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Chapter 6

From Demand to Welfare

Main Topics

Dissecting the effects of a price changeMeasuring changes in consumer welfare

using demand curves

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Dissecting the Effects of aPrice Change

When a price increases two things happen:That good becomes expensive relative to

others; consumers shift their purchases away from the more expensive good

Consumers’ purchasing power fallsEconomists have learned a lot about

consumer demand and welfare from thinking about price changes this way

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Dissecting the Effects of aPrice Change

As the price of a good changes, the consumer’s well-being varies

An uncompensated price change is one with no change in income

A compensated price change is a price change and an income change that together leave the consumer’s well-being unaffected

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if M=10, PB=0.25, then, ★if Ps=0.5, then choose A★if Ps=1, purchasing power declines, L2,

and choose BAs P increases, consumer is worse off b/c

purchasing power is lesshow much $ would need to give consumer

to compensate him for the higher P? if M=15 now, then L3 and C.note that A~Cfrom L2-L3: the effect of compensation on

BL

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L1-L2: uncompensated price change: price change with no change in M

L1-L3: Compensated price change:price change and M change to leave the consumer unaffected

What about a reduction of Ps?the consumer is better offL1-L3: compensated price change

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Compensated Price Effects

If we assume that the good is normal, then the increase in price will result in a fall in the quantity demanded.

This is for two reasons; the IE(have a limited budget, therefore can purchase lower quantities of the good) and the SE (swap with alternative goods that are cheaper).

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Substitution and Income Effects

Due to the price of good x increasing, the budget line has pivoted from B1 to B2 and the consumption point has moved.

The decrease in the quantity demanded can be divided into two effects;

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1. SE: when the consumer switches consumption due to the price change alone but remains on the same indifference curve. To identify the SE, a new BL needs to be constructed. The BL B1* is added, this budget line needs to be parallel with the BL B2 and tangent to I1.Therefore, the movement from Q1 to Q2 is purely due to the SE

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2. IE: consumption changes due to the having a change in purchasing power as a result of the price change. The higher price means BL is B2, hence the optimum consumption point is Q2. This point is on a lower indifference curve (I2).Thus, in the case of a normal good, the IE and SE work to reinforce each other.

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Direction of Substitution Effect

Substitution effect of price increase is:Negative for price increasePositive for price decrease

Consumer substitutes away from the good that becomes relatively more expensive

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Direction of Income Effect

Direction of income effect depends on whether the good is normal or inferior

Increase in the good’s price reduces the consumer’s purchasing powerConsumer will buy less of the good if it is normal,

but more if it is inferior

Income effect of a price increase is:Negative for normal goodPositive for inferior good

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IE: an increase in P will reduce purchasing power

this will reduce Q if good is normal and increase Q if good is inferior

IE<0 if good is normalIE>0 if good is inferiorNormal good: IE and SE move in same same

directiondirection, both are (-) if P increases and both are (+) if P falls

inferior: IE and SE move in opposite directionopposite direction: when P increases, IE increases Q while SE reduces it.

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Substitution & Income Effects for Inferior Goods

IE and SE work in opposite directions with inferior goods.

As the price of X rises there is a decrease in real income. You can see that point A is the original point for X* and Y* on the original Budget Constraint .

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The price of X (inferior good) increased therefore decreasing the real income which caused the budget constraint to rotate inward because the X intercept changes as the price of X changes.

Since the price of X increased the SE sets in as X is substituted by Y as shown by the movement A-B. 

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However, since X is an inferior good, demand for X increases as income decreases therefore countering the SE.

The IE is shown by the movement from B-C.

C is where the combination of the substitution effect and the income effect settles. 

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Why Do Demand Curves Slope Downward?

The Law of Demand states that demand curves slope downward

SE is always consistent with Law of DemandFor normal goods,IE reinforces substitution

effectNormal goods always obey the Law of Demand

Theoretically, if IE for an inferior good is large enough to offset substitution effect, could violate Law of Demand

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A drop in the price of inferior good would raise the purchasing power, making the consumer better off: she will consume more of the other goods and less of the inferior good.

Extreme Inferiority: Giffen GoodsIE>SEand D curve slopes upwardGiffen goods are inferior, and the amount

purchased increases as the price rises

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Giffen goods are hard to find b/c:

1. most goods are normal

2.if spending on a good is a small fraction of M, a large increase in good’s P will not affect M significantly

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Compensating VariationHow can a consumer measure economics gains and

losses in monetary terms? a common measure is compensating variation

Compensating variation: the amount of money that exactly compensates the consumer for a change in circumstances

Example: If the compensating variation for a gasoline tax is $50, then the consumer is better off with the tax as long as he receives a rebate for more than $50

Example: if CV for road improvement =$100, then the consumer is better off as long as his contribution is <$100

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b/c 5$ fully compensate consumer from an increase in P from 0.5 to 1, the compensating variation for this P increase is $5

the compensating variation for P reduction is -$3.75

worked-out problem 6.2in-text-exercise 6.2

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Compensated Price Effects

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Consumer SurplusConsumer surplus is the net benefit a

consume receives from participating in the market for some good

and, the amount of money that would compensate the consumer for losing access to the market, compensating variation

Consumer’s D curve measures the gross benefit of consuming a good

Consumer surplus is area below the D curve and above a horizontal line at the price

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if Q=1, the highest P the consumer is willing to pay is $4000, but Q=0 if P is higher.

Willingness to pay 1st and 2nd =$3000 and $2000 for 3 units and so on

the consumer’s net benefit is is the difference between his gross benefit and the amount he pays

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if P=$1500, the consumer will buy 3 units: he is:

willing to pay $4000 for the first, pays $1500 and enjoys $2500

his net benefit from 2nd unit: $1500net benefit from the 3rd =$500 his consumer surplus: 2500+1500+500

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Figure 6.6: Consumer Surplus

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Using Consumer Surplus to Measure Changes in Welfare

Some public policies alter prices and amounts of traded goods

Consumer surplus is useful, allows us to measure change in net economic benefit from the policy

This is another way to describe compensating variation for the policy

Example:Policy reduces consumer surplus from $100 to $80Must provide her with $20 to compensate fully for

the policy’s effects

6-2030

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Figure 6.7: Change in Consumer Surplus

When price = $2, consumer surplus is grey and brown shaded areas

When price = $4, consumer surplus is grey area

Brown area is change in consumer surplus