II. CONSUMER DEMAND
B. EXTENSIONS AND APPLICATIONS OF CONSUMER THEORY
4. APPLICATIONS OF CONSUMER THEORY
a. COMPARING PRICE VERSUS INCOME POLICIES
? If the government offered you aid, which would you prefer, $1,000 or a basket of food that costs the government the same amount?
The U.S. has a variety of aid programs: cash and
in-kind.
Economic analysis suggests that you can't just add them together, which
makes it tricky to figure how much good government programs really do.
Most market-specific policies =
(1) taxes, making buyers pay a price above what sellers get to cover
costs
(2) subsidies, where buyers a price lower than what sellers get to
cover costs.
Both taxes and subsidies create 2 prices.
To analyze the perceived costs and true costs, we have to consider the
impact on both consumers and the government.
We can then compare results to what would happen if we tried to reach our goals with income taxes or income subsidies instead.
Simplifying assumption: programs that affect a targeted group of consumers without changing the prices paid by others not covered by the policy.
Diagramming taxes and subsidies: See Budget Lines with taxes and subsidies worksheet
Result: For any Qx, vertical distance between old and new BL = policy impact on government.
Resume day 11:
Example: subsidizing food prices (Worksheet)
| Consider a low-income family. Consumes food and other goods. Allow plenty of room to work above and to the left of the diagram. a = no subsidy Now suppose the government offers food stamps which lower the family's price of food to $5. ? What happens to the BL y-intercept? ? What happens to the BL slope? |
|
 |
b = $5 per-unit food price subsidy
I Pf Qf Ig
b 400 5
35 225
2 issues arise:
Issue (1) How much does the government spend on the price subsidy?
The food subsidy spending shows up as the vertical distance between BLb and BLa at the new Qf (Fb=35).
Issue (2): How would the cost of a utility-equivalent income subsidy compare to the price subsidy?
The government can just give extra income instead.
? In that case, how would you show the budget
line the family would need to reach Ub at market prices?
b' = utility-equivalent income
subsidy
I Pf Qf Ig
b' 560 10 24 320
The cost of the utility-equivalent income subsidy shows up as the vertical distance between Blb' and BLa.
But notice also that the family consumes less food than with the utility-equivalent price subsidy. That's due to the substitution effect: since food is more expensive along BLb' than Blb, the family consumes less food.
Note1: The 'right' choice of policy depends on the goal. To specifically boost food consumption to quantity Fb, use a food price subsidy, but if the goal is just to raise the family's welfare to Ub, then use an income subsidy.
Note2: Self-test: try taxes instead of subsidies and contrast the effects of a product tax versus an income tax
Example 2: a gasoline tax/rebate policy
(Java)
(also covered in the text)
b. PRICE CHANGES FROM AN ENDOWMENT POSITION
Example: When housing prices change
(Java)
(also covered in the text)
Final comments regarding consumer theory:
For more practice: Worksheet
of applications
In many cases, the usual old demand curve does well enough, but it has
limitations, and the set of tools used for consumer theory allows us to do a better job.
They...
Resolve possible contradictions (Giffen goods, cross-price
elasticities)
Increase precision (CV and true CS)
Extend the range of questions we can tackle (price vs. income
subsidies)
Highlight consumer choice and the trade-offs between products--and
that's what econ is about, choice and trade-offs