PPA 723: Managerial Economics
First Review Session:
Supply and Demand
Consumer Choice
Managerial Economics: First Review Session
The Living Wage Case
The Question:
Should we recommend the living wage policy for the City of
Syracuse?
We want to understand the impacts of this policy on income
and employment.
We want to particularly understand the impacts of this policy
on low-income households.
We do not have complete information, so we must make
reasonable assumptions to use the information we do have.
(People may disagree about what is reasonable!)
Managerial Economics: First Review Session
The Living Wage Case, 2
Key issue facing the analyst:
How can the information in the case be
organized to help answer the main question?
Managerial Economics: First Review Session
The Living Wage Case, 3
Answer:
Use information on the price (i.e. wage)
elasticity of the demand for labor to calculate
the employment losses associated with the
wage increase (i.e. living wage minimum).
Calculate the loss by wage class.
Managerial Economics: First Review Session
The Living Wage Case
The Key Diagram
w
S
8.96
5.15
w*
D
L1
L0 L*
L
Managerial Economics: First Review Session
Living Wage Case: Basic Information
Demographics
Population
Employment levels
Affected work ers
% Earning minimum wage
% Earning "affected" wage
% employees covered by living wage law
Wages and Elasticity
Elasticity of min wage to labor demand:
Current minimum wage
Proposed increase
Changes in employment
% re-employed in city
% re-employed in county
# of affected jobs
147,306
79,545
7%
25%
15%
-0.2
$5.15
$8.96
35%
15%
2982.95
Managerial Economics: First Review Session
Living Wage Case: Illustrative Calculation
Wage distribution
Wage
$5.15
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
$8.50
% earning
this wage
total #
earning
wage
# affected
earning
wage
% change
in wage
% change
labor
demand
7%
1%
2%
3%
4%
3%
3%
2%
5568.17
795.45
1590.90
2386.36
3181.81
2386.36
2386.36
1590.90
835.23
119.32
238.64
357.95
477.27
357.95
357.95
238.64
74.0%
62.9%
49.3%
37.8%
28.0%
19.5%
12.0%
5.4%
-14.8%
-12.6%
-9.9%
-7.6%
-5.6%
-3.9%
-2.4%
-1.1%
# affected
jobs lost
123.58
15.01
23.55
27.09
26.73
13.94
8.59
2.58
241.07
Managerial Economics: First Review Session
Living Wage Case: Illustrative Tables
Changes in employment
Elasticity
low
median
high
Annual incomes
income group:
low ($5.15/hour)
medium ($6.50/hour)
high ($8.00/hour)
# of low income
workers
19886
19886
19886
# of low
income
workers in gross number net number of
affected jobs
of jobs lost
jobs lost
2983
2983
2983
affected work ers
before
after
$10,300.00
$17,920.00
$13,000.00
$17,920.00
$16,000.00
$17,920.00
121
241
362
91
182
273
other work ers
before
after
$10,300.00
$10,300.00
$13,000.00
$12,565.88
$16,000.00
$15,830.59
Managerial Economics: First Review Session
The Living Wage Case
Summary of Main Issue
These calculations show that a living wage
Raises incomes for low-income workers who
keep their jobs.
Results in unemployment for some workers,
particularly the poorest.
Managerial Economics: First Review Session
The Living Wage Case
Other Issues to Consider
1. Number of people re-hired in city or county
(and associated wage effects)
2. Cost to the city (higher wages to city workers)
of about $70 per capita.
3. Other?
Managerial Economics: First Review Session
Practice Exam
Managerial Economics: First Review Session
1. Governor Bigpol likes to claim that he has done more for education than
any other governor in the history of his state. He bases this claim on the fact
that state aid for education has increased from $2,500 per pupil when he took
office in 1995 to $4,500 per pupil today (2006)—an increase of 80 percent!
a. You have been asked to evaluate Governor Bigpol’s claim. The first
thing you did was to look up the price deflator for state and local
government purchases. With 2006 as the base year, this price
deflator is 50 in 1995. How much has state aid per pupil increased in
real terms since 1995?
Answer:
Nominal
2006 $4500
1995 $2500
Change
Price Index
100
50
Real
$4500
$5000
-10%
Managerial Economics: First Review Session
b. The price deflator for state and local government
purchases is expected to go up to 110 in 2007.
How much will state aid per pupil have to increase
next year to stay constant in real terms?
Answer:
$4,500 (110/100)
= $4,950
= $450 increase
Managerial Economics: First Review Session
2. A recent newspaper column pointed out that “from September 2004 to
September 2005, the average retail gasoline price jumped to $2.90 from
$1.87, or 55 percent. Yet gasoline consumption dropped only 3.5 percent, to
8.83 billion barrels a day in September 2005 from 9.15 billion barrels a day in
September 2004.”
a. Based on these figures, what is the price elasticity of demand for
gasoline?
Answer:
Q / Q
-3.5
e=
=
=  .064
P / P
55
Managerial Economics: First Review Session
b. If the government imposed a $2.00 per gallon tax
on gasoline, how much would the consumption of
gasoline drop? (Be sure to specify any assumptions
you make in answering this question.)
Answer:
P
2.00
=
= 0.689
P
2.90
Q
P
= (e) ( ) = ( 0.064) (0.689)  (-0.04)
Q
P
Q  (8.83) (-0.04) = -0.388
Assumption: Supply curve is horizontal, so tax is
fully passed on to consumers.
Managerial Economics: First Review Session
c. These figures describe the short-run price elasticity of
demand. Do you think the elasticity would be higher or
lower in the long run? Explain.
Answer:
Elasticity measures responsiveness. Consumers can be more
responsive in the long run by, e.g., buying more fuel-efficient
cars, arranging car pools, or buying a bicycle.
Managerial Economics: First Review Session
3. You run a recreation center for the elderly. Your budget is
limited, but you try to provide a range of services, including
movies, concerts, and lectures. A movie, a concert, and a lecture
each cost you $500. To gather information about the best mix of
services to provide, you recently surveyed the people who use
your center. A large majority said that they would be equally
happy with two more movies every month, one more concert
every month, or one more lecture every two months.
Given all this information, should you alter the way your budget
is allocated across these three services? If so, how? Explain your
answer in detail.
Managerial Economics: First Review Session
Answer:
This question gives information about marginal utilities.
MUA
(2 movies)
= MUB
= MUC
(1 concert)
(½ lecture)
Cost of 2 movies = 1000; Cost of ½ lecture = 250
Thus,
MU C
MU A
MU B
<
<
1000
500
250
So you should move money from A to C: Fewer movies, more
lectures. This only applies at the margin; it does not indicate
that you should have more lectures than movies!
Managerial Economics: First Review Session
4. The high cost of heating this winter has been
particularly hard on poor families. One proposal
to address this problem is fuel stamps, which are
coupons issued by the government that can be
used to pay for the gas, oil, or electricity needed
to heat a house or apartment. This proposal
would give each poor family fuel stamps equal to
about 150 percent of the average amount poor
families are currently paying for heat.
Managerial Economics: First Review Session
a. Draw a poor household’s maximization diagram to
show how fuel stamps are likely to affect their fuel
consumption. (Assume that renters all pay their
heating bills separately from their rent.)
EE
F1
1.5 F1
Fuel
Managerial Economics: First Review Session
b. Do you think poor families would consume less fuel if the
government simply gave them income equal to the cost of
the fuel stamps? Explain.
Answer:
They are likely to consume less fuel with a cash grant. The fuel
stamps greatly exceed their current fuel consumption, so with
the added choice associated with a cash grant, they are likely to
select more of other things.
The diagram in (a) shows an income grant (dashed part of
budget line) and a tangency point with a higher indifference
curve than the one reached with the fuel stamps—and with
lower fuel consumption.
Managerial Economics: First Review Session
c. Fuel stamps obviously would affect the demand for fuel.
Draw a supply-demand diagram to show the impact of fuel
stamps on the price of fuel.
Answer:
S
P
So P increases unless S is
infinitely elastic.
D1
Fuel
D2
Managerial Economics: First Review Session
d. Now draw another household maximization
diagram that incorporates the price change from
part (c).
Answer:
EE
Effect of price increase
Possible lost opportunities
Fuel
Managerial Economics: First Review Session
EXTRA CREDIT. Is it possible that the fuel stamps program
could make some poor families worse off? Explain.
Answer:
Yes, it is possible (but unlikely) a household that consumes a lot
of fuel might be hurt more by the price increase that helped by
the fuel stamps. But the price increase would be substantial. In
the figure drawn for part (d), the price increase would have to be
so large that the budget line cut the original budget line (as in
the figure drawn for part (d)), AND the household would have to
consume so much fuel that their original choice was on the
segment of the original budget line that is above the new line
with the price increase.
Managerial Economics: First Review Session
Additional Question 1
Why does a standard welfare program, which
has an income guarantee and a “tax rate,” also
known as a benefit reduction rate, always
reduce work effort?
Answer: Because both the income effect (due to
higher income) and the substitution effect (due
to lower “price” of leisure) lead to more leisure.
Managerial Economics: First Review Session
Additional Question 1, Diagram
Time Constraint
Slope = -w(1-t)



Substitution Effect
0
Guarantee
L1
Income Effect
L2
L3
 Leisure Hours per Day, L
 Work Hours per Day
Managerial Economics: First Review Session
Additional Question 2
George is pondering his entertainment budget.
He likes music and movies. In his community,
he has to pay $20 for a music CD or $10 for a
ticket to a movie.
After some reflection, he recognizes that he
would get equal satisfaction from either
another CD or another movie.
Should George change the way he is allocating
his entertainment budget? Explain with a
diagram.
Managerial Economics: First Review Session
Additional Question 2
Answer:
Yes, George should shift away from CDs toward
movies.
MUmovie /Pmovie is greater than MUCD /PCD , and
George would be better of by moving to the
tangency point where these ratios are equal.
Managerial Economics: First Review Sesssion
Consumer Maximization
Budget line (slope = ½)
CDs
Indifference curve (slope=1 at point c)
Optimal Bundle
(slopes are equal)
c
e
I3
I2
I1
0
Movies