment and receive income m = p1 1 + p2 2
Finding optimal consumption bundle then proceeds along familiar lines, but income depends on prices and the initial endowment

32/63

Budget line
Good 2
m/p2

Endowment
2

m/p1 Good 1
32/63

Budget line
Good 2

1
0
Net seller of good 1

Good 1
32/63

Budget line
Good 2

1
Good 1
Net buyer of good 1
33/63

Optimal choice
Good 2

Optimal choice (net seller of good 1)

2

Good 1
34/63

What happens when the price of good 1 increases?

Value of the endowment increases
Budget line becomes cheaper
. . . but you can always afford your endowment!
Net seller of good 1 will always remain a net seller
(cf. price decreases; net buyers will remain net buyers)

35/63

Increase in price of good 1: budget line pivots around endowment

Good 2

Good 1
36/63

Increase in price of good 1: net seller remains net seller

Good 2

Better than previous optimal choice

2

Good 1
37/63

Example: Adams apples

Adam has an apple tree that produces 500 apples per year. He can
sell apples at a price p per piece. The other product in this economy
are bottles of beer, which sell at a price of one. Adams preferences
are given by u(a, b) = min{a, b}, where a are apples and b bottles
of beer. Derive Adams demand curve for apples.

38/63

Example: Adams apples

Note that Adams income is m = 500 p.
Adam always consumes apples and beer in 1:1 ratio. The cost of the
bundle is p + 1. Hence the number of apples he consumes is given
by
500p
a(p) =
p+1

39/63

Example: Adams apples

Note that
a0 (p) =

500(p + 1) 500p
500
=
>0
2
(p + 1)
(p + 1)2

Upward-sloping demand curve!

Two opposing effects:
As apples become more expensive, Adam will consume less of
them
As apples become more expensive, his income increases and
Adam will consume more apples.

40/63

Example: Adams apples

Note that apples are a normal good. This is not an example of a
Giffen good, just the endowment effect.

41/63

Labor supply
Two goods: material consumption (c) and leisure time (`)
The consumer gets more utility when he can spend more $ on
things
But he also values his free time

Endowment of time L
Choice between working (at an hourly wage rate w) and having free time
` denote work time
Let L L
42/63

The budget constraint

All money is spend on consumption: c = wL
` to obtain
Substitute L = L
`) = c + w` = wL

c = w(L
Note that
The price of leisure time is the wage rate (opportunity cost)
is the total value of the time endowment
wL
43/63

Example
Suppose preferences are given by u(c, `) = c`. Furthermore, w = 15
= 16. Then the budget constraint becomes:
and L
= c + 15` = 240.
c + w` = wL
The MRS is `/c. Equating the MRS to the price ratio yields:
1
`
= c = 15`
=
c
15
Plugging this into the budget constraint:
15` + 15` = 240 = ` = 8 and L = 8
44/63

Labor supply
How many hours will a consumer work as a function of the wage
rate?
As the wage rate increases, leisure time becomes more expensive (work more) but youre also getting richer (work less)
At low wage rates, you can only consume little (the first effect
dominates)
At high wage rates, consumption is at a higher level and you
want to have more leisure time (the second effect dominates)
(Diminishing MRS)
45/63

Backward-bending labor supply

46/63

Note on Chapter 9
The chapter devotes a lot of time on extending the Slutsky equation:
this is reading material only.

47/63

Consumer surplus
Sams demand for good 1 is given by
x1 (p1 , m) =

m
2p1

Suppose Sams income is 1000, the old price of good 1 is 2 and the
new price of good 1 is 1. How much less income will make Sam
indifferent between the old and the new price?

48/63

Consumer surplus
Approximately this amount is equal to
Z 2
Z 2
500
CS =
x1 (p1 , 1000)dp1 =
dp1 = 500 ln 2 347
1
1 p1
Sam (roughly) needs an extra 347 euro if the price of good 1 doesnt
drop from 2 to 1.
Why is this true?

49/63

Consumer surplus

50/63

Change in consumer surplus

51/63

Consumer surplus
Consumer surplus is (roughly) the amount of money that makes a
consumer indifferent between the situation with the old price and
the situation with the new price.
(Change in) consumer surplus is defined as:
Z

old price

CS =

x1 (p)dp
new price

52/63

Equivalent and compensating variation

Consumer surplus is an approximation (only the exact amount
that makes a consumer indifferent when preferences are quasilinear)
If utility function is known, then we can compute the exact
number
Difference between keep the status quo and change to the
new situation
Extra income now (EV) or less income after the change (CV)
53/63

Equivalent and compensating variation

Change income to make consumer indifferent
Old prices

New prices

CV:

EV: m +

CV CS EV

54/63

EV and CV
Suppose you are offered a job. It is the same as your current job,
but in a different city.
If the prices in the other city are lower, then EV is the min. extra
income your current boss has to offer you to keep you.
If the prices in the other city are higher, then CV is the min. extra
income your new boss has to offer you to make you move city.

55/63

Example
Sams demand for good 1 is given by
x1 (p1 , m) =

m
2p1

Suppose Sams income is 1000, the old price of good 1 is 2 and the
new price of good 1 is 1. How much less income will make Sam
indifferent between the old and the new price?

56/63

Example: Extra information

Let p2 = 1 and Sams utility function is
u(x1 , x2 ) =
Note that
x1 (p1 , m) =

x1 x2

m
m
and x2 (p2 , m) =
2p1
2p2

57/63

Indirect utility function

Sams utility at his optimal choice as a function of prices and income:
r
m
m
m
v(p1 , p2 , m) = u(x1 (p1 , m), x2 (p2 , m)) =

=
2p1 2p2
2 p1 p2
Given prices and income, we can calculate utility levels directly.

At the old price of good 1: v(2, 1, 1000) = 250 2

At the new price of good 1: v(1, 1, 1000) = 500

58/63

Compensating variation
Make Sam indifferent by subtracting income after the change:
v(2, 1, 1000) = v(1, 1, 1000 )

1000
250 2 =
2

= 1000 500 2
CV is approx. 293.

59/63

Equivalent variation
Make Sam indifferent by adding income before the change:
v(2, 1, 1000 + ) = v(1, 1, 1000)
1000 +

= 500
2 2

= 1000 2 1000
EV is approx. 414.

60/63

Applications?
Used in cost-benefit analysis, i.e. cost and benefit of extending the
runway of an airport
Some of the benefits are clear (more revenue for the airport)
What are the cost? For the local environment and for the
people who live next to the airport
Start the project only if benefits exceed costs
It matters if you approach things from the status quo or from
the idea that there needs to be compensation after the runway
is extended
61/63

Applications?
Purchasing power parity (PPP, measure per capita income in $ and
US prices)
GDP per capita (in 2012)
Nominal

PPP

the Netherlands

$46,142

$43,198

Sweden

$55,158

$43,180

62/63

References
Popper, K. (1934): Logik der Forschung.
Jensen, R. and N. Miller (2008): Giffen Behavior and Subsistence
Consumption, American Economic Review, vol. 98, pp. 1553 1577.

63/63

The End