Chapter 6
From Demand to Welfare
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
Dissecting the effects of a price change
Measuring changes in consumer welfare
using demand curves
Measuring changes in consumer welfare
using cost-of-living indexes
Labor supply and the demand for leisure
6-2
Dissecting the Effects of a
Price Change
When a price increases two things
happen:
That good becomes expensive relative to
others; consumers shift their purchases
away from the more expensive good
Consumers’ purchasing power falls
Economists have learned a lot about
consumer demand and welfare from
thinking about price changes this way
6-3
Dissecting the Effects of a
Price Change
As the price of a good changes, the
consumer’s well-being varies
An uncompensated price change is one
with no change in income
A compensated price change is a price
change and an income change that
together leave the consumer’s well-being
unaffected
6-4
Figure 6.1: Compensated Price
Effects
6-5
Substitution and Income Effects
Uncompensated price change has two
parts:
Substitution effect: the effect of a
compensated price change, causing the
consumer to substitute one good for another
Income effect: the effect on consumption of
removing the compensation, affecting the
consumer’s purchasing power
6-6
Substitution and Income Effects
Substitution effect involves:
Movement along an indifference curve
To a point where the slope is the same as
the new budget line
Income effect involves:
Parallel shift in the budget constraint
Toward the origin for a price increase
Away from the origin for a price decrease
6-7
Figure 6.2: Substitution and
Income Effects
6-8
Direction of Substitution Effect
Substitution effect of price increase is:
Negative for price increase
Positive for price decrease
Consumer substitutes away from the
good that becomes relatively more
expensive
6-9
Figure 6.3: Direction of the Substitution
Effect for a Price Increase
6-10
Direction of Income Effect
Direction of income effect depends on whether
the good is normal or inferior
Increase in the good’s price reduces the
consumer’s purchasing power
Consumer will buy less of the good if it is normal,
but more if it is inferior
Income effect of a price increase is:
Negative for normal good
Positive for inferior good
6-11
Figure 6.4: Direction of the
Income Effect for a Price Increase
6-12
Direction of Income and
Substitution Effects
Substitution effect is:
Negative for a price increase
Positive for a price reduction
For a normal good, the income effect
reinforces the substitution effect:
Negative for a price increase
Positive for a price reduction
For an inferior good, the income effect opposes
the substitution effect:
Positive for a price increase
Negative for a price reduction
6-13
Why Do Demand Curves Slope
Downward?
The Law of Demand states that demand
curves slope downward
Substitution effect is always consistent with
Law of Demand
For normal goods, income effect reinforces
substitution effect
Normal goods always obey the Law of Demand
Theoretically, if income effect for an inferior
good is large enough to offset substitution
effect, could violate Law of Demand
6-14
Figure 6.5: Giffen Good
Giffen goods are
inferior, and the
amount purchased
increases as the
price rises
Income effect is
larger than the
substitution effect
6-15
Compensating Variation
How can a consumer measure economics
gains and losses in monetary terms?
Compensating variation: the amount of
money that exactly compensates the consumer
for a change in circumstances
Example: If the compensating variation for a
gasoline tax is $50, then the consumer is better
off with the tax as long as he receives a rebate
for more than $50
6-16
Sample Problem 1 (6.6)
Think about your own preferences. What is your
compensating variation for each of the following
changes in your plans or expectations?
Listening to your economics professor perform a onehour poetry reading (I am a trained and skilled actor).
Meeting your favorite musician (boy bands do not
count).
Adding a week to the length of your spring break.
Majoring in economics if you plan to major in
something else; majoring in something else if you plan
to major in economics. (Econ majors earn more!)
Consumer Surplus
Consumer surplus is the net benefit a
consume receives from participating in the
market for some good
Amount of money that would compensate the
consumer for losing access to the market,
compensating variation
Consumer’s demand curve measures the
gross benefit of consuming a good
Consumer surplus is area below the demand
curve and above a horizontal line at the price
6-18
Figure 6.6: Consumer Surplus
6-19
Using Consumer Surplus to
Measure Changes in Welfare
Some public policies alter prices and amounts
of traded goods
Consumer surplus is useful, allows us to
measure change in net economic benefit from
the policy
This is another way to describe compensating
variation for the policy
Example:
Policy reduces consumer surplus from $100 to $80
Must provide her with $20 to compensate fully for
the policy’s effects
6-20
Figure 6.7: Change in Consumer
Surplus
When price = $2,
consumer surplus is
grey and brown
shaded areas
When price = $4,
consumer surplus is
grey area
Brown area is
change in consumer
surplus
6-21
Sample Problem 2 (6.10)

Beatriz enjoys writing and uses a large amount of
paper. Currently, paper costs $2 for 100 sheets. The
formula for her demand curve is S = 525 – 50PS,
where PS is the price of 100 sheets and S is the
number of sheets purchased. The governor of her
state has proposed taxing paper at the rate of $0.5 for
each 100 sheets. Assume that this policy would
increase the price of paper to $2.50 (including tax).
a. Draw Beatriz’ demand curve. Compute the change in her
consumer surplus for the proposed tax increase.
b. How much revenue will the government raise by taxing
Beatriz? How does that revenue compare to her
economic losses? Does the new tax raise enough
revenue to compensate her for her loss?
Measuring Changes in Consumer Welfare
Using Cost-of-Living Indexes
A cost-of-living index measures the relative
cost of achieving a fixed standard of living in
different situations
Commonly used to measure changes in the
cost of living over time
Can be used to measure changes in consumer
well-being due to public policies that alter
prices or income
Example: Consumer Price Index
6-23
Cost-of-Living Indexes: Basics
Base value of one during some specific period
Level of index in the base period is
unimportant
All that matters is percentage change in the
index
Example: Value of index in 1998 is 1; value in 2006
is 1.2, then cost of living has risen by 20%
Ideally should allow us to quickly evaluate
changes in consumer well-being following
changes in prices and income
6-24
Cost-of-Living Indexes: Basics
 Use to convert nominal income into real income
Real income 
Nominal income
Value of cost - of - living index
 If real income has risen, then:
 Nominal income has grown more rapidly than then cost of
living
 Consumer should be better off
 Ideally, change in real income should measure the
change in the consumer’s well-being
 Difficult to construct a good cost-of-living index
because different prices change by different
proportions
6-25
Fixed-Weight Price Indexes
Select a consumption bundle and measure its
cost in multiple time periods, using prices at
which the goods were available
Fixed-weight price index: measures
percentage change in the cost of a fixed
consumption bundle
Easy to calculate, requires no information
about consumer preferences
But what consumption bundle is appropriate?
Example: Laspeyres price index
6-26
Sample Problem 3 (6.11)
Arnold spends all his money on sunscreen and
lemonade. In June he bought 5 ounces of
sunscreen at $1 per ounce and 20 gallons of
lemonade at $1.30 per gallon. In July he bought 7
ounces of sunscreen at $1.10 per ounce and 18
gallons of lemonade at $1.70 per gallon. In
August he bought 3 ounces of sunscreen at
$1.40 per ounce and 23 gallons of lemonade at
$1.80 per gallon.
Create a Laspayeres price index using June as the
base period. How did his cost of change according to
this measure?
Labor Supply
Consumer buy goods and services
Many are also sellers (e.g., sell their
work effort)
Labor supply refers to the sale of a
consumer’s time and effort to an
employer
To study labor supply, economists often
study demand for leisure
6-28
Labor-Leisure Choice:
An Example
Javier’s possible income sources:
Allowance of $30 per day (no strings attached!)
Job that pays $5 per hour
14 hours per day available to allocate toward
work and leisure
Assume all money spent on food
Decision about how many hours of leisure to
enjoy (and thus how many to work) depends
on his preferences
6-29
Figure 6.10: Labor-Leisure Choice
With the dark red
preferences, Javier
chooses 8 hours of
leisure (6 hours of
work) per day
With the light red
preferences, Javier
chooses not to work
6-30
Effect of Wages on Hours of Work
How does a change in wage affect a
consumer’s budget line?
In Javier’s case, he will have $30 to spend on
food regardless of his wage
Wage change rotates his budget line, getting
steeper with higher hourly wages
Points of tangency between indifference curves
and budget lines form a price-consumption
path
This leads to Javier’s leisure demand curve in
Figure 6.11(b)
6-31
Figure 6.11: Leisure Demand and
Labor Supply Curves
6-32
Labor Demand Curves
Do labor demand curves obey the Law of
Demand?
Some people may have backward bending
labor supply curves
Increase in wage reduces the supply of labor
for some range of wages
Due to income effects:
People own more time than they consume
Increase in wage rate raises their purchasing power
Increases their consumption of leisure, a normal
good
6-33
Figure 6.12: Effects of Increase in
Wage Rate
 Increase in wage rate
leads to opposing
income and substitution
effects
 Income effect
overwhelms substitution
effect
 Wage increase results in
reduced number of labor
hours
6-34
Effect of Wages on Labor Force
Participation
Given that backward bending labor
supply curves exist:
Can a wage reduction cause someone who
would not otherwise work to enter the labor
market?
NO!
Can a wage increase drive someone who
would otherwise work out of the labor
market?
NO!
6-35
Figure 6.13: Effect of Wage Rate
on Labor Force Participation
 A wage lower than the
wage represented on the
black budget line cannot
lead Javier to enter the
labor force
 A wage increase rotates
the budget line upward
and can entice him to
choose to work (e.g., by
selecting bundle G)
6-36
Thought Question
Empirical studies estimate the following labor
supply elasticities for the head of the household:
Single men (no children): 0.26
Single women: 0.011; with children: 0.106
 One-earner family (with children): -0.078
 Two-earner family (with children): -0.002
Two-earner family (no children): -0.107
What do these estimates tell us about household
labor supply behavior?