Term 1 Week 7: Applications Flashcards
What are the three ways changes in welfare can be measured (3)
-Consumer surplus
-Compensating variation
-Equivalent variation
How can we measure consumer surplus (2)
-We measure consumer surplus with a compensated demand curve (Hicksian/Marginal Willingness to Pay Curve)
-The CS is the difference between the total area under the curve and the area actually purchased
How can we measure the compensating variation (3)
-Compensating variation measures how much money the government would have to give the consumer after the price change to make them just as well off as before
-How far should we shift the new budget line so it is tangential to the original indifference curve
How can we measure the equivalent variation (3,1)
-Equivalent variation measures how much money would have to be taken from the consumer before the price change to make them just as well off as they’d be after the price change
-How far must the original budget constraint be shifted to be tangential to the new indifference curve
-How much income would be taken away to have the same impact as the loss of welfare from the price change (so we know what to repay)
-Used extensively in government, but can be overinflated
What is an endowment (2,3)
-An endowment is a bundle of goods (e1, e2) owned by a consumer, and tradeable for other goods
-If you have e1 of good 1, but would choose x1>e1, you are a net demander of good x1
-Income is determined by your endowments and prices, and the budget constraint will always pass/pivot through (e1, e2), as you can always keep what you have
-C(p1, p2, e1, e2) = {(x1, x2) I p1x1 + p2x2 ≤ p1e1 + p2e2}
-Income is now endogenous
What is the difference with utility maximisation with endogenous and exogenous income (2)
-Utility maximisation with exogenous income (aM/P1) implies x1 is independent of P2
-Utility maximisation with endogenous income (aM/P1, where M = P1e1 + P2e2) now implies x depends on both prices
How does the slutsky identity change to the endowment income effect (3, 1)
-Previously when P1 fell, real income rose and so x1 is affected, but now your money income is affected
-The endowment income effect is the (change income when price changes)x (change in demand when income changes)
-if we differentiate our budget constraint with respect to p1 we get e1, and we already have the change in demand when income changes
-Hence, the revised Slutsky equation is Δx1/Δp1 = Δx1s/Δp1 + (e1 - x1)Δx1m/ΔM
How does the endowment income effect impact the impacts of the substitution and income effect ()
-The substitution effect is always negative, the a normal good the ordinary income effect > 0, and the size of the total income effect depends on the sign of e1-x1
-For a net demander, demand must fall, but for a net supplier, it depends on the magnitude of the +ive combined income effect vs -ive substitution effect
How can we apply a consumer choice model on present and future value (2,1)
Assume current consumption = c1, future consumption = c2, current income = m1, future income = m2
-(1+r)c1 + c2 ≤ m1(1+r) + m2 (future value)
-c1 + c2/(1+r) ≤ m1 + m2/(1+r)
-If c1 = 0, we could consume m1(1+r) next summer, and for every £1 consumed today, next years consumption falls by (1+r)
How do we make a consumer choice model n periods (2,2)
-In the N period model, the opp. cost is (1 + r)^n
-If you consumed nothing until the last year, the most you could consume is Cn = Mn + (1+r)M(n-1) + (1+r)^2(m)(n-2)…
-When adding consumption in, you have to factor in the opp. cost of consuming
-Therefore: Cn + (1+r)c(n-1) + (1+r)^2(c)(n-2)… = Mn + (1+r)M(n-1) + (1+r)^2(m)(n-2)..
How to graphically represent the 2 period intertemporal budget constraint (3)
-Have C1 on the X axis, and C2 on the y axis
-Draw a budget constraint, where x intercept = m1 + m2/(1+r), and the y intercept = m1(1+r) + m2
-There will be a point where m1 = m2, and if you optimally consume above this point, you are a lender, and if you optimally consume below, you are a borrower
