CHAPTER 04 - PHALL-82241 PINDYCK CHAPTER 04 FIGURE 4.1...

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Unformatted text preview: PHALL-82241 PINDYCK CHAPTER 04 FIGURE 4.1 Effect of Price Changes Clothing (units per month) Price-Consumption Curve A 6 5 U1 4 D B U3 U2 4 12 20 (a) Price of food Food (units per month) E $2.00 1.50 Demand Curve G 1.00 H .50 4 12 20 (b) Food (units per month) A reduction in the price of food, with income and the price of clothing fixed, causes this consumer to choose a different market basket. In (a), the baskets that maximize utility for various prices of food (point A, $2; B, $1; D, $0.50) trace out the price-consumption curve. Part (b) gives the demand curve, which relates the price of food to the quantity demanded. (Points E, G, and H correspond to points A, B, and D, respectively). Fig 04-01.EPS page 5 of 23 PHALL-82241 PINDYCK CHAPTER 04 FIGURE 4.2 Effect of Income Changes Clothing (units per month) Income-Consumption Curve 7 D U3 5 B 3 A 4 U2 U1 10 16 Food (units per month) (a) Price of food G E $1.00 H D3 D2 D1 4 10 16 (b) Food (units per month) An increase in income, with the prices of all goods fixed, causes consumers to alter their choice of market baskets. In part (a), the baskets that maximize consumer satisfaction for various incomes (point A, $10; B, $20; D, $30) trace out the income consumption curve. The shift to the right of the demand curve in response to the increases in income is shown in part (b). (Points E, G, and H correspond to points A, B, and D, respectively.) Fig 04-02.EPS page 6 of 23 PHALL-82241 PINDYCK CHAPTER 04 page 7 of 23 FIGURE 4.3 An Inferior Good 15 Steak (units per month) Income-Consumption Curve C 10 U3 B 5 U2 A U1 5 10 20 30 Hamburger (units per month) An increase in a person’s income can lead to less consumption of one of the two goods being purchased. Here, hamburger, though a normal good between A and B, becomes an inferior good when the income-consumption curve bends backward between B and C. Fig 04-03.EPS PHALL-82241 PINDYCK CHAPTER 04 page 8 of 23 FIGURE 4.4 Engel Curves Income (dollars per month) Income (dollars per 30 month) 30 Engel Curve 20 Inferior 20 Normal 10 0 10 4 8 12 (a) 16 Food (units per month) 0 10 Hamburger (units per month) 5 (b) Engel curves relate the quantity of a good consumed to income. In (a), food is a normal good and the Engel curve is upward sloping. In (b), however, hamburger is a normal good for income less than $20 per month and an inferior good for income greater than $20 per month. Fig 04-04.EPS PHALL-82241 PINDYCK CHAPTER 04 page 9 of 23 FIGURE 4.5 Engel Curves for U.S. Consumers Annual $80,000 income $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 $500 $1000 Entertainment $1500 $2000 $2500 Annual Expenditure Rented Dwellings $3000 $3500 Health Care Average per-household expenditures on rented dwellings, health care, and entertainment are plotted as functions of annual income. Health care and entertainment are normal goods, as expenditures increase with income. Rental housing, however, is an inferior good for incomes above $35,000. Fig 04-05.EPS $4000 PHALL-82241 PINDYCK CHAPTER 04 page 10 of 23 FIGURE 4.6 Income and Substitution Effects: Normal Good Clothing (units per month) R A C1 B C2 D U2 U1 O F1 E Substitution Effect S F2 Income Effect T Food (units per month) Total Effect A decrease in the price of food has both an income effect and a substitution effect. The consumer is initially at A, on budget line RS. When the price of food falls, consumption increases by F1F2 as the consumer moves to B. The substitution effect F1E (associated with a move from A to D) changes the relative prices of food and clothing but keeps real income (satisfaction) constant. The income effect EF2 (associated with a move from D to B) keeps relative prices constant but increases purchasing power. Food is a normal good because the income effect EF2 is positive. Fig 04-06.EPS PHALL-82241 PINDYCK CHAPTER 04 page 11 of 23 FIGURE 4.7 Income and Substitution Effects: Inferior Good Clothing (units per month) R A B U2 D U1 O F1 F2 Substitution Effect Total Effect E S Income Effect Food T (units per month) The consumer is initially at A on budget line RS. With a decrease in the price of food, the consumer moves to B. The resulting change in food purchased can be broken down into a substitution effect, F1E (associated with a move from A to D), and an income effect, EF2 (associated with a move from D to B). In this case, food is an inferior good because the income effect is negative. However, because the substitution effect exceeds the income effect, the decrease in the price of food leads to an increase in the quantity of food demanded. Fig 04-07.EPS PHALL-82241 PINDYCK CHAPTER 04 page 12 of 23 FIGURE 4.8 Upward-Sloping Demand Curve: The Giffen Good Clothing (units per month) B U2 A D U1 O F 2 F1 E Substitution Effect Income Effect Total Effect When food is an inferior good, and when the income effect is large enough to dominate the substitution effect, the demand curve will be upward-sloping. The consumer is initially at point A, but, after the price of food falls, moves to B and consumes less food. Because the income effect EF2 is larger than the substitution effect F1E, the decrease in the price of food leads to a lower quantity of food demanded. Fig 04-08.EPS Food (units per month) PHALL-82241 PINDYCK CHAPTER 04 page 13 of 23 FIGURE 4.9 Effect of a Gasoline Tax with a Rebate After Gasoline Tax Plus Rebate F A Expenditures on other goods ($) H After Gasoline Tax C E U2 U1 900 913.5 1200 Original Budget Line D J B Gasoline consumption (gallons per year) A gasoline tax is imposed when the consumer is initially buying 1200 gallons of gasoline at point C. After the tax takes effect, the budget line shifts from AB to AD and the consumer maximizes his preferences by choosing E, with a gasoline consumption of 900 gallons. However, when the proceeds of the tax are rebated to the consumer, his consumption increases somewhat, to 913.5 gallons at H. Despite the rebate program, the consumer’s gasoline consumption has fallen, as has his level of satisfaction. Fig 04-09.EPS PHALL-82241 PINDYCK CHAPTER 04 page 14 of 23 FIGURE 4.10 Summing to Obtain a Market Demand Curve Price (dollars per unit) 5 4 3 Market Demand 2 1 0 DA 5 DB 10 DC 15 20 25 The market demand curve is obtained by summing our three consumers’ demand curves DA, DB, and DC. At each price, the quantity of coffee demanded by the market is the sum of the quantities demanded by each consumer. At a price of $4, for example, the quantity demanded by the market (11 units) is the sum of the quantity demanded by A (no units), B (4 units), and C (7 units). Fig 04-10.EPS 30 Quantity PHALL-82241 PINDYCK CHAPTER 04 page 15 of 23 FIGURE 4.11 Unit-Elastic Demand Curve Price of movie tickets 9 ($) 6 3 D 600 900 1800 Thousands of movie tickets When the price elasticity of demand is ?1.0 at every price, the total expenditure is constant along the demand curve D. Fig 04-11.EPS PHALL-82241 PINDYCK CHAPTER 04 page 16 of 23 FIGURE 4.12 The Aggregate Demand for Wheat 30 A Price (dollars per bushel) 25 Total Demand C 20 E 15 Export Demand 10 Domestic Demand 5 0 B 0 500 F D 1000 1500 2000 Quantity (million bushels per year) 2500 The total world demand for wheat is the horizontal sum of the domestic demand AB and the export demand CD. Even though each individual demand curve is linear, the market demand curve is kinked, reflecting the fact that there is no export demand when the price of wheat is greater than about $21 per bushel. Fig 04-12.EPS 3000 PHALL-82241 PINDYCK CHAPTER 04 page 17 of 23 FIGURE 4.13 Consumer Surplus Price (dollars per ticket) 20 19 18 17 16 15 Consumer Surplus 14 13 0 1 2 3 4 5 6 Rock concert tickets Consumer surplus is the total benefit from the consumption of a product, less the total cost of purchasing it. Here, the consumer surplus associated with six concert tickets (purchased at $14 per ticket) is given by the yellow-shaded area. Fig 04-13.EPS PHALL-82241 PINDYCK CHAPTER 04 page 18 of 23 FIGURE 4.14 Consumer Surplus Generalized 20 Price (dollars per 19 ticket) 18 17 16 Consumer Surplus 15 Market Price 14 13 Actual Expenditure 0 1 Demand Curve 2 3 4 5 6 7 Rock concert tickets (thousands) For the market as a whole, consumer surplus is measured by the area under the demand curve and above the line representing the purchase price of the good. Here, the consumer surplus is given by the yellow-shaded triangle and is equal to 1/2 ⋅ ($20 ? $14) ⋅ 6500 = $19,500. Fig 04-14.EPS PHALL-82241 PINDYCK CHAPTER 04 page 19 of 23 FIGURE 4.15 Valuing Cleaner Air Value (dollars per pphm 2000 of reduction) A 1000 0 5 10 NOX (pphm) pollution reduction The yellow-shaded triangle gives the consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrogen oxide at a cost of $1000 per part reduced. The surplus is created because most consumers are willing to pay more than $1000 for each unit reduction of nitrogen oxide. Fig 04-15.EPS PHALL-82241 PINDYCK CHAPTER 04 page 20 of 23 FIGURE 4.16 Positive Network Externality: Bandwagon Effect Price (dollars per D 20 unit) D 40 D 60 D 80 D 100 30 20 Demand 20 40 Pure price effect 48 60 80 Bandwagon effect 100 Quantity (thousands per month) A bandwagon effect is a positive network externality in which the quantity of a good that an individual demands grows in response to the growth of purchases by other individuals. Here, as the price of the product falls from $30 to $20, the bandwagon effect causes the demand for the good to shift to the right, from D40 to D80. Fig 04-16.EPS PHALL-82241 PINDYCK CHAPTER 04 page 21 of 23 FIGURE 4.17 Negative Network Externality: Snob Effect Price (dollars per unit) Demand 30,000 15,000 D2 D4 D6 D8 2 4 6 8 14 Pure Price Effect Net Effect Snob Effect Quantity (thousands per month) The snob effect is a negative network externality in which the quantity of a good that an individual demands falls in response to the growth of purchases by other individuals. Here, as the price falls from $30,000 to $15,000 and more people buy the good, the snob effect causes the demand for the good to shift to the left, from D2 to D6. Fig 04-17.EPS PHALL-82241 PINDYCK CHAPTER 04 page 22 of 23 FIGURE 4.18 Estimating Demand Price 25 20 15 d1 10 d2 5 D d3 0 5 10 15 20 25 Quantity Price and quantity data can be used to determine the form of a demand relationship. But the same data could describe a single demand curve D or three demand curves d1, d2, and d3 that shift over time. Fig 04-18.EPS PHALL-82241 PINDYCK CHAPTER 04 page 23 of 23 FIGURE A4.1 Hicksian Substitution Effect Clothing R (units per month) R′ A B S T′ T Food (units per month) The individual initially consumes market basket A. A decrease in the price of food shifts the budget line from RS to RT. If a sufficient amount of income is taken away to make the individual no better off than he or she was at A, two conditions must be met: The new market basket chosen must lie on line segment BT? of budget line R?T? (which intersects RS to the right of A), and the quantity of food consumed must be greater than at A. Fig A04-01.EPS ...
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This note was uploaded on 09/28/2011 for the course ECON 105 taught by Professor Prof.eco during the Spring '11 term at Indian School of Business.

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