1 00:00:00,040 --> 00:00:02,460 The following content is provided under a Creative 2 00:00:02,460 --> 00:00:03,870 Commons license. 3 00:00:03,870 --> 00:00:06,910 Your support will help MIT OpenCourseWare continue to 4 00:00:06,910 --> 00:00:10,560 offer high quality educational resources for free. 5 00:00:10,560 --> 00:00:13,460 To make a donation or view additional materials from 6 00:00:13,460 --> 00:00:17,390 hundreds of MIT courses, visit MIT OpenCourseWare at 7 00:00:17,390 --> 00:00:18,640 ocw.mit.edu. 8 00:00:22,460 --> 00:00:24,000 PROFESSOR: We're going to start with an interesting 9 00:00:24,000 --> 00:00:32,040 application of demand curve analysis, of the kind of 10 00:00:32,040 --> 00:00:34,320 indifference curve and constrained choice analysis 11 00:00:34,320 --> 00:00:38,200 we've been doing, the case of food stamps. 12 00:00:38,200 --> 00:00:40,100 And then we're going to move on and talk about deriving 13 00:00:40,100 --> 00:00:41,510 demand curves. 14 00:00:41,510 --> 00:00:43,710 So let's talk about food stamps. 15 00:00:43,710 --> 00:00:44,850 It's an interesting case. 16 00:00:44,850 --> 00:00:48,530 This is a policy that's been in place in the US government 17 00:00:48,530 --> 00:00:53,440 for a very long time, which are essentially coupons that 18 00:00:53,440 --> 00:00:55,430 individuals can use to buy food. 19 00:00:55,430 --> 00:00:56,880 It used to literally be coupons. 20 00:00:56,880 --> 00:00:59,800 It used to literally, you'd get a stamp, a coupon, and 21 00:00:59,800 --> 00:01:01,510 you'd go to the supermarket and hand this in instead of 22 00:01:01,510 --> 00:01:03,830 cash to buy your goods. 23 00:01:03,830 --> 00:01:05,660 Now it's actually a debit card. 24 00:01:05,660 --> 00:01:08,830 And it's given to low-income individuals as a way of 25 00:01:08,830 --> 00:01:10,020 redistributing income in society. 26 00:01:10,020 --> 00:01:13,900 So individuals of income below a certain level, typically, 27 00:01:13,900 --> 00:01:17,960 say, a family with income below about $25,000 a year, 28 00:01:17,960 --> 00:01:24,760 below what we call the US poverty line, will be eligible 29 00:01:24,760 --> 00:01:27,020 for food stamps, which is a debit card they can use to 30 00:01:27,020 --> 00:01:29,670 charge their food purchases. 31 00:01:29,670 --> 00:01:33,160 Now, what I want to talk about today is how we can use the 32 00:01:33,160 --> 00:01:36,470 kind of analysis we've done so far to think about the effect 33 00:01:36,470 --> 00:01:38,010 of food stamps. 34 00:01:38,010 --> 00:01:40,830 So let's start with figure 6-1. 35 00:01:40,830 --> 00:01:43,150 And let's think about someone with an original budget line. 36 00:01:43,150 --> 00:01:46,280 If someone has a budget line, they have income of $1,000. 37 00:01:46,280 --> 00:01:50,050 OK, a very poor person, they have income of $1,000. 38 00:01:50,050 --> 00:01:52,450 And let's talk about them, their choices between food and 39 00:01:52,450 --> 00:01:53,270 all other goods. 40 00:01:53,270 --> 00:01:54,390 Once again we have this analysis. 41 00:01:54,390 --> 00:01:55,930 We put everything in two dimensions. 42 00:01:55,930 --> 00:01:59,230 What we think about is via mental accounting, as we 43 00:01:59,230 --> 00:02:00,790 talked about last time. 44 00:02:00,790 --> 00:02:03,010 However you want to justify it to yourself, the way we model 45 00:02:03,010 --> 00:02:04,900 it is thinking about people having this choice along two 46 00:02:04,900 --> 00:02:07,290 dimensions, food and other goods, and they 47 00:02:07,290 --> 00:02:09,800 have income of $1000. 48 00:02:09,800 --> 00:02:10,949 Let's say we'll have two individuals, 49 00:02:10,949 --> 00:02:12,460 individual x and y. 50 00:02:12,460 --> 00:02:16,570 Individual x doesn't care that much about food. 51 00:02:16,570 --> 00:02:19,010 They really like consuming other goods. 52 00:02:19,010 --> 00:02:21,470 So they spend $600 of their income on other 53 00:02:21,470 --> 00:02:23,560 goods and $400 on food. 54 00:02:23,560 --> 00:02:26,015 Individual y cares a lot about food. 55 00:02:26,015 --> 00:02:29,300 They end up spending $900 of their budget on food. 56 00:02:29,300 --> 00:02:31,690 And that should be 100. 57 00:02:31,690 --> 00:02:32,910 100 on other goods. 58 00:02:32,910 --> 00:02:37,590 So that y-intercept should be 100 for person y. 59 00:02:37,590 --> 00:02:40,780 So they spend 900 on food and 100 on other goods. 60 00:02:40,780 --> 00:02:43,820 Now let's say the government comes in and wants to consider 61 00:02:43,820 --> 00:02:45,130 two options. 62 00:02:45,130 --> 00:02:47,800 The government decides, look, we want to help poor people. 63 00:02:47,800 --> 00:02:50,560 And particularly we want to give people like these people 64 00:02:50,560 --> 00:02:53,890 $500 in resources. 65 00:02:53,890 --> 00:02:55,180 Let's think of two different ways the 66 00:02:55,180 --> 00:02:56,850 government could do that. 67 00:02:56,850 --> 00:02:58,060 One way the government could do it is it 68 00:02:58,060 --> 00:02:59,530 could give them cash. 69 00:02:59,530 --> 00:03:00,960 It could say, look, we're going to send 70 00:03:00,960 --> 00:03:03,500 you a check for $500. 71 00:03:03,500 --> 00:03:06,070 What would that do to their budget constraint? 72 00:03:06,070 --> 00:03:08,450 Well that would shift it out, as we talked about last time. 73 00:03:08,450 --> 00:03:11,440 It would be an outward shift of $500 at every point. 74 00:03:11,440 --> 00:03:13,460 So their new budget constraint would be the line that runs 75 00:03:13,460 --> 00:03:17,470 from $1,500 of all other goods to $1,500 dollars in food. 76 00:03:17,470 --> 00:03:18,570 So include that. 77 00:03:18,570 --> 00:03:21,570 So both the solid and dashed portions would be their new 78 00:03:21,570 --> 00:03:23,360 budget constraint. 79 00:03:23,360 --> 00:03:26,830 So the new budget constraint would run from 1,500 to 1,500. 80 00:03:26,830 --> 00:03:32,450 Person x would choose to move from x1 to x2. 81 00:03:32,450 --> 00:03:34,800 I'm sorry, they would choose to move from x1. 82 00:03:34,800 --> 00:03:36,250 It's not labeled as a point. 83 00:03:36,250 --> 00:03:39,710 But they would actually choose to move from indifference 84 00:03:39,710 --> 00:03:42,020 curve 2 to indifference curve 3. 85 00:03:42,020 --> 00:03:44,200 OK, that's where they'd choose to move if they could choose 86 00:03:44,200 --> 00:03:45,720 along this entire line. 87 00:03:45,720 --> 00:03:47,990 Let me sort of, well, I'm not going to draw it, because I'll 88 00:03:47,990 --> 00:03:48,730 do a bad job. 89 00:03:48,730 --> 00:03:50,730 But basically, if you can think about the new budget 90 00:03:50,730 --> 00:03:54,530 constraint running from 1,500 to 1,500, person x would move 91 00:03:54,530 --> 00:03:58,140 from indifference curve 2 to indifference curve 3. 92 00:03:58,140 --> 00:03:59,390 They would choose-- 93 00:04:01,640 --> 00:04:02,390 Actually, you know what? 94 00:04:02,390 --> 00:04:03,700 Let's put this graph aside. 95 00:04:03,700 --> 00:04:04,970 It's not quite right along the number of dimensions. 96 00:04:04,970 --> 00:04:07,170 I'm going to draw this, because there's a number of 97 00:04:07,170 --> 00:04:08,420 problems with that. 98 00:04:11,260 --> 00:04:19,029 So you've got an original budget line that runs from 99 00:04:19,029 --> 00:04:23,730 1,000 to 1,000. 100 00:04:23,730 --> 00:04:28,110 And we've got person x up here, and they're choosing to 101 00:04:28,110 --> 00:04:31,725 spend 400 on food and 600 on other goods. 102 00:04:31,725 --> 00:04:33,590 And we've got person y down here. 103 00:04:33,590 --> 00:04:35,890 This is person x, and they're in section x1. 104 00:04:42,000 --> 00:04:47,150 And person y intercepts at y1 where they choose to spend 900 105 00:04:47,150 --> 00:04:50,600 on food and 100 on other goods. 106 00:04:50,600 --> 00:04:52,350 Now, the government first says, look, we're going to 107 00:04:52,350 --> 00:04:54,440 give people $500 in cash. 108 00:04:54,440 --> 00:04:58,050 That just shifts the budget constraint out parallel, but 109 00:04:58,050 --> 00:05:02,360 now runs from 1,500 to 1,500. 110 00:05:02,360 --> 00:05:04,920 Let's say that the choices people make-- 111 00:05:04,920 --> 00:05:06,853 Person x would say, great, I'm going to take that money, I'm 112 00:05:06,853 --> 00:05:09,920 going to spend almost all of it on other goods. 113 00:05:09,920 --> 00:05:14,880 So I'm going to move to a point like x2, where I'm going 114 00:05:14,880 --> 00:05:20,480 to consume $1,200 on-- 115 00:05:20,480 --> 00:05:22,730 I'm going to consume-- 116 00:05:22,730 --> 00:05:23,210 They were consuming-- 117 00:05:23,210 --> 00:05:23,910 No, I'm sorry. 118 00:05:23,910 --> 00:05:28,440 15, right. 119 00:05:28,440 --> 00:05:32,360 They're going to move from spending $600 on other goods 120 00:05:32,360 --> 00:05:35,940 and $400 on food to spending $1,100 of their dollars on 121 00:05:35,940 --> 00:05:38,224 other goods, and-- 122 00:05:38,224 --> 00:05:39,940 let me think for a second. 123 00:05:39,940 --> 00:05:41,380 Let's say they would go vertically. 124 00:05:41,380 --> 00:05:44,380 So let's say they'd choose to spend all 125 00:05:44,380 --> 00:05:46,180 of it on other goods. 126 00:05:46,180 --> 00:05:51,990 So they'd take the whole 500, and they'd go from spending-- 127 00:05:51,990 --> 00:05:54,460 they'd continue to spend 400 on food, but now they'd spend 128 00:05:54,460 --> 00:05:56,220 1,100 on other goods. 129 00:05:56,220 --> 00:05:58,270 So person x, they would continue to 130 00:05:58,270 --> 00:05:59,800 spend $400 on food. 131 00:05:59,800 --> 00:06:02,420 They'd say I'm going to take that entire $500, instead of 132 00:06:02,420 --> 00:06:04,860 spending $600 on other goods, I'm going to spend $1,100 on 133 00:06:04,860 --> 00:06:06,400 other goods. 134 00:06:06,400 --> 00:06:09,384 Let's say person y, they would say, well I'm going to 135 00:06:09,384 --> 00:06:10,030 sort of split it. 136 00:06:10,030 --> 00:06:11,430 I'm going to spend some on food. 137 00:06:11,430 --> 00:06:14,200 So this is their new intercept x2. 138 00:06:14,200 --> 00:06:16,180 I'm going to spend some on food, and I'm going to spend 139 00:06:16,180 --> 00:06:16,870 some on other goods. 140 00:06:16,870 --> 00:06:19,000 So I'm going to go out here. 141 00:06:19,000 --> 00:06:20,240 I'm going to spend now-- 142 00:06:20,240 --> 00:06:22,030 instead of spending $900 on food, I'll 143 00:06:22,030 --> 00:06:25,590 spend $1,200 on food. 144 00:06:25,590 --> 00:06:27,050 I'll take $300 and spend it on food. 145 00:06:27,050 --> 00:06:29,935 Instead of spending $100 on other goods, I'll spend $300 146 00:06:29,935 --> 00:06:31,460 on other goods. 147 00:06:31,460 --> 00:06:33,660 OK, so that's person y2. 148 00:06:33,660 --> 00:06:37,780 OK, so that's what they'd do if we gave them $500 in cash. 149 00:06:37,780 --> 00:06:39,360 Now say the government came in and said, you know, we're 150 00:06:39,360 --> 00:06:42,056 going to give you $500 but in the form of a coupon that you 151 00:06:42,056 --> 00:06:43,880 can spend on food. 152 00:06:43,880 --> 00:06:45,710 So the first question is, what does that do to the budget 153 00:06:45,710 --> 00:06:47,130 constraint? 154 00:06:47,130 --> 00:06:47,880 This is a bit tricky. 155 00:06:47,880 --> 00:06:49,280 We've got to think about this. 156 00:06:49,280 --> 00:06:50,300 Think about their budget constraint. 157 00:06:50,300 --> 00:06:57,820 What that says is for anyone who wants to continue to, at 158 00:06:57,820 --> 00:07:01,390 least spend $1,000 on-- 159 00:07:01,390 --> 00:07:06,460 anyone who wants to at least spend $500 on food, it does 160 00:07:06,460 --> 00:07:08,810 not change their opportunities at all. 161 00:07:08,810 --> 00:07:11,610 So the new budget constraint looks like this. 162 00:07:11,610 --> 00:07:14,270 It's a solid line to here, and then it goes down. 163 00:07:14,270 --> 00:07:16,710 This intersects at 500. 164 00:07:16,710 --> 00:07:21,100 It's a solid line to the point at $500, and then it goes down 165 00:07:21,100 --> 00:07:22,390 and follows the old budget constraint. 166 00:07:22,390 --> 00:07:23,640 Why does it do that? 167 00:07:23,640 --> 00:07:28,750 Because for anyone to this side, they are $500 richer 168 00:07:28,750 --> 00:07:31,280 regardless of whether you give them cash or food. 169 00:07:31,280 --> 00:07:32,290 Either way they're $500 richer. 170 00:07:32,290 --> 00:07:32,950 Why? 171 00:07:32,950 --> 00:07:35,720 Because as long as you intended to spend $500 on food 172 00:07:35,720 --> 00:07:38,370 anyway, it doesn't matter the form in which the government 173 00:07:38,370 --> 00:07:39,420 gives you the money. 174 00:07:39,420 --> 00:07:40,215 Think about that for a second. 175 00:07:40,215 --> 00:07:41,890 It's very important. 176 00:07:41,890 --> 00:07:44,950 If you were going to spend $500 on food anyway, it does 177 00:07:44,950 --> 00:07:47,840 not matter if the government gives you a check for 500, or 178 00:07:47,840 --> 00:07:50,350 a food card for 500. 179 00:07:50,350 --> 00:07:51,930 Why is that? 180 00:07:51,930 --> 00:07:55,170 That's because your budget is what we call fungible. 181 00:07:55,170 --> 00:07:58,120 You can always move money around within your budget. 182 00:07:58,120 --> 00:08:01,700 So let's say you're spending 500 on cash. 183 00:08:01,700 --> 00:08:02,950 Let's take a person like y. 184 00:08:02,950 --> 00:08:04,030 Let's take a person like y. 185 00:08:04,030 --> 00:08:08,890 They were spending 900 on food and 100 on other goods. 186 00:08:08,890 --> 00:08:10,090 The government comes in and gives them a 187 00:08:10,090 --> 00:08:12,640 food card for 500. 188 00:08:12,640 --> 00:08:15,045 Well to them that's the same as $500 in cash because 189 00:08:15,045 --> 00:08:17,150 they're already spending $900 on food. 190 00:08:17,150 --> 00:08:19,670 They can just take some of the cash on food, spend it on 191 00:08:19,670 --> 00:08:22,460 other things, and use the card for the food instead. 192 00:08:22,460 --> 00:08:25,060 So for them, there's no difference in giving them cash 193 00:08:25,060 --> 00:08:27,120 or giving them the food card. 194 00:08:27,120 --> 00:08:28,180 It has the same effect. 195 00:08:28,180 --> 00:08:30,130 They move to y2 either way. 196 00:08:30,130 --> 00:08:31,610 Now let's take a person like x. 197 00:08:31,610 --> 00:08:34,826 Well, if you gave them cash, $500 cash, they'd spend none 198 00:08:34,826 --> 00:08:35,890 of it on food. 199 00:08:35,890 --> 00:08:39,200 So they've been consuming $1,100 of other 200 00:08:39,200 --> 00:08:40,400 goods and $400 of food. 201 00:08:40,400 --> 00:08:42,760 But they can't do that if you give them a food card, right, 202 00:08:42,760 --> 00:08:44,250 if you give them food stamps. 203 00:08:44,250 --> 00:08:45,710 That's not a choice. 204 00:08:45,710 --> 00:08:52,630 They are now constrained to move to a point like x3. 205 00:08:52,630 --> 00:08:55,580 They're now constrained to move to a point like x3 where 206 00:08:55,580 --> 00:08:58,770 they have to go to this intersection. 207 00:08:58,770 --> 00:09:01,630 Because this point is not attainable. 208 00:09:01,630 --> 00:09:02,710 This point is not attainable. 209 00:09:02,710 --> 00:09:03,910 If you give them food stamps, the new budget 210 00:09:03,910 --> 00:09:04,940 constraint is this. 211 00:09:04,940 --> 00:09:06,770 So x2 is no longer attainable. 212 00:09:06,770 --> 00:09:10,960 They have to move to a point like x3. 213 00:09:10,960 --> 00:09:15,330 So what do we know about their level of happiness 214 00:09:15,330 --> 00:09:16,800 at x3 versus x2? 215 00:09:19,940 --> 00:09:21,801 Someone raise their hand and tell me. 216 00:09:21,801 --> 00:09:22,643 Yeah. 217 00:09:22,643 --> 00:09:23,910 AUDIENCE: It's lower. 218 00:09:23,910 --> 00:09:24,475 PROFESSOR: It's what? 219 00:09:24,475 --> 00:09:25,320 AUDIENCE: Lower. 220 00:09:25,320 --> 00:09:25,910 PROFESSOR: It's lower. 221 00:09:25,910 --> 00:09:26,900 And how do you know that? 222 00:09:26,900 --> 00:09:30,161 AUDIENCE: Because it's kind of like, if it was on the full 223 00:09:30,161 --> 00:09:32,420 curve, they would be elsewhere. 224 00:09:32,420 --> 00:09:33,900 PROFESSOR: Well OK, so there's two different ways to see it. 225 00:09:33,900 --> 00:09:35,090 One is you could say, look they're at a lower 226 00:09:35,090 --> 00:09:35,900 indifference curve. 227 00:09:35,900 --> 00:09:37,360 You can see what's wrong with this graph. 228 00:09:37,360 --> 00:09:38,540 The indifference curves cross. 229 00:09:38,540 --> 00:09:39,570 The indifference curves can never cross. 230 00:09:39,570 --> 00:09:41,360 So that's wrong there. 231 00:09:41,360 --> 00:09:43,640 They're on a lower indifference curve, OK. 232 00:09:43,640 --> 00:09:45,763 But what's the other way to think about it? 233 00:09:45,763 --> 00:09:47,535 AUDIENCE: The marginal rate of substitution and 234 00:09:47,535 --> 00:09:48,870 transformation aren't the same. 235 00:09:48,870 --> 00:09:50,130 PROFESSOR: The marginal rate of substitution and 236 00:09:50,130 --> 00:09:51,260 transformation aren't the same. 237 00:09:51,260 --> 00:09:52,200 That's another way to think about. 238 00:09:52,200 --> 00:09:54,320 And that's always true at the optimum. 239 00:09:54,320 --> 00:09:57,240 But what else do we know about a point like this? 240 00:09:57,240 --> 00:10:00,680 They could have chosen that point before and didn't. 241 00:10:00,680 --> 00:10:01,030 Right? 242 00:10:01,030 --> 00:10:04,920 When they had the cash, they had the option of choosing 243 00:10:04,920 --> 00:10:07,210 this point, but they didn't, they chose a different point. 244 00:10:07,210 --> 00:10:15,450 So we know by something called revealed preference that 245 00:10:15,450 --> 00:10:16,130 they're worse off. 246 00:10:16,130 --> 00:10:18,000 This is a very important concept. 247 00:10:18,000 --> 00:10:25,280 If someone makes a choice that they turned down before, then 248 00:10:25,280 --> 00:10:27,900 by revealed preference they're less well off. 249 00:10:27,900 --> 00:10:31,400 We've revealed that they're worse, because they could have 250 00:10:31,400 --> 00:10:32,890 chosen this point before, but they didn't. 251 00:10:32,890 --> 00:10:35,300 When you gave them the cash, they chose this point. 252 00:10:35,300 --> 00:10:38,310 So by revealed preference we revealed they're worse off. 253 00:10:38,310 --> 00:10:39,370 So it's the same as saying their 254 00:10:39,370 --> 00:10:41,210 indifference curve is lower. 255 00:10:41,210 --> 00:10:44,120 We've revealed they're worse off. 256 00:10:44,120 --> 00:10:48,810 So what we've learned is for person y, they don't care if 257 00:10:48,810 --> 00:10:52,390 you give them cash or a food card, food stamps. 258 00:10:52,390 --> 00:10:55,090 It's called food stamps, but it's now a debit card. 259 00:10:55,090 --> 00:11:00,140 Person x is made worse off if you give them the food stamps 260 00:11:00,140 --> 00:11:02,980 instead of the cash. 261 00:11:02,980 --> 00:11:04,690 Why do it? 262 00:11:04,690 --> 00:11:05,950 You're the government. 263 00:11:05,950 --> 00:11:10,760 The US government spends $35 billion every year giving 264 00:11:10,760 --> 00:11:12,970 people food stamps instead of cash. 265 00:11:12,970 --> 00:11:15,810 Why don't we just take that $35 billion and give it to 266 00:11:15,810 --> 00:11:18,530 them in cash? 267 00:11:18,530 --> 00:11:18,960 Yeah? 268 00:11:18,960 --> 00:11:20,864 AUDIENCE: Probably because the government doesn't trust 269 00:11:20,864 --> 00:11:22,768 people to spend it on what they actually need. 270 00:11:22,768 --> 00:11:26,100 And that will just lead to more poverty and people 271 00:11:26,100 --> 00:11:28,020 wasting it on things they don't need. 272 00:11:28,020 --> 00:11:30,050 PROFESSOR: Or to put it more succinctly, what if this axis 273 00:11:30,050 --> 00:11:31,990 was not labeled other goods but labeled cocaine. 274 00:11:34,560 --> 00:11:37,080 Then we might be sad that you took the whole $500 and spent 275 00:11:37,080 --> 00:11:38,230 it on cocaine. 276 00:11:38,230 --> 00:11:42,400 We might want you to take that $500 and spend it on food. 277 00:11:42,400 --> 00:11:43,830 So it's paternalism. 278 00:11:43,830 --> 00:11:46,610 The reason we give the guys food stamps instead of cash is 279 00:11:46,610 --> 00:11:48,750 we don't trust them with the cash. 280 00:11:48,750 --> 00:11:52,180 If we trusted people with the cash, there'd be no reason not 281 00:11:52,180 --> 00:11:53,110 to give them the cash. 282 00:11:53,110 --> 00:11:57,740 We are unambiguously making them worse off by forcing them 283 00:11:57,740 --> 00:12:00,370 to consume a bundle that's on a lower utility curve, lower 284 00:12:00,370 --> 00:12:01,220 indifference curve. 285 00:12:01,220 --> 00:12:03,900 But since we don't trust them, since we're paternalistic, we 286 00:12:03,900 --> 00:12:06,830 are willing to go ahead and force them to do that. 287 00:12:06,830 --> 00:12:10,050 So then the interesting question becomes, well, how 288 00:12:10,050 --> 00:12:11,570 much are we costing them? 289 00:12:11,570 --> 00:12:12,510 In fact, it's not obvious. 290 00:12:12,510 --> 00:12:15,880 If everyone in the world looks like y, then there's no cost 291 00:12:15,880 --> 00:12:16,560 to food stamps. 292 00:12:16,560 --> 00:12:19,270 There's no good done either. 293 00:12:19,270 --> 00:12:21,570 Then it doesn't matter if we give them cash or food stamps. 294 00:12:21,570 --> 00:12:25,490 But if a lot of people look like x, then there is a 295 00:12:25,490 --> 00:12:27,360 welfare cost to people. 296 00:12:27,360 --> 00:12:30,430 They are worse off, from their own perspective, 297 00:12:30,430 --> 00:12:31,360 getting food stamps. 298 00:12:31,360 --> 00:12:33,400 Society may think they're better off. 299 00:12:33,400 --> 00:12:36,000 So how do we tell? 300 00:12:36,000 --> 00:12:36,890 How do we tell? 301 00:12:36,890 --> 00:12:38,330 Can anyone take a guess? 302 00:12:38,330 --> 00:12:40,320 If you're now an empirical economist, and you want to 303 00:12:40,320 --> 00:12:45,000 test, how would you tell if people are like x or like y? 304 00:12:45,000 --> 00:12:45,610 Any ideas? 305 00:12:45,610 --> 00:12:48,180 It's tricky, but let's see if we have any budding empirical 306 00:12:48,180 --> 00:12:48,840 economists here. 307 00:12:48,840 --> 00:12:49,190 Yeah? 308 00:12:49,190 --> 00:12:51,965 AUDIENCE: You'd see if they're spending any cash beyond the 309 00:12:51,965 --> 00:12:54,875 $500 that you gave them, because then you'd basically 310 00:12:54,875 --> 00:12:55,850 [UNINTELLIGIBLE]. 311 00:12:55,850 --> 00:12:57,665 PROFESSOR: See if they're buying food beyond the $500 312 00:12:57,665 --> 00:12:58,350 you gave them. 313 00:12:58,350 --> 00:12:59,840 AUDIENCE: They might spend $100 cash on food. 314 00:12:59,840 --> 00:13:00,320 PROFESSOR: Excellent. 315 00:13:00,320 --> 00:13:01,290 So that's one way you'd do it. 316 00:13:01,290 --> 00:13:03,640 You could look at people who get food stamps and see if 317 00:13:03,640 --> 00:13:04,540 they're spending more. 318 00:13:04,540 --> 00:13:05,550 That's a great idea. 319 00:13:05,550 --> 00:13:09,300 The other thing you could do is you could actually 320 00:13:09,300 --> 00:13:12,920 literally run an experiment where you take people who are 321 00:13:12,920 --> 00:13:15,390 getting food stamps and replace them with cash or vice 322 00:13:15,390 --> 00:13:17,910 versa and see what happens to their behavior. 323 00:13:17,910 --> 00:13:21,540 When we do this, we find that about 15% of 324 00:13:21,540 --> 00:13:22,980 people are like x. 325 00:13:22,980 --> 00:13:24,700 Or in other words, the way to say it, is 326 00:13:24,700 --> 00:13:27,940 about $0.15 more precisely. 327 00:13:27,940 --> 00:13:30,820 When you give people food stamps instead of cash, they 328 00:13:30,820 --> 00:13:33,940 spend 15% more on food than they would if you just gave 329 00:13:33,940 --> 00:13:36,280 them the cash. 330 00:13:36,280 --> 00:13:43,020 So there's about 15% lower utility compared to what 331 00:13:43,020 --> 00:13:47,500 they'd want for spending it on the food instead of the cash. 332 00:13:47,500 --> 00:13:53,120 So the question is, is it worth it? 333 00:13:53,120 --> 00:13:55,620 We're basically taking people and making them spend $0.15 334 00:13:55,620 --> 00:13:57,800 more on food than they'd want to. 335 00:13:57,800 --> 00:13:58,880 That's the right way to think about it. 336 00:13:58,880 --> 00:14:00,870 If you give them food stamps instead of cash, they spend 337 00:14:00,870 --> 00:14:02,680 $0.15 more on food than they would if you 338 00:14:02,680 --> 00:14:04,240 just gave them cash. 339 00:14:04,240 --> 00:14:05,390 Is it worth it? 340 00:14:05,390 --> 00:14:06,400 That's a great question. 341 00:14:06,400 --> 00:14:08,730 It depends on how stupid we think people are and how 342 00:14:08,730 --> 00:14:10,730 paternalistic we want to be. 343 00:14:10,730 --> 00:14:12,750 If we think people would really waste the money, then 344 00:14:12,750 --> 00:14:15,210 $0.15 is not much to give up to make sure they eat. 345 00:14:15,210 --> 00:14:17,160 If we think nobody would waste the money, then we're just 346 00:14:17,160 --> 00:14:20,140 throwing $0.15 down the toilet by making them buy food 347 00:14:20,140 --> 00:14:21,640 instead of goods they prefer. 348 00:14:21,640 --> 00:14:23,990 And that's the interesting kind of public policy question 349 00:14:23,990 --> 00:14:25,260 we have to struggle with. 350 00:14:25,260 --> 00:14:28,320 We think about government policy and redistribution. 351 00:14:28,320 --> 00:14:29,500 That's exactly the kind of question we 352 00:14:29,500 --> 00:14:30,030 need to struggle with. 353 00:14:30,030 --> 00:14:31,940 And we'll come back to that again later in the course when 354 00:14:31,940 --> 00:14:34,490 we talk about efficiency versus equity. 355 00:14:34,490 --> 00:14:37,470 OK, questions about that? 356 00:14:37,470 --> 00:14:38,376 Yeah? 357 00:14:38,376 --> 00:14:39,626 AUDIENCE: [INAUDIBLE PHRASE]. 358 00:14:47,610 --> 00:14:48,210 PROFESSOR: Sure. 359 00:14:48,210 --> 00:14:49,930 I mean, so basically you make a good point. 360 00:14:49,930 --> 00:14:51,990 We sort of like to know. 361 00:14:51,990 --> 00:14:53,030 Actually that's a very good point. 362 00:14:53,030 --> 00:14:55,240 You say, when we run these experiments and replace the 363 00:14:55,240 --> 00:14:56,710 food stamps with cash, we like to know what 364 00:14:56,710 --> 00:14:57,500 they spend the cash. 365 00:14:57,500 --> 00:15:00,330 We want to know not just what happens to food consumption. 366 00:15:00,330 --> 00:15:02,830 So if you run the experiment, and you say, I was giving you 367 00:15:02,830 --> 00:15:03,880 food stamps. 368 00:15:03,880 --> 00:15:05,800 I now cash you out and give you cash. 369 00:15:05,800 --> 00:15:07,985 And I find you spend 15% less on food. 370 00:15:07,985 --> 00:15:10,010 Well what do you spend more on? 371 00:15:10,010 --> 00:15:11,865 If it's clothes, maybe we're not so worried. 372 00:15:11,865 --> 00:15:13,750 If it's cocaine, maybe we are. 373 00:15:13,750 --> 00:15:14,630 So that's a very good point. 374 00:15:14,630 --> 00:15:15,770 That's something we could look at. 375 00:15:15,770 --> 00:15:18,460 Excellent. 376 00:15:18,460 --> 00:15:21,590 OK, so that's an example of how we can use the kind of 377 00:15:21,590 --> 00:15:24,550 analysis we did last time to think about policy making. 378 00:15:24,550 --> 00:15:25,510 Once again, this is an incredibly 379 00:15:25,510 --> 00:15:27,270 simple framework, right? 380 00:15:27,270 --> 00:15:31,600 Yet I just described to you a succinct way to think about 381 00:15:31,600 --> 00:15:32,920 the implications for society of 382 00:15:32,920 --> 00:15:33,960 different government policies. 383 00:15:33,960 --> 00:15:36,630 That's the power of this kind of simplified framework. 384 00:15:36,630 --> 00:15:39,860 Now let's move on, and let's get to the core of 385 00:15:39,860 --> 00:15:41,240 why we did all this. 386 00:15:41,240 --> 00:15:43,530 The reason we did all this is we wanted to figure out how we 387 00:15:43,530 --> 00:15:47,560 come up with demand curves, where demand curves come from. 388 00:15:47,560 --> 00:15:49,530 The stork doesn't bring them. 389 00:15:49,530 --> 00:15:51,690 Demand curves come from underlying utility 390 00:15:51,690 --> 00:15:52,070 maximization. 391 00:15:52,070 --> 00:15:55,020 And we'll see that now. 392 00:15:55,020 --> 00:15:58,230 And basically the way to do this is to return to our 393 00:15:58,230 --> 00:15:59,930 example from last time. 394 00:15:59,930 --> 00:16:05,880 Your parents gave you $96. 395 00:16:05,880 --> 00:16:10,860 You could buy movies at $8 a pop or pizzas at $16 a pop. 396 00:16:10,860 --> 00:16:12,540 So we said last time, if you turn to the 397 00:16:12,540 --> 00:16:15,320 next page of the handout. 398 00:16:15,320 --> 00:16:21,040 What we said last time is if given your utility function, u 399 00:16:21,040 --> 00:16:24,560 equals square root of p times m, you would choose 400 00:16:24,560 --> 00:16:26,960 a point like a. 401 00:16:26,960 --> 00:16:31,340 If the price of pizzas was $16, the price of movies was 402 00:16:31,340 --> 00:16:37,070 $8, your income was $96, you would choose a point like a, 403 00:16:37,070 --> 00:16:39,820 where you consumed-- 404 00:16:39,820 --> 00:16:44,570 At point a, you're consuming six movies and three pizzas. 405 00:16:44,570 --> 00:16:51,670 Once again that should be p on the y-axis. 406 00:16:51,670 --> 00:16:58,510 You're consuming six movies and three pizzas at point a. 407 00:16:58,510 --> 00:17:06,024 Now let's say the price of pizzas rises. 408 00:17:09,869 --> 00:17:16,880 I'm sorry, now let's say the price of movies rises to $12. 409 00:17:16,880 --> 00:17:21,874 So the price of movies rises from $8 to $12. 410 00:17:21,874 --> 00:17:24,619 Well what does that do to the budget constraint? 411 00:17:24,619 --> 00:17:28,290 That steepens the budget constraint, moves it inward. 412 00:17:28,290 --> 00:17:31,530 Because now think about your opportunity set. 413 00:17:31,530 --> 00:17:33,910 For the same income of $96 you can buy the same number of 414 00:17:33,910 --> 00:17:38,100 pizzas you could have before, but now you're 415 00:17:38,100 --> 00:17:41,260 buying fewer movies. 416 00:17:41,260 --> 00:17:42,690 Same number of pizzas you could have bought before, but 417 00:17:42,690 --> 00:17:44,690 now you can buy fewer movies. 418 00:17:44,690 --> 00:17:46,890 So your new budget constraint, you have a new constrained 419 00:17:46,890 --> 00:17:47,700 opportunity set. 420 00:17:47,700 --> 00:17:49,430 With a steeper budget constraint, the slope, instead 421 00:17:49,430 --> 00:17:52,830 of being minus 1/2, is minus 3/4. 422 00:17:52,830 --> 00:17:57,290 And given the preference I wrote, u equals square root of 423 00:17:57,290 --> 00:18:01,500 c times m, you should be able to show yourself that you'd 424 00:18:01,500 --> 00:18:07,870 now choose a point like b, where you have three pizzas 425 00:18:07,870 --> 00:18:10,670 but now only four movies. 426 00:18:10,670 --> 00:18:12,310 So you reduce the number of movies, you keep the number of 427 00:18:12,310 --> 00:18:14,030 pizzas constant. 428 00:18:14,030 --> 00:18:16,950 And you check that we still spent our total budget. 429 00:18:16,950 --> 00:18:22,750 Well, 4 times 12 plus 3 times 16 is still $96. 430 00:18:22,750 --> 00:18:25,060 So we're still spending our total budget. 431 00:18:25,060 --> 00:18:27,960 The marginal rate of substitution you can compute 432 00:18:27,960 --> 00:18:30,130 if you write it down from that utility function, will be 433 00:18:30,130 --> 00:18:32,600 minus 3/4, which is the same as the marginal rate of 434 00:18:32,600 --> 00:18:34,890 transformation with this new price. 435 00:18:34,890 --> 00:18:39,800 So you will choose a point like point b. 436 00:18:39,800 --> 00:18:43,720 Now let's say instead the price of movies 437 00:18:43,720 --> 00:18:47,230 fell from $8 to $6. 438 00:18:47,230 --> 00:18:50,470 Well in that case, your budget constraint would flatten. 439 00:18:50,470 --> 00:18:53,210 It would move outwards. 440 00:18:53,210 --> 00:18:57,040 Your opportunity set would expand in that case, because 441 00:18:57,040 --> 00:18:59,330 effectively you're richer. 442 00:18:59,330 --> 00:19:00,280 Your opportunity set expands. 443 00:19:00,280 --> 00:19:02,860 You move to bc little 3. 444 00:19:02,860 --> 00:19:04,740 You move to bc little 3. 445 00:19:04,740 --> 00:19:07,356 And given those preferences I wrote down, u equals square 446 00:19:07,356 --> 00:19:10,870 root of p times m. 447 00:19:10,870 --> 00:19:12,710 u equals square root of p times m. 448 00:19:12,710 --> 00:19:17,220 You end up choosing point c, with the same three pizzas but 449 00:19:17,220 --> 00:19:20,170 now eight movies. 450 00:19:20,170 --> 00:19:21,420 Once again, how do we know that's right? 451 00:19:21,420 --> 00:19:23,450 Well first of all the marginal rate of substitution, you can 452 00:19:23,450 --> 00:19:25,350 compute, will equal the new marginal rate of 453 00:19:25,350 --> 00:19:26,600 transformation. 454 00:19:28,610 --> 00:19:32,650 And also you can see you spend your entire $96 income. 455 00:19:32,650 --> 00:19:34,925 You're still roughly splitting it with $48 on movies and $48 456 00:19:34,925 --> 00:19:37,630 on pizza, exactly splitting it. 457 00:19:37,630 --> 00:19:41,110 So all we've done here-- 458 00:19:41,110 --> 00:19:42,250 Forget the bottom diagram for a second. 459 00:19:42,250 --> 00:19:45,830 All we're doing in this top diagram is saying, given your 460 00:19:45,830 --> 00:19:55,800 utility is u equals square root of p times m and given 461 00:19:55,800 --> 00:19:59,380 your income and the prices, these are the choices you 462 00:19:59,380 --> 00:20:01,290 would make as prices change. 463 00:20:01,290 --> 00:20:03,960 Are there questions about that? 464 00:20:03,960 --> 00:20:06,665 Now armed with that, we can draw a demand curve. 465 00:20:06,665 --> 00:20:07,910 Because what have we done? 466 00:20:07,910 --> 00:20:12,190 We've just given you three different prices for movies 467 00:20:12,190 --> 00:20:14,740 and three different quantities of movies you choose. 468 00:20:14,740 --> 00:20:18,830 We know when the price of movies was $8, 469 00:20:18,830 --> 00:20:20,760 you chose six movies. 470 00:20:20,760 --> 00:20:22,010 That's point b. 471 00:20:26,195 --> 00:20:27,445 I'm sorry, that's point a. 472 00:20:31,460 --> 00:20:32,960 The points are mislabeled too on this. 473 00:20:32,960 --> 00:20:34,540 I'm sorry. 474 00:20:34,540 --> 00:20:36,380 If you go to this bottom graph, these points are 475 00:20:36,380 --> 00:20:37,450 mislabeled. 476 00:20:37,450 --> 00:20:40,845 So it should go b, a, c. 477 00:20:40,845 --> 00:20:42,095 It should go b, a, c. 478 00:20:46,680 --> 00:20:50,670 So when the price of movies is $8, that's point a in the 479 00:20:50,670 --> 00:20:55,160 middle, you choose 6 movies. 480 00:20:55,160 --> 00:20:59,260 When the price of movies rises to $12, your 481 00:20:59,260 --> 00:21:00,410 demand for movies falls. 482 00:21:00,410 --> 00:21:02,550 You only choose 4 movies. 483 00:21:02,550 --> 00:21:07,890 When the price of movies falls to $6, you choose 8 movies. 484 00:21:07,890 --> 00:21:09,610 Thus the demand curve. 485 00:21:09,610 --> 00:21:10,310 And we're done. 486 00:21:10,310 --> 00:21:13,080 That's where demand curves come from. 487 00:21:13,080 --> 00:21:15,040 They just come from utility, constrained utility 488 00:21:15,040 --> 00:21:16,440 maximization. 489 00:21:16,440 --> 00:21:20,500 You just take your utility function, you maximize it, 490 00:21:20,500 --> 00:21:22,970 given the constraint the budget constraint places on 491 00:21:22,970 --> 00:21:24,970 you, and boom, you have a demand curve. 492 00:21:27,740 --> 00:21:31,920 Now note that this a particular case we did. 493 00:21:31,920 --> 00:21:34,000 And it's a particular case that's interesting. 494 00:21:34,000 --> 00:21:37,260 In this case as we change the price of movies, what happened 495 00:21:37,260 --> 00:21:39,890 to demand for pizzas? 496 00:21:39,890 --> 00:21:40,780 AUDIENCE: Stayed the same. 497 00:21:40,780 --> 00:21:41,800 PROFESSOR: Stayed the same. 498 00:21:41,800 --> 00:21:43,910 That is a particular case. 499 00:21:43,910 --> 00:21:45,510 It's basically the case that will happen with utility 500 00:21:45,510 --> 00:21:46,690 function of this form. 501 00:21:46,690 --> 00:21:51,190 It's a case of what we call no cross-price elasticity. 502 00:21:51,190 --> 00:21:58,040 This example has no cross-price elasticity. 503 00:21:58,040 --> 00:22:01,600 What that means is that in this particular case we chose, 504 00:22:01,600 --> 00:22:03,840 as the price of one good changes, it does not change 505 00:22:03,840 --> 00:22:05,520 your demand for the other good. 506 00:22:05,520 --> 00:22:08,040 That's a special case that will not in general be true. 507 00:22:08,040 --> 00:22:12,190 You can imagine if your income was only $96, and the price of 508 00:22:12,190 --> 00:22:14,720 movies was swinging around, that might affect your taste 509 00:22:14,720 --> 00:22:15,710 for pizzas. 510 00:22:15,710 --> 00:22:17,880 That might affect your demand for pizzas as well, because 511 00:22:17,880 --> 00:22:19,160 you're only have a fixed budget. 512 00:22:19,160 --> 00:22:20,220 That's a more general case. 513 00:22:20,220 --> 00:22:23,070 We've chosen a particular case here with no cross-price 514 00:22:23,070 --> 00:22:23,810 elasticity. 515 00:22:23,810 --> 00:22:24,910 But don't think that's general. 516 00:22:24,910 --> 00:22:26,690 This is not a general lesson. 517 00:22:26,690 --> 00:22:28,390 There's the price of one good changes the other goods 518 00:22:28,390 --> 00:22:29,240 unaffected. 519 00:22:29,240 --> 00:22:31,590 In fact, in general, both goods will be affected when 520 00:22:31,590 --> 00:22:33,470 any one price changes. 521 00:22:33,470 --> 00:22:37,290 That's a more general result. 522 00:22:37,290 --> 00:22:39,740 You should be able to check at home that you can do this 523 00:22:39,740 --> 00:22:43,530 exact same exercise for pizzas and draw the demand curve for 524 00:22:43,530 --> 00:22:45,660 pizzas the exact same way. 525 00:22:45,660 --> 00:22:47,190 You'll still get a flat-- you'll still get no 526 00:22:47,190 --> 00:22:47,690 cross-price elasticity. 527 00:22:47,690 --> 00:22:52,320 You'll still get this flat curve-- well now it will be 528 00:22:52,320 --> 00:22:57,190 vertical curve with respect to movie purchases. 529 00:22:57,190 --> 00:22:59,890 But you can see as you change the price of pizzas, you'll 530 00:22:59,890 --> 00:23:04,020 find a well-defined pizza demand curve as well. 531 00:23:04,020 --> 00:23:05,350 OK? 532 00:23:05,350 --> 00:23:07,850 So that's where demand curves come from. 533 00:23:07,850 --> 00:23:13,860 We basically maximize utility at different prices given your 534 00:23:13,860 --> 00:23:18,650 income, and we end up with a demand curve that shows us the 535 00:23:18,650 --> 00:23:21,170 relationship between how many movies you choose and the 536 00:23:21,170 --> 00:23:22,420 price of movies. 537 00:23:24,930 --> 00:23:28,690 Demand curves themselves can also shift. 538 00:23:28,690 --> 00:23:32,530 We talked about that in the second lecture. 539 00:23:32,530 --> 00:23:34,370 We talked about demand curve shifting. 540 00:23:34,370 --> 00:23:36,710 And one reason demand curves can shift is 541 00:23:36,710 --> 00:23:39,120 because you get richer. 542 00:23:39,120 --> 00:23:41,290 So let's talk about how that can happen. 543 00:23:41,290 --> 00:23:43,410 Let's now turn to figure 6-3, which is really tiny. 544 00:23:46,690 --> 00:23:47,930 My bifocals are in at the mall. 545 00:23:47,930 --> 00:23:48,960 I just haven't picked them up yet. 546 00:23:48,960 --> 00:23:50,680 So let's take the glasses off for this one. 547 00:23:54,400 --> 00:23:55,490 Now let's take a case. 548 00:23:55,490 --> 00:24:01,380 Once again, originally you're at point a, where you're 549 00:24:01,380 --> 00:24:04,940 choosing six movies and three pizzas. 550 00:24:04,940 --> 00:24:07,530 Now let's say your income rises. 551 00:24:07,530 --> 00:24:09,350 Your parents are feeling generous. 552 00:24:09,350 --> 00:24:11,740 And instead of giving you $96, they're 553 00:24:11,740 --> 00:24:16,700 going to give you $128. 554 00:24:16,700 --> 00:24:19,890 Once again, on that y-axis it should be labeled p, not c. 555 00:24:19,890 --> 00:24:26,230 You can now afford up to 8 movies and up to 16 pizzas 556 00:24:26,230 --> 00:24:28,070 with your $128 income. 557 00:24:28,070 --> 00:24:29,490 So your budget constraint has shifted 558 00:24:29,490 --> 00:24:33,750 outwards from bc1 to bc2. 559 00:24:33,750 --> 00:24:36,170 At that new higher budget constraint, you're going to 560 00:24:36,170 --> 00:24:40,200 choose, instead of choosing a, which is six movies and three 561 00:24:40,200 --> 00:24:43,260 pizzas, you'll choose b, which is eight 562 00:24:43,260 --> 00:24:44,770 movies and four pizzas. 563 00:24:44,770 --> 00:24:47,530 You're richer so you choose more of both. 564 00:24:47,530 --> 00:24:53,360 Likewise if your parents cut your income to $64, you're 565 00:24:53,360 --> 00:24:54,690 budget constraint will shift inwards. 566 00:24:54,690 --> 00:24:56,270 Your opportunity set will be constricted. 567 00:24:56,270 --> 00:24:58,060 You move to budget constraint three. 568 00:24:58,060 --> 00:25:01,460 And you choose fewer of both pizzas and movies. 569 00:25:01,460 --> 00:25:04,440 So you can see as your budget constraint shifts, how you 570 00:25:04,440 --> 00:25:06,960 choose different amounts of both pizza and movies. 571 00:25:06,960 --> 00:25:09,600 We can translate that to shifting 572 00:25:09,600 --> 00:25:11,670 demand curves for movies. 573 00:25:11,670 --> 00:25:13,910 So if you draw that down to the next diagram, you say, 574 00:25:13,910 --> 00:25:18,310 look, I can now graph that at a given price of movies-- 575 00:25:18,310 --> 00:25:19,650 prices have not changed in the example. 576 00:25:19,650 --> 00:25:21,450 The slope of the budget constraint is the same. 577 00:25:21,450 --> 00:25:24,180 Only your income has changed. 578 00:25:24,180 --> 00:25:29,645 At a given price of movies of $8, as my income changes, I am 579 00:25:29,645 --> 00:25:31,090 on different demand curves. 580 00:25:31,090 --> 00:25:34,640 You can see the demand curve for movies shifting out and in 581 00:25:34,640 --> 00:25:35,960 as my income changes. 582 00:25:35,960 --> 00:25:37,810 So as my income went up, the demand curve for movies went 583 00:25:37,810 --> 00:25:40,010 out and moved from point a to point b. 584 00:25:40,010 --> 00:25:43,820 As my income fell, the demand curve for movies went up, 585 00:25:43,820 --> 00:25:46,480 shifted in, moved from point a to point c. 586 00:25:46,480 --> 00:25:49,530 We can then drop that down one more level, just to make life 587 00:25:49,530 --> 00:25:54,330 especially interesting, and draw the relationship between 588 00:25:54,330 --> 00:25:56,940 your income and your demand for movies. 589 00:25:56,940 --> 00:25:58,570 And that's the third figure. 590 00:25:58,570 --> 00:26:01,455 Here we graph the relationship of your income and your demand 591 00:26:01,455 --> 00:26:01,740 for movies. 592 00:26:01,740 --> 00:26:03,770 This is not a demand curve. 593 00:26:03,770 --> 00:26:06,300 Demand curves only relate price to quantity. 594 00:26:06,300 --> 00:26:10,360 This is what we call an Engel curve. 595 00:26:10,360 --> 00:26:13,150 Those of you who studied your socialism theory will remember 596 00:26:13,150 --> 00:26:15,290 Engels worked with Marx. 597 00:26:15,290 --> 00:26:16,240 It's not him. 598 00:26:16,240 --> 00:26:17,450 It's Engel not Engels. 599 00:26:17,450 --> 00:26:19,100 Different guy. 600 00:26:19,100 --> 00:26:24,140 So basically this is an Engel curve. 601 00:26:24,140 --> 00:26:26,760 And basically it shows the relationship between your 602 00:26:26,760 --> 00:26:30,180 income and your demand for a good. 603 00:26:30,180 --> 00:26:33,810 And this turns out to be a very important concept. 604 00:26:33,810 --> 00:26:36,870 Because an important thing that we'll focus on now is 605 00:26:36,870 --> 00:26:45,500 what we call the income elasticity of demand. 606 00:26:45,500 --> 00:26:48,700 We've talked about price elasticities. 607 00:26:48,700 --> 00:26:51,030 What's the price elasticity of demand? 608 00:26:51,030 --> 00:26:52,795 Someone quickly, someone raise their hand and tell me, what's 609 00:26:52,795 --> 00:26:55,392 the price elasticity of demand? 610 00:26:55,392 --> 00:26:57,080 Get some other folks involved here. 611 00:26:57,080 --> 00:26:57,560 Yeah? 612 00:26:57,560 --> 00:26:59,960 AUDIENCE: How demand changes with the price of the item? 613 00:26:59,960 --> 00:27:02,070 PROFESSOR: Right, so as price changes, how demand changes. 614 00:27:02,070 --> 00:27:03,880 The income elasticity is the same concept. 615 00:27:03,880 --> 00:27:08,530 It's a change in demand as your income changes. 616 00:27:08,530 --> 00:27:09,990 In the book it's this fancy letter. 617 00:27:09,990 --> 00:27:12,670 I can't write, so I'm going to call it gamma. 618 00:27:12,670 --> 00:27:15,730 But it's some c thing that I can't draw in the book. 619 00:27:15,730 --> 00:27:23,470 Which is delta Q over Q over delta y over y. 620 00:27:23,470 --> 00:27:26,000 So just like the price elasticity is the percentage 621 00:27:26,000 --> 00:27:28,590 change of quantity, percentage change in price, the income 622 00:27:28,590 --> 00:27:32,660 elasticity is the percent change in quantity with 623 00:27:32,660 --> 00:27:33,910 percent change in income. 624 00:27:37,270 --> 00:27:41,820 Once again, just like price elasticities are locals. 625 00:27:41,820 --> 00:27:42,870 You talked about it in section. 626 00:27:42,870 --> 00:27:45,140 You talked about, sort of, local versus global price 627 00:27:45,140 --> 00:27:47,030 elasticities and how it's really local to that segment 628 00:27:47,030 --> 00:27:47,750 of the curve. 629 00:27:47,750 --> 00:27:49,690 Income elasticities are local too. 630 00:27:49,690 --> 00:27:52,190 Your income elasticity will obviously change along an 631 00:27:52,190 --> 00:27:56,520 Engel, could change along an Engel curve. 632 00:27:56,520 --> 00:28:00,660 But the key point is that for most goods the Engel curve is 633 00:28:00,660 --> 00:28:02,300 upward sloping. 634 00:28:02,300 --> 00:28:06,240 That is for most goods, this is greater than zero. 635 00:28:06,240 --> 00:28:08,550 Just like we talked about the price elasticity being less 636 00:28:08,550 --> 00:28:13,530 than zero in general, this is less general, but for most 637 00:28:13,530 --> 00:28:15,450 goods, the income elasticity is greater than zero. 638 00:28:15,450 --> 00:28:17,830 We call these normal goods. 639 00:28:21,290 --> 00:28:23,800 Normal goods are goods for which the income elasticity is 640 00:28:23,800 --> 00:28:24,250 greater than zero. 641 00:28:24,250 --> 00:28:27,560 As you have more income, you buy more of them. 642 00:28:27,560 --> 00:28:32,250 On the other hand, if the income elasticity was less 643 00:28:32,250 --> 00:28:36,340 than zero, we would call those inferior goods. 644 00:28:40,750 --> 00:28:46,550 Inferior goods, goods where as your income goes up, you buy 645 00:28:46,550 --> 00:28:47,800 less of them. 646 00:28:49,800 --> 00:28:50,080 Yeah. 647 00:28:50,080 --> 00:28:53,300 AUDIENCE: Is there any term for when income elasticity 648 00:28:53,300 --> 00:28:55,085 equals zero? 649 00:28:55,085 --> 00:28:57,840 PROFESSOR: If it equals zero, you're just income inelastic. 650 00:28:57,840 --> 00:28:59,140 It's in between normal and inferior. 651 00:28:59,140 --> 00:29:00,210 I don't think there's a precise term. 652 00:29:00,210 --> 00:29:02,570 You're just income inelastic. 653 00:29:02,570 --> 00:29:05,870 So can someone tell me how you could get an inferior good? 654 00:29:05,870 --> 00:29:07,236 Does anyone have a good idea of an example 655 00:29:07,236 --> 00:29:09,130 of an inferior good? 656 00:29:09,130 --> 00:29:10,556 How could a good be inferior? 657 00:29:10,556 --> 00:29:11,042 Yeah. 658 00:29:11,042 --> 00:29:15,416 AUDIENCE: Canned food, because if you have a low income, you 659 00:29:15,416 --> 00:29:17,360 buy canned food because it's cheaper. 660 00:29:17,360 --> 00:29:19,320 But [INAUDIBLE]. 661 00:29:19,320 --> 00:29:21,710 PROFESSOR: Exactly, so canned food versus fresh food. 662 00:29:21,710 --> 00:29:25,790 As your income goes up, you'll substitute away from canned 663 00:29:25,790 --> 00:29:26,580 food to fresh food. 664 00:29:26,580 --> 00:29:27,920 So actually as you get richer, you'll 665 00:29:27,920 --> 00:29:29,490 consume less canned food. 666 00:29:29,490 --> 00:29:31,690 So canned food is an inferior good. 667 00:29:31,690 --> 00:29:32,200 Excellent. 668 00:29:32,200 --> 00:29:34,140 The classic example uses potatoes. 669 00:29:34,140 --> 00:29:37,190 Potatoes is a good cost-effective, cheap source 670 00:29:37,190 --> 00:29:39,190 of nutrition. 671 00:29:39,190 --> 00:29:40,920 But, you know, no one wants to eat potatoes all the time if 672 00:29:40,920 --> 00:29:41,460 they don't have to. 673 00:29:41,460 --> 00:29:43,710 So when the income goes up, we substitute away from potatoes 674 00:29:43,710 --> 00:29:46,820 towards arugula or whatever. 675 00:29:46,820 --> 00:29:50,810 So basically, essentially we could think of 676 00:29:50,810 --> 00:29:53,120 inferior goods as goods-- 677 00:29:53,120 --> 00:29:54,980 Once again, more is always better. 678 00:29:54,980 --> 00:29:57,620 There's no goods we don't like. 679 00:29:57,620 --> 00:29:58,740 More is always better. 680 00:29:58,740 --> 00:30:01,280 But there are goods we'd like to substitute away from. 681 00:30:01,280 --> 00:30:03,060 We'd like to have others instead. 682 00:30:03,060 --> 00:30:05,850 And goods you substitute away from as you get richer are 683 00:30:05,850 --> 00:30:07,230 inferior goods. 684 00:30:07,230 --> 00:30:14,020 Goods you move towards as you get richer are normal goods. 685 00:30:14,020 --> 00:30:16,270 Moreover, we can break this down further. 686 00:30:16,270 --> 00:30:20,480 Within the class of normal goods we can talk about gamma 687 00:30:20,480 --> 00:30:24,230 less than one and gamma greater than one. 688 00:30:24,230 --> 00:30:26,370 Any guess as to what terms I'll use for gamma? 689 00:30:26,370 --> 00:30:31,040 Any examples in, sort of, the class of goods where it would 690 00:30:31,040 --> 00:30:32,530 be less than one versus greater than one? 691 00:30:37,090 --> 00:30:38,970 What's an example of a good that would be less than one? 692 00:30:38,970 --> 00:30:41,302 Think about what that means. 693 00:30:41,302 --> 00:30:42,294 Yeah. 694 00:30:42,294 --> 00:30:45,270 AUDIENCE: Perhaps food, because if your income 695 00:30:45,270 --> 00:30:46,520 [INAUDIBLE PHRASE]. 696 00:30:49,750 --> 00:30:50,120 PROFESSOR: Right. 697 00:30:50,120 --> 00:30:52,426 AUDIENCE: [INAUDIBLE] 698 00:30:52,426 --> 00:30:54,850 if your income increases. 699 00:30:54,850 --> 00:30:55,480 PROFESSOR: Excellent. 700 00:30:55,480 --> 00:30:57,566 So we call these necessities. 701 00:31:00,850 --> 00:31:04,120 And we call these luxuries. 702 00:31:04,120 --> 00:31:06,000 Goods where the income elasticity is less than one 703 00:31:06,000 --> 00:31:06,610 are necessities. 704 00:31:06,610 --> 00:31:10,400 You want more of them as you get richer. 705 00:31:10,400 --> 00:31:13,730 But you don't want as much more as you get richer. 706 00:31:13,730 --> 00:31:16,630 So you've got the food as the classic example. 707 00:31:16,630 --> 00:31:20,490 As your income doubles, you're going to eat more food but not 708 00:31:20,490 --> 00:31:23,300 twice as much food. 709 00:31:23,300 --> 00:31:26,380 Likewise luxuries are things where as your income doubles, 710 00:31:26,380 --> 00:31:28,170 you'll buy more than twice as much. 711 00:31:28,170 --> 00:31:31,650 So you think about fancy cars. 712 00:31:31,650 --> 00:31:34,710 You might buy one with your first million but three with 713 00:31:34,710 --> 00:31:36,950 your next million. 714 00:31:36,950 --> 00:31:39,830 So those are luxuries. 715 00:31:39,830 --> 00:31:41,487 They'll increase more than proportionally as 716 00:31:41,487 --> 00:31:42,770 your income goes up. 717 00:31:42,770 --> 00:31:44,850 Necessities will increase less than proportionally as your 718 00:31:44,850 --> 00:31:45,940 income goes up. 719 00:31:45,940 --> 00:31:48,070 Now, of course, it's a very hard distinction to draw. 720 00:31:48,070 --> 00:31:49,800 And of course it varies by person. 721 00:31:49,800 --> 00:31:51,470 So take clothing. 722 00:31:51,470 --> 00:31:53,800 Is clothing a necessity or a luxury? 723 00:31:53,800 --> 00:31:55,990 Well, some clothing is probably a necessity, and some 724 00:31:55,990 --> 00:31:57,375 clothing is probably a luxury. 725 00:31:57,375 --> 00:31:59,745 You know, Dolce and Gabbana is a luxury. 726 00:31:59,745 --> 00:32:01,270 You know, Keds is a necessity. 727 00:32:01,270 --> 00:32:05,410 Or whatever, I don't know, what, The Gap is a necessity. 728 00:32:05,410 --> 00:32:08,490 So basically we could think about, it's actually a subtle 729 00:32:08,490 --> 00:32:10,890 distinction what makes luxury and what's-- 730 00:32:10,890 --> 00:32:13,700 Normal versus inferior is kind of stark. 731 00:32:13,700 --> 00:32:17,270 Luxury versus necessity, that's a little bit trickier. 732 00:32:17,270 --> 00:32:18,860 That's going to depend on the person and depend 733 00:32:18,860 --> 00:32:20,090 on the type of goods. 734 00:32:20,090 --> 00:32:22,980 But it's important to understand that concept. 735 00:32:22,980 --> 00:32:25,980 OK, questions about that. 736 00:32:25,980 --> 00:32:26,200 Yeah. 737 00:32:26,200 --> 00:32:27,646 AUDIENCE: I have a question in general. 738 00:32:27,646 --> 00:32:30,538 Is there a way to relate income elasticity to, like, 739 00:32:30,538 --> 00:32:31,788 own-price elasticity? 740 00:32:34,010 --> 00:32:35,400 PROFESSOR: Actually that's a great question. 741 00:32:35,400 --> 00:32:37,530 That's a great segue to what we're going to do next. 742 00:32:37,530 --> 00:32:40,060 It's actually a fundamental determinant of own-price 743 00:32:40,060 --> 00:32:42,660 elasticity, and we'll talk about why next. 744 00:32:42,660 --> 00:32:44,310 Other questions about this concept? 745 00:32:44,310 --> 00:32:45,210 Yeah. 746 00:32:45,210 --> 00:32:47,730 AUDIENCE: [INAUDIBLE PHRASE]? 747 00:32:47,730 --> 00:32:50,240 PROFESSOR: Yes, income elasticity is, once again, 748 00:32:50,240 --> 00:32:53,660 just like price elasticities are not necessarily constant. 749 00:32:53,660 --> 00:32:56,180 You could have a constant income elasticity curve or a 750 00:32:56,180 --> 00:32:57,490 non-constant income elasticity curve. 751 00:32:57,490 --> 00:32:58,820 It can absolutely change. 752 00:32:58,820 --> 00:33:00,440 In general it will. 753 00:33:00,440 --> 00:33:03,730 But it might not. 754 00:33:03,730 --> 00:33:04,630 Good questions. 755 00:33:04,630 --> 00:33:07,040 But that other question in the back, gee, how does this 756 00:33:07,040 --> 00:33:09,510 relate to own-price elasticity? 757 00:33:09,510 --> 00:33:10,190 Great segue. 758 00:33:10,190 --> 00:33:13,310 In fact the income effect is going to be one of two key 759 00:33:13,310 --> 00:33:16,210 determinants of own-price elasticity. 760 00:33:16,210 --> 00:33:17,880 Now what we're going to do is we're going to go even further 761 00:33:17,880 --> 00:33:21,110 behind the demand curve. 762 00:33:21,110 --> 00:33:23,190 We talked about the demand curve comes from. 763 00:33:23,190 --> 00:33:25,650 We talked before about how the slope of the demand curve is 764 00:33:25,650 --> 00:33:27,660 the price elasticity. 765 00:33:27,660 --> 00:33:29,370 Remember, the price elasticity was the slope. 766 00:33:29,370 --> 00:33:30,790 Now we're going to talk about where does 767 00:33:30,790 --> 00:33:32,350 the slope come from. 768 00:33:32,350 --> 00:33:33,330 Where do price elasticities come from? 769 00:33:33,330 --> 00:33:34,940 So I've shown you where the demand curve comes from. 770 00:33:34,940 --> 00:33:37,110 Now let's talk about what determines the underlying 771 00:33:37,110 --> 00:33:38,230 slope of the demand curve. 772 00:33:38,230 --> 00:33:40,280 What determines the price elasticity. 773 00:33:40,280 --> 00:33:43,240 And what's going to determine it is two different effects 774 00:33:43,240 --> 00:33:47,500 which work generally together but sometimes in opposition. 775 00:33:47,500 --> 00:33:52,320 There are two effects that determine price elasticity. 776 00:33:54,890 --> 00:33:59,040 The first is the substitution effect. 777 00:34:05,720 --> 00:34:16,900 The Substitution Effect is the change in quantity demanded 778 00:34:16,900 --> 00:34:21,840 when price increases holding utility constant. 779 00:34:21,840 --> 00:34:27,469 So the Substitution Effect is delta p-- 780 00:34:27,469 --> 00:34:30,110 it's in percentage terms-- delta p over p, over delta q 781 00:34:30,110 --> 00:34:34,840 over q, holding utility constant at a 782 00:34:34,840 --> 00:34:37,139 fixed level u bar. 783 00:34:37,139 --> 00:34:43,179 So given that your utility has not changed, how does your 784 00:34:43,179 --> 00:34:44,429 demand for the good shift? 785 00:34:47,639 --> 00:34:49,260 We're now getting kind of deep. 786 00:34:49,260 --> 00:34:52,940 Think of this as, as a good gets relatively expensive, how 787 00:34:52,940 --> 00:34:56,580 do you shift away from that good? 788 00:34:56,580 --> 00:34:57,710 Think of this as the shift away from the 789 00:34:57,710 --> 00:34:59,420 good as it gets expensive. 790 00:34:59,420 --> 00:35:02,090 But at the same time, there's a second effect which we just 791 00:35:02,090 --> 00:35:06,950 introduced, which is the Income Effect. 792 00:35:06,950 --> 00:35:12,380 The Income Effect is the complement of the Substitution 793 00:35:12,380 --> 00:35:16,840 Effect, which is the change in quantity demanded because of a 794 00:35:16,840 --> 00:35:19,910 change in income holding prices constant. 795 00:35:23,060 --> 00:35:26,700 So this is the Income Effect we just introduced. 796 00:35:26,700 --> 00:35:33,700 So it's delta Q over Q over delta y over y. 797 00:35:33,700 --> 00:35:35,985 But this is holding prices constant. 798 00:35:39,530 --> 00:35:43,360 And these two put together determine your 799 00:35:43,360 --> 00:35:45,650 own elasticity demand. 800 00:35:45,650 --> 00:35:46,950 Think of it intuitively. 801 00:35:46,950 --> 00:35:48,530 We'll do it intuitively, and graphically, and 802 00:35:48,530 --> 00:35:49,580 mathematically. 803 00:35:49,580 --> 00:35:53,490 Intuitively, it's when a price goes up, two things happen. 804 00:35:53,490 --> 00:35:56,840 On the one hand, you're like, gee, at that different price 805 00:35:56,840 --> 00:35:58,980 ratio, I might want to substitute 806 00:35:58,980 --> 00:36:00,800 my consumption bundle. 807 00:36:00,800 --> 00:36:02,520 The second is, gee, the price just went up, 808 00:36:02,520 --> 00:36:04,190 I'm effectively poorer. 809 00:36:04,190 --> 00:36:07,040 And that's also going to affect my demand. 810 00:36:07,040 --> 00:36:09,860 So to see that let's go to the graphical 811 00:36:09,860 --> 00:36:11,410 analysis and figure 6-4. 812 00:36:16,710 --> 00:36:19,245 And we're going to actually decompose income and 813 00:36:19,245 --> 00:36:20,180 substitution effects. 814 00:36:20,180 --> 00:36:22,140 This is one of the things that's sort of hard to do it 815 00:36:22,140 --> 00:36:22,380 intuitively. 816 00:36:22,380 --> 00:36:25,480 The graphics kind of makes it the most clear. 817 00:36:31,660 --> 00:36:35,420 We're going to start at a point like a. 818 00:36:35,420 --> 00:36:37,940 Point a is our initial equilibrium at our budget 819 00:36:37,940 --> 00:36:40,420 constraint one, where we're choosing six 820 00:36:40,420 --> 00:36:41,650 movies and three pizzas. 821 00:36:41,650 --> 00:36:44,350 Once again, this is pizzas not CDs. 822 00:36:44,350 --> 00:36:49,570 We're choosing six movies and three pizzas. 823 00:36:49,570 --> 00:36:51,570 That's at point a. 824 00:36:51,570 --> 00:36:56,560 Now we're going to say imagine the price of movies 825 00:36:56,560 --> 00:36:59,050 has risen to $12. 826 00:36:59,050 --> 00:37:02,560 Well we know that ultimately you'll end up at 827 00:37:02,560 --> 00:37:03,920 a point like c. 828 00:37:03,920 --> 00:37:05,320 We demonstrated that before. 829 00:37:05,320 --> 00:37:08,100 That was when we derived the demand curve for movies. 830 00:37:08,100 --> 00:37:11,880 We know that if the price of movies rises from $8 to $12, 831 00:37:11,880 --> 00:37:14,100 your demand for movies will shrink from six 832 00:37:14,100 --> 00:37:15,280 movies to four movies. 833 00:37:15,280 --> 00:37:17,910 We already established that. 834 00:37:17,910 --> 00:37:20,240 But now what we can see is that that's actually a 835 00:37:20,240 --> 00:37:23,000 composition of two effects. 836 00:37:23,000 --> 00:37:25,500 The first effect is the Substitution Effect. 837 00:37:25,500 --> 00:37:30,500 And the Substitution Effect is the change in prices holding 838 00:37:30,500 --> 00:37:31,320 utility constant. 839 00:37:31,320 --> 00:37:33,140 How do we hold utility constant? 840 00:37:33,140 --> 00:37:36,320 You have to be on the same indifference curve. 841 00:37:36,320 --> 00:37:39,430 So the way to measure the Substitution Effect is we 842 00:37:39,430 --> 00:37:43,090 effectively draw an imaginary budget constraint. 843 00:37:43,090 --> 00:37:46,050 We say, look, imagine you're on the same indifference 844 00:37:46,050 --> 00:37:50,100 curve, but prices changed. 845 00:37:50,100 --> 00:37:53,940 So we draw budget constraint-- 846 00:37:53,940 --> 00:37:55,800 you're originally on budget constraint one. 847 00:38:00,240 --> 00:38:04,180 Now we draw a new budget constraint, 848 00:38:04,180 --> 00:38:07,380 budget constraint three. 849 00:38:07,380 --> 00:38:09,590 Budget constraint three, it's sort of hard to see. 850 00:38:09,590 --> 00:38:14,050 Budget constraint three is drawn so that it has the new 851 00:38:14,050 --> 00:38:15,460 price ratio. 852 00:38:15,460 --> 00:38:19,720 That is, it's parallel to the final budget constraint bc2, 853 00:38:19,720 --> 00:38:24,730 but it's tangent to the original indifference curve. 854 00:38:24,730 --> 00:38:27,150 This is hard, so let me just walk this through again. 855 00:38:27,150 --> 00:38:30,070 You've got your original budget constraint, bc 1. 856 00:38:30,070 --> 00:38:32,130 You chose your point a. 857 00:38:32,130 --> 00:38:34,980 Now the price of movies has just increased, so you move to 858 00:38:34,980 --> 00:38:38,190 bc2 in reality. 859 00:38:38,190 --> 00:38:41,320 And at bc2, you choose point c. 860 00:38:41,320 --> 00:38:45,870 But for the Substitution Effect we're going to say, 861 00:38:45,870 --> 00:38:50,220 let's hold utility constant and ask what package you'd 862 00:38:50,220 --> 00:38:52,370 choose at these new price holding utility constant? 863 00:38:52,370 --> 00:38:54,780 Well the way to do that is to draw an imaginary bc3-- 864 00:38:54,780 --> 00:38:57,190 bc3 never existed in reality-- 865 00:38:57,190 --> 00:39:00,530 that is parallel to the new budget constraint, that is the 866 00:39:00,530 --> 00:39:04,320 new set of prices, but it's tangent to your old 867 00:39:04,320 --> 00:39:08,490 indifference curve, that is utility is constant. 868 00:39:08,490 --> 00:39:11,010 If that were the case, you'd choose point b. 869 00:39:11,010 --> 00:39:14,240 You'd choose 4.89 movies. 870 00:39:14,240 --> 00:39:19,750 Therefore we say that the Substitution Effect is 1.11. 871 00:39:19,750 --> 00:39:22,700 We reduce your movies by 1.11 through the Substitution 872 00:39:22,700 --> 00:39:24,270 Effect only. 873 00:39:24,270 --> 00:39:29,800 The price change only, holding your income, holding utility 874 00:39:29,800 --> 00:39:33,360 constant, is 1.11. 875 00:39:33,360 --> 00:39:35,800 Then we say, well, what's the Income Effect? 876 00:39:35,800 --> 00:39:39,830 The income effect is given prices are fixed, what's the 877 00:39:39,830 --> 00:39:43,620 effect of just being poorer, because movies 878 00:39:43,620 --> 00:39:45,010 are now more expensive. 879 00:39:45,010 --> 00:39:46,740 We know how to make someone poorer, we 880 00:39:46,740 --> 00:39:47,990 just lower their income. 881 00:39:47,990 --> 00:39:52,940 So we shift from bc3 to bc2 and from point b to point c, 882 00:39:52,940 --> 00:39:54,590 and we're done. 883 00:39:54,590 --> 00:39:56,390 We get the total effect of the price. 884 00:39:56,390 --> 00:39:59,270 So we have to shift from a to c is all that you see in the 885 00:39:59,270 --> 00:40:01,110 real world. 886 00:40:01,110 --> 00:40:04,450 But behind that is the Substitution Effect which 887 00:40:04,450 --> 00:40:08,780 shifts you from a to b and the Income Effect, which is this 888 00:40:08,780 --> 00:40:11,300 parallel shift inwards of the budget constraint, which 889 00:40:11,300 --> 00:40:12,550 shifts you from b to c. 890 00:40:16,120 --> 00:40:21,490 I'm going to go through that again in a minute. 891 00:40:21,490 --> 00:40:23,620 But let me first answer these questions, then I want to show 892 00:40:23,620 --> 00:40:24,630 you some of the math of this. 893 00:40:24,630 --> 00:40:26,850 Are there questions about what's going on here? 894 00:40:26,850 --> 00:40:27,370 Yeah. 895 00:40:27,370 --> 00:40:30,100 AUDIENCE: The income effect can have either sign, right? 896 00:40:30,100 --> 00:40:30,380 PROFESSOR: The income effect can have either sign. 897 00:40:30,380 --> 00:40:31,340 Excellent point. 898 00:40:31,340 --> 00:40:32,800 What have I illustrated here? 899 00:40:32,800 --> 00:40:36,150 What kind of good is this? 900 00:40:36,150 --> 00:40:37,220 This is a normal good. 901 00:40:37,220 --> 00:40:38,280 Excellent point. 902 00:40:38,280 --> 00:40:39,960 This is a normal good. 903 00:40:39,960 --> 00:40:42,700 I've assumed a normal good. 904 00:40:42,700 --> 00:40:44,750 And this should actually say in the title income and 905 00:40:44,750 --> 00:40:46,550 substitution effects for normal good. 906 00:40:46,550 --> 00:40:48,480 So I've assumed a normal good. 907 00:40:48,480 --> 00:40:51,010 And we know this student aptly pointed out the normal good, 908 00:40:51,010 --> 00:40:55,100 because we know that as your income fell, moving from point 909 00:40:55,100 --> 00:40:58,870 b to c, you consumed less of it. 910 00:40:58,870 --> 00:41:02,350 This comes to the question that was in the back, which is 911 00:41:02,350 --> 00:41:05,720 as the price changes, whether we consume more or less is 912 00:41:05,720 --> 00:41:07,730 related to the Income Effect but doesn't tell you precisely 913 00:41:07,730 --> 00:41:09,070 what the Income Effect is. 914 00:41:09,070 --> 00:41:11,440 But as your income changes, if you consume more or less, 915 00:41:11,440 --> 00:41:12,360 that's directly Income Effect. 916 00:41:12,360 --> 00:41:13,330 So we see it's a normal good. 917 00:41:13,330 --> 00:41:16,895 So the Substitution Effect moves us from a to b. 918 00:41:16,895 --> 00:41:18,480 The Income Effect, from b to c. 919 00:41:18,480 --> 00:41:21,480 What I want to do is one more thing before we stop. 920 00:41:21,480 --> 00:41:23,600 And then I'm going to come back next time and go back 921 00:41:23,600 --> 00:41:26,160 over this and then talk about some applications. 922 00:41:26,160 --> 00:41:28,620 What I want to do right now is I want to-- 923 00:41:28,620 --> 00:41:32,750 The Income Effect, say the following, the sign is 924 00:41:32,750 --> 00:41:37,600 ambiguous, because it depends on if it's a normal or an 925 00:41:37,600 --> 00:41:38,900 inferior good. 926 00:41:38,900 --> 00:41:42,930 The Substitution Effect is unambiguous. 927 00:41:42,930 --> 00:41:47,430 Substitution Effects are always negative. 928 00:41:47,430 --> 00:41:52,910 Holding utility constant, a price increase of a good 929 00:41:52,910 --> 00:41:55,060 always shifts you away from that good. 930 00:41:55,060 --> 00:41:57,550 Negative or less than or equal to zero could have no effect. 931 00:41:57,550 --> 00:41:59,890 But once again, I always talk in inequalities even though 932 00:41:59,890 --> 00:42:01,240 they're typically inexact. 933 00:42:04,480 --> 00:42:08,160 The key is the Substitution Effect is always negative. 934 00:42:08,160 --> 00:42:10,890 We can think about this in two different ways depending on 935 00:42:10,890 --> 00:42:12,620 how you want to think about it. 936 00:42:12,620 --> 00:42:15,420 Graphically we could show this by the 937 00:42:15,420 --> 00:42:17,880 fact that if the price-- 938 00:42:17,880 --> 00:42:19,320 think about it graphically. 939 00:42:19,320 --> 00:42:20,980 If you're on the same indifference 940 00:42:20,980 --> 00:42:22,820 curve as you were before-- 941 00:42:22,820 --> 00:42:24,660 that's the definition of Substitution Effect where I 942 00:42:24,660 --> 00:42:26,700 keep the same indifference curve-- 943 00:42:26,700 --> 00:42:31,840 but you're tangent to a steeper budget constraint, 944 00:42:31,840 --> 00:42:34,720 which is what happened when prices go up, you must be 945 00:42:34,720 --> 00:42:36,800 choosing less of the good. 946 00:42:36,800 --> 00:42:37,400 Think of it graphically. 947 00:42:37,400 --> 00:42:38,160 Just look at the graph. 948 00:42:38,160 --> 00:42:40,290 I'm in the same indifference curve. 949 00:42:40,290 --> 00:42:43,160 But to be tangent to a steeper curve, it's going to have to 950 00:42:43,160 --> 00:42:44,640 be to the left. 951 00:42:44,640 --> 00:42:47,320 So graphically it's going to have to be that I'll choose 952 00:42:47,320 --> 00:42:51,330 fewer movies when the price of movies goes up. 953 00:42:51,330 --> 00:42:52,480 That's graphically. 954 00:42:52,480 --> 00:42:56,240 Mathematically we can just say, look, what do we know is 955 00:42:56,240 --> 00:42:59,120 our rule for utility maximization? 956 00:42:59,120 --> 00:43:01,880 We know our rule for utility maximization is that the 957 00:43:01,880 --> 00:43:05,130 marginal utility of movies over the marginal utility of 958 00:43:05,130 --> 00:43:09,400 prices equals the price of movies over the price-- 959 00:43:09,400 --> 00:43:10,390 marginal utility of pizza. 960 00:43:10,390 --> 00:43:11,230 I'm sorry. 961 00:43:11,230 --> 00:43:11,450 Marginal utility of pizza. 962 00:43:11,450 --> 00:43:13,370 So the price of movies, so the price of pizza. 963 00:43:13,370 --> 00:43:16,060 Or the MRS equals the MRT. 964 00:43:16,060 --> 00:43:17,230 We know that mathematically. 965 00:43:17,230 --> 00:43:20,350 That's our maximization condition right? 966 00:43:20,350 --> 00:43:26,400 Well if the price of movies goes up, holding the price of 967 00:43:26,400 --> 00:43:29,345 pizza constant, then the right hand side has risen. 968 00:43:33,120 --> 00:43:37,770 If the right hand side rises, then the left hand side has to 969 00:43:37,770 --> 00:43:40,680 rise to get this equality. 970 00:43:40,680 --> 00:43:44,090 How does the left hand side rise? 971 00:43:44,090 --> 00:43:46,990 The left hand side rises by either the marginal utility of 972 00:43:46,990 --> 00:43:49,300 movies going up or the marginal 973 00:43:49,300 --> 00:43:52,270 utility of pizzas falling. 974 00:43:52,270 --> 00:43:53,770 And how do you do that? 975 00:43:53,770 --> 00:44:00,340 By shifting away from movies towards pizza. 976 00:44:00,340 --> 00:44:02,840 How do you make the marginal utility of movies go up? 977 00:44:02,840 --> 00:44:05,000 Consume fewer movies. 978 00:44:05,000 --> 00:44:08,060 How do you make the marginal utility of pizza go down? 979 00:44:08,060 --> 00:44:09,300 Consume more pizza. 980 00:44:09,300 --> 00:44:11,410 Now in this case, pizza doesn't change in this 981 00:44:11,410 --> 00:44:13,740 particular case, but in general it can. 982 00:44:13,740 --> 00:44:18,145 But the key point is you are going to see this Substitution 983 00:44:18,145 --> 00:44:20,760 Effect is going to shift you towards fewer 984 00:44:20,760 --> 00:44:24,170 movies to try to get-- 985 00:44:24,170 --> 00:44:29,210 basically because given utility constant, to try to 986 00:44:29,210 --> 00:44:31,870 equilibrate this, you're going to have to move to a higher 987 00:44:31,870 --> 00:44:33,240 marginal utility of movies. 988 00:44:33,240 --> 00:44:35,430 Given that the price of movies has gone up, you're going to 989 00:44:35,430 --> 00:44:38,310 have to move to worlds where you care about movies more, or 990 00:44:38,310 --> 00:44:39,560 you're not in equilibrium. 991 00:44:41,370 --> 00:44:42,470 Think about it this way. 992 00:44:42,470 --> 00:44:49,170 If the price of movies goes to $100 a movie, and you're going 993 00:44:49,170 --> 00:44:53,330 to be indifferent to where you were before, on the same 994 00:44:53,330 --> 00:44:56,610 utilities you were before, it can't possibly be true that 995 00:44:56,610 --> 00:44:59,030 you consume the same number of movies. 996 00:44:59,030 --> 00:45:01,060 You'd have to be sadder if you consumed the same movies. 997 00:45:01,060 --> 00:45:04,310 You're going to have to move away from movies. 998 00:45:04,310 --> 00:45:05,590 And that's why the Substitution 999 00:45:05,590 --> 00:45:08,440 Effect is always negative. 1000 00:45:08,440 --> 00:45:09,970 You're always going to move away from the good where the 1001 00:45:09,970 --> 00:45:13,370 price increases, holding utility constant. 1002 00:45:13,370 --> 00:45:17,360 But then we have the second effect with the Income Effect, 1003 00:45:17,360 --> 00:45:22,180 which then basically, if the good is normal, reinforces 1004 00:45:22,180 --> 00:45:23,420 that Substitution Effect. 1005 00:45:23,420 --> 00:45:25,990 It says not only do you not want movies because they've 1006 00:45:25,990 --> 00:45:28,650 gotten more expensive, you also don't want movies because 1007 00:45:28,650 --> 00:45:30,410 you're poorer. 1008 00:45:30,410 --> 00:45:31,790 Your opportunity set's restricted. 1009 00:45:31,790 --> 00:45:33,780 And when your opportunity set's restricted, you buy less 1010 00:45:33,780 --> 00:45:35,760 of everything including movies. 1011 00:45:35,760 --> 00:45:37,170 So there's two reasons. 1012 00:45:37,170 --> 00:45:40,800 We only saw one own-price elasticity demand, one shift. 1013 00:45:40,800 --> 00:45:43,020 But there's two reasons behind that. 1014 00:45:43,020 --> 00:45:44,300 The first reason is because the 1015 00:45:44,300 --> 00:45:46,370 relative prices have changed. 1016 00:45:46,370 --> 00:45:49,080 And the other is because you're effectively poorer. 1017 00:45:49,080 --> 00:45:52,280 You add those up, and you get the final effect. 1018 00:45:52,280 --> 00:45:55,040 Now the first, as I said, is unambiguous. 1019 00:45:55,040 --> 00:45:57,410 That Substitution Effect will always move you to the left. 1020 00:45:57,410 --> 00:45:59,620 You're always going to want less of a good if its price 1021 00:45:59,620 --> 00:46:01,240 goes up from Substitution Effect. 1022 00:46:01,240 --> 00:46:03,180 The second is ambiguous. 1023 00:46:03,180 --> 00:46:06,780 That depends on whether the good is normal or inferior. 1024 00:46:06,780 --> 00:46:09,690 Next time we'll talk about what happens 1025 00:46:09,690 --> 00:46:11,170 with inferior goods. 1026 00:46:11,170 --> 00:46:15,390 With inferior goods, we can see that we can actually get 1027 00:46:15,390 --> 00:46:17,210 what we call a Giffen good. 1028 00:46:21,570 --> 00:46:28,830 A Giffen Good is a good where it's inferior, so the income 1029 00:46:28,830 --> 00:46:30,820 effect goes the other way. 1030 00:46:30,820 --> 00:46:32,900 And you can actually technically get a good where 1031 00:46:32,900 --> 00:46:37,105 when the price goes up, you actually want more of it. 1032 00:46:37,105 --> 00:46:38,750 When the price goes down you want less of it. 1033 00:46:38,750 --> 00:46:40,590 That is, you can get a wrong sign, wrong 1034 00:46:40,590 --> 00:46:42,370 slope demand curve. 1035 00:46:42,370 --> 00:46:43,930 I say demand curves always slope down. 1036 00:46:43,930 --> 00:46:45,950 I might even refer to it as the law of demand. 1037 00:46:45,950 --> 00:46:48,070 That's not technically true. 1038 00:46:48,070 --> 00:46:49,900 Technically there exist goods, we'll talk about the next 1039 00:46:49,900 --> 00:46:52,210 time, called Giffen Goods where you can actually get the 1040 00:46:52,210 --> 00:46:54,390 demand curve sloping the wrong way. 1041 00:46:54,390 --> 00:46:57,190 The price increase can actually cause you to want 1042 00:46:57,190 --> 00:46:58,820 more of it. 1043 00:46:58,820 --> 00:47:00,350 In fact, these are based-- 1044 00:47:00,350 --> 00:47:02,680 I like the name Giffen because it's close to griffin. 1045 00:47:02,680 --> 00:47:05,520 And griffins are imaginary and so are Giffens. 1046 00:47:05,520 --> 00:47:08,670 In fact, there's no evidence such goods exist, but it's a 1047 00:47:08,670 --> 00:47:11,160 nice theoretical concept to build your understanding of 1048 00:47:11,160 --> 00:47:12,530 Income versus Substitution Effects. 1049 00:47:12,530 --> 00:47:14,900 So for next time think a bit about how that could be. 1050 00:47:14,900 --> 00:47:17,490 And we'll come and show you graphically how you can get 1051 00:47:17,490 --> 00:47:20,750 Giffen goods depending on the sign of the Income Effect.