Applications of Consumer Theory

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

• P Q 2.5 40 5 20 10 10

5
Income and Substitution Effects
XN
X0
Xs
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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?

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Budget with Gift of 10 Units of X
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Consumer Indifferent Between In-Kind Transfer and
Cash
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Consumer Better Off With Cash
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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 Y1 (Y is numeraire.)

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Labor/Leisure Trade Off
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Derivation of Labor Supply
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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
X0X1
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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.

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Problems with the CPI

• Does the CPI overstate Inflation?

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