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
Tmax
0
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
Tmax
0
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
Tmax
0
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
IC
N
0
Tmax
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
Why?
IC
N
0
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
w
Y
w
N
IC
N
0
L*
a
Tmax
L*
Leisure
L, Labour
Supply
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
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
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
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
Substitution Effect,
‘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
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
When the S-effect dominates the I-effect
Income
w
a*
a*
Ls
a
a
I
L*
S
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
When the S-effect dominates the I-effect
Income
w
Ls
a*
a*
S I
a
a
I
L*
S
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*
I S
a
a
I
L*
S
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 . . .
Ls
w
I S
S I
S I
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 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
24