Topic 1 Lecture 9 Applications of Consumer Choice

Topic 1 Lecture 9 Applications of Consumer Choice Theory 1. Labour Supply: The Income-Leisure Trade-off Income IC Leisure Robin Naylor, Department of Economics, Warwick 1

Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Tmax Income Time Constraint: Tmax IC 0 Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick 2

Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Tmax Income Wage Constraint: w (wage per hour) w 0 Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick 3

Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Tmax Income Wage Constraint: w (wage per hour) And Non-labour income, N. w N 0 Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick 4

Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Tmax Optimisation, given w, N and Tastes. Income Total Income = Labour Income + Non-Labour Income Y w N IC Total Income = Y + N N 0 L* Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick 5

Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Tmax Optimisation, given w, N and Tastes. Income What happens to optimal Labour Supply if N rises (why might it? )? Y w N IC N 0 L* Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick 6

Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Tmax What happens to optimal Labour Supply if N rises Income N 0 Tmax IC Leisure Robin Naylor, Department of Economics, Warwick 7

Topic 1 Lecture 9 Tmax What happens to optimal Labour Supply if N rises? Income b Under what assumption? IC* a N 0 Why? IC Tmax Leisure Labour Supply: The Income-Leisure Trade-off Robin Naylor, Department of Economics, Warwick 8

Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Tmax Income w a Y w w N IC N 0 L* a Tmax L* Leisure L, Labour Supply 0 What happens to optimal Labour Supply if w rises? Robin Naylor, Department of Economics, Warwick 9

Topic 1 Lecture 9 Tmax Income w a a w IC N 0 L* Tmax L* Leisure L, Labour Supply 0 What happens to optimal Labour Supply if w rises? Robin Naylor, Department of Economics, Warwick 10

Topic 1 Lecture 9 Tmax Income w a* a a w IC L* 0 L* Tmax Leisure L, Labour Supply 0 What happens to optimal Labour Supply if w rises? Robin Naylor, Department of Economics, Warwick 11

Topic 1 Lecture 9 Tmax Income w a* a* a a IC L* 0 L* Tmax Leisure L, Labour Supply 0 What is the implied shape of the Labour Supply curve in this case? Robin Naylor, Department of Economics, Warwick 12

Topic 1 Lecture 9 Tmax Income w a* Ls a IC L* 0 L* Tmax Labour Supply 0 Leisure L, Labour Supply What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply? Robin Naylor, Department of Economics, Warwick 13

Topic 1 Lecture 9 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. Tmax Income a* a IC 0 L* Tmax To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve. . . Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick 14

Topic 1 Lecture 9 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. Tmax Income a* a To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve. . . 0 L* Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick 15

Topic 1 Lecture 9 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. Tmax Income a* b a 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: I S 0 L* Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick ‘a’ –> ‘b’; Substitution Effect, ‘b’ –> ‘a*’; Income Effect. 16

Topic 1 Lecture 9 Tmax Income ‘a’ –> ‘b’; a* b Substitution Effect, ‘b’ –> ‘a*’; Income Effect. a I S 0 L* Tmax Leisure 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. Labour Supply 0 Robin Naylor, Department of Economics, Warwick 17

Topic 1 Lecture 9 ‘a’ –> ‘b’; Tmax ‘b’ –> ‘a*’; Income Effect. Income a* b How would you interpret the Income Effect in words? a And the Substitution Effect I (Hint: exploit the concept of the Opportunity Cost) S 0 Substitution Effect, L* Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick 18

Topic 1 Lecture 9 ‘a’ –> ‘b’; Tmax Income Substitution Effect, ‘b’ –> ‘a*’; Income Effect. a* b 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. a I S 0 L* Tmax Leisure Labour Supply 0 Robin Naylor, Department of Economics, Warwick What about if the Substitution Effect dominates? What is the shape of the Labour Supply curve in this case? 19

Topic 1 Lecture 9 Tmax Income When the S-effect dominates the I-effect w a* a* Ls a a IS L* 0 L* Tmax Labour Supply 0 Leisure L, Labour Supply What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply? Robin Naylor, Department of Economics, Warwick 20

Topic 1 Lecture 9 Tmax Income When the S-effect dominates the I-effect w a* Ls a* a a IS L* 0 L* Tmax Labour Supply 0 Leisure L, Labour Supply What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply? Robin Naylor, Department of Economics, Warwick 21

Topic 1 Lecture 9 Tmax When the I-effect dominates the S-effect Income w Ls a* a* a a SI L* 0 L* Tmax Labour Supply 0 Leisure L, Labour Supply What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply? Robin Naylor, Department of Economics, Warwick 22

Topic 1 Lecture 9 Labour Supply: the evidence. . . w Ls L And for most people? And the implication for income tax cuts? Robin Naylor, Department of Economics, Warwick 23

Topic 1: Lecture 9 Now read B&B 4 th 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 24