CH5new07 - Chapter 5 APPLICATIONS OF RATIONAL CHOICE AND...

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Chapter 5 APPLICATIONS OF RATIONAL CHOICE AND DEMAND THEORIES Boiling Down Chapter 5 The tools developed in the preceding chapters are useful in analyzing many policy options and situations of consumer choice. In the case of a gasoline tax with a rebate, the tax on gasoline is designed to conserve fuel without making the consumer substantially worse off. Here the substitution away from fuel because of the price increase (substitu- tion effect) is greater than the increased spending on fuel that comes because of the tax rebate (income effect) and so the policy objective is achieved. The school voucher example shows how the present school funding policy of tax-fin- anced public schools limits the consumer choices and discourages many parents from in- creasing the quality of education beyond that provided by the public system. This is be- cause any private education must be totally self-financed by the family while the school tax is also paid. Faced with this double school payment, most parents opt for public school education only. However, if they were allowed to use the school tax to purchase the education of their choice, they would end up buying more education, and we would have a more highly educated population. There is usually a difference between what a consumer has to pay for a good and what she would be willing to pay for a good. If the decision to buy is an easy one, it means that more utility was gained than was given up from a purchase. The difference is called consumer surplus. It can be measured by taking the difference between the area under the demand curve of the items bought and the amount that the consumer paid for the goods. The seller will sometimes try to capture some of this consumer surplus by charging a flat up-front access fee for the product or service in addition to a per unit charge. Consumer theory tools make it possible to compare the welfare of alternative situ- ations and policies. When prices change from one year to the next, consumers will adjust their market basket and their overall welfare will be impacted. Consider a consumer who is utility maximizing with a given set of prices. Then the relative prices change over time but the consumer is still able to buy his original market basket. However, a wise con- sumer will substitute toward the good that has fallen in price and away from the higher priced good. By observing the budget constraints and the new consumer’s choices, it is possible to show that increased welfare results from the price changes or that the con- sumer can maintain his utility level with a lower level of income. The ability to substi- tute toward lower prices and away from higher prices is a powerful strategy for improv- ing welfare. In the story of the housing price changes, the consumer takes advantage of price
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This note was uploaded on 05/25/2008 for the course ECON 73-150 taught by Professor Dubra during the Spring '08 term at Carnegie Mellon.

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CH5new07 - Chapter 5 APPLICATIONS OF RATIONAL CHOICE AND...

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