Prepared by Dr Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 5: Using Consumer Choice Theory By Edgar K Browning & Mark A Zupan John Wiley & Sons, Inc 13th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives    Determine how an excise subsidy affects consumer welfare and why it results in a deadweight loss Examine how the public provision of a certain quantity of a good such as education may lead to less consumption of the good Analyze how a voucher program would affect the quantity of educational services chosen by parents for their children (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives    (continued) Explore the impact of per-bag charges versus a fixed annual fee on the amount of trash generated by a community, recycling, and household welfare Develop an intertemporal model that illuminates the consumer’s choice to save or borrow and shows how changes in endowment and the interest rate affect that choice Understand how the theory of consumer choice can explain what types of financial assets an individual intent on saving for the future should purchase, or invest in Copyright © 2015 John Wiley & Sons, Inc All rights reserved Determine how an excise subsidy affects consumer welfare and why it results in a deadweight loss 5.1 EXCISE SUBSIDIES, HEALTH CARE, AND CONSUMER WELFARE Copyright © 2015 John Wiley & Sons, Inc All rights reserved Excise Subsidies, Health Care, and Consumer Welfare Excise subsidy – a form of subsidy in which the government pays part of the per-unit price of a good and allows consumers to purchase as many units as desired at the subsidized price  Example: tax credit for a expenditures on a specific good or service  Lowers the price to the consumer or taxpayer Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 5.1 - Excise versus Lump-Sum Subsidy Copyright © 2015 John Wiley & Sons, Inc All rights reserved The Relative Effectiveness of a LumpSum Transfer  Lump-sum transfer – a form of subsidy in which the government gives the consumer a cash grant to be spent in any way the recipient wants  Cash transfer: has an income effect  Excise subsidy: has both an income effect and a substitution effect  Consequently, consumers prefer a cash grant but they not necessarily purchase more of an otherwise subsidized good Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using the Consumer Surplus Approach  Implication – The consumer could be better off with an alternative subsidy of the same cost to the government  Deadweight loss – a measure of the aggregate loss in wellbeing resulting from output not being at the efficient level  It does NOT mean that the consumer is worse off under the excise subsidy than with no subsidy at all Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 5.2 – Excise Subsidy Using Consumer Surplus Copyright © 2015 John Wiley & Sons, Inc All rights reserved Subsidizing Consumption  The government has two ways to subsidize consumption:    Reduce the price Provide a particular quantity of the good or service at a price below the market price Examples:      Health insurance Education Garbage disposal The Consumer’s Choice to Save or Borrow Investor Choice Copyright © 2015 John Wiley & Sons, Inc All rights reserved 10 The Consumer’s Choice to Save or Borrow   Decision to save (or borrow): a decision to rearrange consumption between various time periods What factors influence decisions to save or borrow?  Current income  Future income  Interest rate Copyright © 2015 John Wiley & Sons, Inc All rights reserved 28 Endowment Point  Endowment point: the consumption mix available to the individual if no saving or borrowing takes place  By saving or borrowing, the consumer can choose a different market basket Copyright © 2015 John Wiley & Sons, Inc All rights reserved 29 Figure 5.9 – Consumer Choice over Two Time Periods Copyright © 2015 John Wiley & Sons, Inc All rights reserved 30 A Change in Endowment Endowment Point can change due to  Change in current income  Change in future income  Change in interest rate  Circumstances in intertemporal choice between saving and borrowing Copyright © 2015 John Wiley & Sons, Inc All rights reserved 31 Figure 5.10 - An Income Change and Intertemporal Choice Copyright © 2015 John Wiley & Sons, Inc All rights reserved 32 Figure 5.11 - Social Security and Saving Copyright © 2015 John Wiley & Sons, Inc All rights reserved 33 Figure 5.12 - A Change in Interest Rate on Saving or Borrowing Copyright © 2015 John Wiley & Sons, Inc All rights reserved 34 Understand how the theory of consumer choice can explain what types of financial assets an individual intent on saving for the future should invest in, or purchase 5.6 INVESTOR CHOICE Copyright © 2015 John Wiley & Sons, Inc All rights reserved 35 Investor Choice - Terminology  Two characteristics of financial assets:      return risk Tradeoff between return and risk Expected return – the summed value of each possible rate of return weighted by its probability Expected utility – the summed value of each possible utility weighted by its probability Copyright © 2015 John Wiley & Sons, Inc All rights reserved 36 Risk: Attitude and Utility  Risk averse – a state of preferring a certain return to an uncertain prospect that generates the same expected return  Risk neutral – a state of deriving the same utility from a certain return as from an uncertain prospect generating the same expected return  Risk loving – a state of deriving less utility from a certain return than from an uncertain prospect generating the same expected return Copyright © 2015 John Wiley & Sons, Inc All rights reserved 37 Figure 5.13 - The Return-Risk Tradeoff Copyright © 2015 John Wiley & Sons, Inc All rights reserved 38 Figure 5.14 - Differences in Individuals’ Risk-Return Preferences Copyright © 2015 John Wiley & Sons, Inc All rights reserved 39 Figure 5.15 - Investor Preferences and Risk Copyright © 2015 John Wiley & Sons, Inc All rights reserved 40 Minimizing Exposure to Risk  Insurance – an arrangement by which the consumer pays a premium in return for the promise that the insurer will provide compensation for losses due to misfortune  Diversification – investing a given amount of resources in numerous independent projects instead of a single project in order to minimize exposure to risk Copyright © 2015 John Wiley & Sons, Inc All rights reserved 41 Figure 5.16 – Pricing Insurance Copyright © 2015 John Wiley & Sons, Inc All rights reserved 42 ... borrow and shows how changes in endowment and the interest rate affect that choice Understand how the theory of consumer choice can explain what types of financial assets an individual intent on... Change in Endowment Endowment Point can change due to  Change in current income  Change in future income  Change in interest rate  Circumstances in intertemporal choice between saving and. .. a LumpSum Transfer  Lump-sum transfer – a form of subsidy in which the government gives the consumer a cash grant to be spent in any way the recipient wants  Cash transfer: has an income effect