1

Chapters 5: Using Consumer Choice Theory

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Returning to the Conceptof Consumer Surplus

• Consumer surplus is a dollar measure of the extent to which a consumer (or many) benefits from participating in a transaction– Assuming that transactions occur voluntarily (implying that those engaging in them are better off than had the transactions not occurred), consumer surplus represents the difference in what one was willing to pay for a product/service and what one actually had to pay to obtain that product/service

• The concept of consumer surplus is key to evaluating public policies such as taxation/subsidization, price ceilings/floors, etc.

3

Consumer Surplus

P*

Q

PConsumer’s surplus

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Algebra of Consumer Surplus

10

12

20

Consumer surplus before tax =

Consumer surplus after tax =

Change in C.S. after tax =

8 10

12 (20 10)10 50

12 (20 12)8 32

50 32 [(12 10)8] [1/2(12 10)(8 10)] 18

5

Price Elasticity and Consumer Surplus

Elastic Demand

Inelastic Demand

S0

S1

Loss in C.S. for elastic demand

Loss in C.S. for inelastic demand

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Calculating Loss in Consumer Surplus

• Loss in Consumer Surplus

(P Q) .5(P Q)

P

Q

Q

Demand

Supply0

Supply1

Q

P

7

Taxation

Tax RevenueLoss in C.S.

Loss in P.S.

Deadweight Loss

Q

P

D

S

ST

8

Taxation on the Supply Side

D1

S1

S2

A B

CF

E D

Pc

Pno tax

Pp

Pc = Price paid by consumer Pp = Price received by producer

G

• Lost P.S. = FCDE• Lost C.S. = ABCF• Tax Revenue = ABDE • Deadweight Loss = BCD• Tax Paid By Consumer=ABFG• Tax Paid By Producer = FGDE

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Taxation on the Demand Side

D1D2

S

A B

C

D

E

FPno tax

Pc

Pp

• Lost P.S. = FCDE• Lost C.S. = ABCF• Tax Revenue = ABDE • Deadweight Loss = BCD• Tax Paid By Consumer=ABFG• Tax Paid By Producer = FGDE

Pc = Price paid by consumer Pp = Price received by producer

G

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Algebraic Example of Taxation

• The government imposes a $0.404/pack cigarette tax– What is the total amount of the tax?

– What percentage of the tax is paid by the consumers?

– What percentage of the tax is paid by the producers?

– What is the total deadweight loss of the tax?

$0.404 9,996 $4030.38

$0.40 9,996 $3,998.4 99% of Tax

$0.004 9,996 $39.98 1% of Tax

.5 ($0.404 4) $0.81

QD 10,040 10P

QS 6000 1000PSupply and Demand Before Tax

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Burden of Taxation: Elastic Demand

Loss in C.S.

Loss in P.S. D

SST

Q

P

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Burden of Taxation: Inelastic Demand

Loss in C.S.

Loss in P.S.

Q

P

D

S

ST

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Algebra of Taxation: Elastic and Inelastic

Demand

Supply : QS 850 P

Elastic Demand :Qd (e ) 1450 5P

Inelastic Demand : Qd (i) 1000 .5P

• Government imposes tax of $60

Supply Tax :QST 790 P

Elastic Demand : P eT 110, QeT 900 C.S. 9250

Inelastic Demand : P iT =140, QiT 930 C.S. 38,400

• Two demand curves (elastic & inelastic) have the same initial equilibrium price and quantity

P* 100, Q* 950

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Bias in Consumer Price Index

• Substitution Bias: The CPI does not take into account the fact that consumers will change their consumption basket as relative prices change. (Substitution Effect)

• Quality Change: The CPI holds a basket of goods as fixed, when in fact the quality of some of the goods may be changing dramatically over time (e.g. the efficacy of pharmaceuticals)

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CAFÉ Standards for Automobiles

• Justification for government intervention– Imperfect information about long-term benefits– Imperfect capital markets– Externalities (pollution and national security) - estimated to be 12 cents per gallon

• Government solution - regulations governing average fleet mileage– Fines imposed on those who don’t meet government standard

• (Possible) consequences– Increased lobbying expenditure– Increased fleet sales– “Rebound Effect”

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Graphical Depiction of CAFÉ Standards

Quantity of Automobiles

Price of Automobiles

Supply without CAFÉ Standards

Supply with CAFÉ Standards

Demand for automobiles

PC

QC

PE

QE

Marginal Social Cost (MSC)

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Alternative Way to Meet Objective: Tax and Rebate

Amount of rebate

Gasoline

$

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Strip Club Moratorium

• Justification for government intervention: negative externalities

• Government solution - restrict the number of strip clubs in Seattle to 4 (existing) clubs

• (Possible) consequences– Higher prices– Economic profits– Possible loss of consumer surplus

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Graphical Depiction of Strip Club Moratorium

market supply

market demand

Quantity of strip clubs

Price

Regulated

Supply = S 1

Regulated

Supply = S 2

Ps

QS

PE

QE

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Intertemporal Choice

• Just as consumers make decisions over the purchase of different combinations of goods, they make decisions about whether to purchase goods today or in the future

• We can examine consumer preferences over intertemporal choice using the tradition IC framework– Intertemporal ICs show combinations of current/future consumption for which consumers are indifferent

– The marginal rate of time preference (MRTP), which is the slope of the Intertemporal IC, shows the rate at which the consumer is willing to trade off consumption today versus consumption tomorrow

– Consumers may exhibit positive, negative, or neutral time preference (most exhibit positive)

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Factors Affecting Time Preferences

• Inidividual preferences

• Uncertainty about future events

• Value of anticipated future utility/disutility

• Preferences for a rising consumption standard

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Graphical Illustration of Time Preferences

C1C1 C1

C2 C2 C2

Impatience Neutrality Patience

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Intertemporal Budget Constraint

• The intertemporal budget constraint is determined by r, the interest rate

• Assuming consumers can borrow freely, the intertemporal budget constraint is represented by:

C1 C2

1 rY1

Y2

1 r

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Intertemporal Optimality

C1

C2

Y1 (1+r) + Y2

Y1+Y2(1+r)-1

C1*

C2*

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Changes in the Interest Rate and Optimality

Y1+Y2(1+r1)-1Y1+Y2(1+r0)-1

Y1 (1+r0) + Y2

Y1 (1+r1) + Y2

• Interest rate falls from r0

to r1

• Interest rate begins at r0

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Algebraic Example of Intertemporal Choice

If James earns $50,000 this year and will earn $60,000 next year, what is the maximum interest rate that would allow him to spend $100,000 this year?

What is the minimum interest rate that would allow him to spend $115,000 next year?

$50,000$60,000

1 r$100,000 r.2

$50,000(1 r) $60,000 $115,000 r.1

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Homo Economicus?

• Some people may function as perfect examples of Homo Economicus, but most only approximate this behavior– We are satisfiers not maximizers, but this is rational!

• Limitations of rationality– Asymmetric treatment of gains and losses (K-T value function)– Failure to appropriately ignore sunk costs– Judgmental heuristics and biases

• Availability• Representativeness• Anchoring and adjustment

• So long as people practice “bounded rationality” economic theory is useful

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Kahneman-Tversky Value Function

Losses Gains

Value

V(gain)

V(loss)

loss

gain

V(loss) V(gain)

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Sunk Costs

• James and AJ have the same preferences for movies. They’re both eager to see the latest summer blockbuster but work different schedules: James can only attend the matinee ($3.50) and AJ can only attend the evening show ($9.00). Halfway through the movie they both realize they hate it. Which is more likely to walk out?

• K-T value function helps explain failure to ignore sunk costs!

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K-T Value Function and the Market

• Sellers, gift givers, etc. can “manipulate” consumers by:– Segregating gains (e.g. separate lottery wins)– Combining losses (e.g. state and fed tax delinquency notices)

– Offsetting small loss with a larger gain (e.g. lottery and ink drop)

– Segregating small gains from large losses (e.g. car rebate)

• We see examples of all of these practices above in the marketplace

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Graphical Depiction of K-T Practices

1000

1000

A manufacturer offers a $1000 rebate on a car

purchase

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Judgmental Heuristics (Rules of Thumb)

• Availability - memory research shows that it is easier to recall an event the more vivid, sensational, or recent it is– As a consequence, we often put too much weight on these type of events (e.g. murders and suicides in NYC, “r” as first or third letter)

• Representativeness - we often overstate the importance of representative events– Judgments about muggings– Regression to the mean– Sophomore/SI jinx

• Anchoring and adjustment - we often overstate the importance of the anchor (e.g. which is larger 1x2x3…x9 or 9x8x7…1)