Chapter 5

Consumer surplus

Household choice in input markets

Consumer Surplus

• The difference between the maximum amount a person is willing to pay for a good and its current market price

Example - Consider consumer surplus in the market for hamburgers...

Millions of hamburgers per month

Price ($)

1 7

$2.50

$5.00

Demand

A

E

2 3

B C

Example - Consider consumer surplus in the market for hamburgers...

Millions of hamburgers per month

Price ($)

1 7

$2.50

$5.00

Demand

A

E

2 3

B C

Price ($)

1 7

$2.50

$5.00

Demand

E

2 3

Total consumer surplus

Diamond/water paradox

• Water: – greatest value in use, little value in exchange– Plentiful supply – Each of us enjoys an enormous consumer

surplus

• Diamond – Greatest value in exchange, little value in use

Household Choice in Input Markets

• Households must sell land, labor, and capital in markets for inputs in order to earn the income that they spend on goods and services.

• We will focus on the labor supply decision...

Labor supply

• In labor markets, households must decide:– Whether to work

– How much to work

– What kind of a job to take

• These decisions are affected by:– The availability of jobs

– Market wage rates

– The skill possessed by the household

Labor or Leisure?

• The labor supply decision involves a choice between consuming “labor” or “leisure”.

• Labor is defined as working in exchange for a wage.

• Leisure is defined as time spent doing nonmarket activities.

Example-Suppose Sally’s market wage is $10 per hour.

• Consider Sally. She has 24 hours per day to allocate between labor and leisure.

• If Sally chooses no hours of leisure per day, she will earn 24 times her hourly wage. (A)

• If Sally chooses no hours of work per day, she will earn no income but will enjoy 24 hours of leisure.(B)

24w

24 Hours of leisure per day

A

B

Income per day

0

Example-Suppose Sally’s market wage is $10 per hour.

• Sally could choose to work 24 hours per day and earn $240. (A)

• Sally could choose to work no hours and earn no income. (B)

• Sally could choose to work 8 hours per day, earn $80, and “buy” 16 hours of leisure. (C)

• The “price” of leisure is $10 per hour.

$240

24Hours of leisure per day

A

B

C

Income per day

$80

160

Example-suppose sally’s wage is $12 now

• Suppose Sally’s market wage rises from $10 per hour to $12 per hour

• Does she work MORE, or LESS?

• Depends

$240

24Hours of leisure per day

A

B

C

Income per day

$80

160

$288

$96 C’

What if wages increase?

• Consider the household’s response to an increase in wages.– The income effect says that the household can

now afford to buy more leisure,however,

– the substitution effect says that the opportunity cost of leisure is now higher; given the law of demand, the household will buy less leisure.

Labor Supply Curve

• A diagram that shows the quantity of labor supplied as a function of the wage rate

• Its shape depends on the income and substitution effects of a wage change.

Labor supply curve• Since either of these effects can dominate, the labor

supply curve can have several different shapes.

Wage rate $/hour

Units of labor

Substitution effect > Income effect Income effect > Substitution effectWage rate

Units of labor

$10

$12

Saving and Borrowing: Present vs. Future Consumption

• Households can use present income to finance future spending (i.e., save), or they can use future funds to finance present spending (i.e., borrow).

Interest

• Interest = the opportunity cost of present spending.

• When interest rates rise, present spending becomes more expensive.

Changes in interest rates have income and substitution effects.

• SUPPOSE INTEREST RATES RISE: • Income effect: Households will now earn

more on all previous savings, so they will save less

• Substitution effect: The opportunity cost of present consumption is now higher; given the law of demand, the household will save more.

Financial capital market

• The complex set of institutions in which suppliers of capital (households that save) and the demand for capital (business firms wanting to invest) interact.

• We won’t discuss in detail in our class.

Chapter Summary

• A household’s opportunity set describes what can be purchased; along with utility theory, it helps to describe what will be purchased.

• A household’s utility maximizing bundle of outputs has equal marginal utility per dollar spent on each good.

• The labor supply curve can be upsloping or backward bending, depending upon the relative strength of income and substitution effects.

• Saving and borrowing decisions depend on interest rates.