Applying Consumer Theory

Deriving DD curves Each (P, Q) point on DD results from a U-maxing decision (IC & budget line tangency) P changes shift budget line & change Qd

Panel (a): ICs & budget line, beer & wine Pbeer falls budget line shifts out L1 L2 L3 Consumption bundle e1 e2 e3 (price-consumption curve thru eqm bundles) Panel (b) DD for beer: As Pbeer falls, Qd beer increases E1 E2 E3

Changes in income

(a) ICs & budget, (b) DD curve, (c) Engel curve (r/ship between Y & Qd, keeping P constant) L1, e1 correspond to E1 & E*1 If Y , shift to L2, e2, E2 & E*2 Income elasticities: = % in Qd / % in Y = Q/Q = Y/Y Q x Y Y Q

e.g. Mimi: beer = 0.88, wine = 1.38. 0: Normal goods Necessities (staple goods): 0 < 1 Luxuries: > 1 < 0: Inferior goods (often goods consumed in large Qs by poorest) Income-consumption curve: tells us is + or ve

Peter chooses housing & food. Start at e. As Y s, income-consumption line could be ICC1 or ICC2 or ICC3 depends on whether food & housing are normal or inferior for Peter. Note all goods cannot be inferior. can vary with Y Spending patterns differ among income groups (e.g. SA LSM data.) zero-rate VAT on goods with < 1 - including maize, bread, cereal, potatoes, beans, fish, milk, fruit & vegetables, oils, sugar, & kerosene; higher VAT on luxuries including e.g. cameras, video cameras, decoders, satellite dishes, CDs, furs, binoculars, lawn trimmers, air conditioners, cordless phones, cellphones, caravans, yachts, dishwashers, tumble dryers, microwaves.

(Currently zero-rated: mostly food e.g. brown bread, rice, maize, but also petrol, diesel & paraffin.)

Effects of a price change: 2 impacts on Qd: substitution effect income effect

Normal good: Pmusic tracks ; Lauras Qd Total effect = move from e1 to e2. Substitution effect: in Qd when a goods P changes other prices & utility constant a compensated change in Pbeer. Imagine we Y to offset Pmusic tracks, so she stays on I1. Draw imaginary budget constraint, L*, parallel to L2 and tangent to I1. Substn effect is the move from bundle e1 to e*. Always negative for P (unambiguous). Income effect: in Qd when Y changes keeping Ps constant. Shift L* to L2. Income effect is shift from e* to e2. Direction depends on income elasticity: normal good - negative Y effect for P; inferior good positive Y effect for P. (offsets substn effect). Usually substn effect > Y effect so total effect is negative for P.

Recap: Straightforward normal good: P substn effect: Qd income effect: Qd & total effect Qd Law of DD holds, P Qd (& vice versa)

Inferior good: (Y Qd) P substn effect: Qd (always) income effect: Qd Usually, substitution effect > income effect, so total effect is still Qd (but total effect < substn effect)

BUT an exceptional case: movies are the inferior good. Giffen good: inferior good that is such a big part of a households budget that income effect of a price change > substitution effect, so P causes Qd & vice versa; upsloping DD curve! (Law of DD???) e.g. Irish potatoes (now disputed); Chinese experiment with subsidised wheat & rice. Strongly inferior - & P is like Y. Income & substitution effects for an ordinary inferior good (not a Giffen good)

Income and Substitution Effects with a Normal Good

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Beginning from budget constraint L , an increase in the price of music tracks rotates budget
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constraint into L . The total effect of this price change, a decrease in quantity of 12 tracks per quarter, can be decomposed into income and substitution effects.

Deriving labour SS curves - leisure (time spent NOT working) is a good, with a price (opp cost: foregone earnings, w). Labour-leisure choice: H = 24 N e.g. Jackie buys Y goods U = U (Y, N) Y = wH + Y* (Y* is unearned income)

(a): choice between goods & leisure. Initial budget constraint, L1, is Y = w1H = w1 (24 N); slope = -w1 (1 extra hour leisure costs w1 goods). ICs show her prefs ito bundles of leisure & goods. On L1, optimal bundle is e1: N = 16 (& H = 8). Derive DD curve for leisure: vary the price (wage), shift the budget line, find new optimal point e.g. w to w2 L2, e2 (N = 12, H = 12). (b) shows this on DD curve. SS of work (labour) is the mirror image of DD for leisure Fig 5.9.

Wage change has income & substitution effects.

Fig: wage s from w1 to w2. Total effect: e1 e2. Draw imaginary budget line L* parallel to L2 & tangent to I1. Substn effect, e1 e*, must be negative: subst away from the relatively more expensive good (leisure). As w s, so does income; so if leisure is a normal good (for Jackie), shell consume more of it (work less) = movement from e* to e2. Leisure normal: income & substn effects work in opposite directions. Net effect depends on which is larger. If income effect dominates, she will DD more leisure - & work fewer hours as w rises, i.e. her labour SS curve is backward bending. Leisure inferior: substn & income effects work in the same direction; hours of leisure (& hours of work ) as w rises.

Shape of the L SS curve depends on the income elasticity of leisure. Panel (a) leisure choice, (b) L SS. Real-world L SS curves: mostly close to vertical. Some studies show slightly backbending for men (Y effects > substn) & slightly positive for women (substn effects dominate). Income tax rates & L SS: how will change in tax rates affect hours worked? If L SS curves are upsloping, higher taxes will cause ppl to work fewer hours ( production & less revenue). If backward bending, a small in tax can revenue AND induce ppl to work more hours. Relationship of Tax Revenue to Tax Rates

Marginal tax rate & total tax revenue. ( Laffer curve). Inverted U why? Slopes up because: (i) govt collecting more cents per $ earned; (ii) income effects ppl work more as theyre in backward-bending part of their L SS. Then slopes down because further tax s discourage ppl from working (substn effects outweigh i & ii leisure relatively cheaper; ppl are in the upsloping part of their L SS curves). In SA: tax rates a lot (& thresholds ) since 1994; yet much more revenue has been collected. (Due to improved collection systems but also Laffer curve effects according to Trevor Manuel!)