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
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
Time Constraint: Tmax
0
Labour Supply0
2
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
Tmax
Tmax
Wage Constraint: w (wage per hour)
0
Labour Supply0
w
3
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
Tmax
Tmax
Wage Constraint: w (wage per hour)
And Non-labour income, N.
0
Labour Supply0
w
N
4
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Labour Supply: The Income-Leisure Trade-off
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
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Labour Supply: The Income-Leisure Trade-off
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
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
What happens to optimal Labour Supply if N rises
0
N
7
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
What happens to optimal Labour Supply if N rises?
Under what assumption?
Why?
0
N
IC*a
b
8
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Labour Supply: The Income-Leisure Trade-off
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
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
IC
Tmax
Tmax
0
Labour Supply0
w
N
L*
w
L, Labour
Supply
What happens to optimal Labour Supply if w rises?
aa
L*
10
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
IC
Tmax
Tmax
0
Labour Supply0
w
L*
w
L, Labour
Supply
What happens to optimal Labour Supply if w rises?
aa
L*
a*
11
Robin Naylor, Department of Economics, Warwick
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
Robin Naylor, Department of Economics, Warwick
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
Robin Naylor, Department of Economics, Warwick
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
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
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*
15
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
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 . . . with the move from ‘a’ to ‘a*’ split into:
‘a’ –> ‘b’; Substitution Effect,
‘b’ –> ‘a*’; Income Effect.
a
a*b
S
I
16
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
a
a*b
S
I
‘a’ –> ‘b’; Substitution Effect,
‘b’ –> ‘a*’; Income Effect.
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
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
‘a’ –> ‘b’; Substitution Effect,
‘b’ –> ‘a*’; Income Effect.
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
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
‘a’ –> ‘b’; Substitution Effect,
‘b’ –> ‘a*’; Income Effect.
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
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
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?
aLs
L*
a*
I S
When the S-effect dominates the I-effect
a
a*
20
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
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*
I S
When the S-effect dominates the I-effect
a
a*
S I
21
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Leisure
Income
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*
I S
When the I-effect dominates the S-effect
a
a*
I S
22
Robin Naylor, Department of Economics, Warwick
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
Robin Naylor, Department of Economics, Warwick
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)