Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Applications of Consumer Choice...

Robin Naylor, Department of Economics, Warwick

Topic 1 Lecture 9Applications of Consumer Choice Theory

1. Labour Supply: The Income-Leisure Trade-off

Leisure

Income

IC

1


Topic 1 Lecture 9

Labour Supply: The Income-Leisure Trade-off

Leisure

Income

IC

Tmax

Tmax

Time Constraint: Tmax

0

Labour Supply0

2


Topic 1 Lecture 9


Leisure

Income

Tmax

Tmax

Wage Constraint: w (wage per hour)

0

Labour Supply0

w

3


Topic 1 Lecture 9


Leisure

Income

Tmax

Tmax

Wage Constraint: w (wage per hour)

And Non-labour income, N.

0

Labour Supply0

w

N

4


Topic 1 Lecture 9


Leisure

Income

IC

Tmax

Tmax

Optimisation, given w, N and Tastes.

Total Income = Labour Income +

Non-Labour Income

Total Income = Y + N

0

Labour Supply0

w

N

L*

N

Y

5


Topic 1 Lecture 9


Leisure

Income

IC

Tmax

Tmax

Optimisation, given w, N and Tastes.

What happens to optimal Labour Supply if N rises (why might it?)?

0

Labour Supply0

w

N

L*

N

Y

6


Topic 1 Lecture 9


Leisure

Income

IC

Tmax

Tmax

What happens to optimal Labour Supply if N rises

0

N

7


Topic 1 Lecture 9


Leisure

Income

IC

Tmax

Tmax

What happens to optimal Labour Supply if N rises?

Under what assumption?

Why?

0

N

IC*a

b

8


Topic 1 Lecture 9


Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

w

N

L*

N

Y

w

L, Labour

Supply

What happens to optimal Labour Supply if w rises?

aa

L*

w

9


Topic 1 Lecture 9

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

w

N

L*

w

L, Labour

Supply


aa

L*

10


Topic 1 Lecture 9

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

w

L*

w

L, Labour

Supply


aa

L*

a*

11


Topic 1 Lecture 9

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply

What is the implied shape of the Labour Supply curve in this case?

aa

L*

a*a*

12


Topic 1 Lecture 9

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply

What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply?

a Ls

L*

a*

13


Topic 1 Lecture 9

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

L*

To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects.

To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . .

a

a*

14


Topic 1 Lecture 9

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*


To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . .

a

a*

15


Topic 1 Lecture 9

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*


To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . . with the move from ‘a’ to ‘a*’ split into:

‘a’ –> ‘b’; Substitution Effect,

‘b’ –> ‘a*’; Income Effect.

a

a*b

S

I

16


Topic 1 Lecture 9

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*

a

a*b

S

I



When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen.

17


Topic 1 Lecture 9

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*



How would you interpret the Income Effect in words?

And the Substitution Effect

(Hint: exploit the concept of the Opportunity Cost)

a

a*b

S

I

18


Topic 1 Lecture 9

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*



When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen.

What about if the Substitution Effect dominates?

What is the shape of the Labour Supply curve in this case?

a

a*

b

S

I

19


Topic 1 Lecture 9

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply


aLs

L*

a*

I S

When the S-effect dominates the I-effect

a

a*

20


Topic 1 Lecture 9

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply


a

Ls

L*

a*

I S

When the S-effect dominates the I-effect

a

a*

S I

21


Topic 1 Lecture 9

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply


a

Ls

L*

a*

I S

When the I-effect dominates the S-effect

a

a*

I S

22


Topic 1 Lecture 9

I S

S I

Labour Supply: the evidence . . .

And for most people?

And the implication for income tax cuts?

w

L

Ls

S I

23


Topic 1: Lecture 9

24

Now read B&B 4th Ed., pp. 187-191

(but don’t worry about issues (especially the mathematical material) which go beyond what you have seen in lecture notes or seminar exercise sheets)

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Applications of Consumer Choice...

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