learn basic economics · learn basic economics lesson 7: appling consumer theory: labour. if the...
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Learn Basic EconomicsLesson 7: Appling consumer theory: Labour
If the price increases and the utility function remains constant, then you will buy less of that good. (utility falls as the consumer is effectively poorer).
Budget = £9.60, Donuts = £0.80 and Coffee = £1.60. (BC1)
Point A shows optimal solution. A
BC1
In this example Donuts have increased in price from £0.80 BC1 to £1.20 BC2
(income remains £9.60)
With this price increase the new optimal solution to maximise utility will be at C, as there is now insufficient income for solution A. Donuts are a normal good.
BAC
BC1BC2 BC*
Substitution effect
Income effect
BC1 = Chicken costs £2.50, Rice costs £0.50 and income is £12.50.
Point A shows optimal utility.
A
BC1
If the price of Rice increases to £1.50, then consumer moves to point C.
Substitution effect from AB
Income effect from BC
This means the consumer is effectively poorer so must consume a greater ratio of Rice to Chicken than you may predict given an increase in price.
This means rice is an inferior good.
A
B
C
BC1BC2
BC*
Substitution effect
Income effect
Theoretically, the income effect could be so significant that it offsets the substitution effect
and could increase the quantity bought if the price increases. These are called Giffen goods.
However there are few examples of Giffen goods and their existence is contested, there
have been some studies to show rice and wheat/noodles have the properties of a Giffen
good in parts of China [1].
Giffen goods have an upward sloping demand curve.
[1] Source: “The impact of food price increases on caloric intake in China”. Agricultural Economics
Substitution effect Income effect Total effect
Normal Good:
Price increase = Negative Negative Negative
Price decrease = Positive Positive Positive
Inferior Good:
Price increase = Negative Positive ?
Price decrease = Positive Negative ?
Labour
Leisure is a normal good, we shall denote leisure as N.
In order to model an undesirable quantity (such as hours worked), the
complimentary good is modelled instead.
Hours worked = 24 – N (leisure)
By modelling leisure and consumption the amount of labour can then be
worked out.
Wage = W per hour
(Price of Goods = 1)
A trade off is made between leisure and consumption.
Opportunity cost: By not working, you are missing put on wage therefore the price of leisure is the same as the wage per hour.
Slope of budget constraint = -W
BC
Income and substitution effects for labour supply: Income effect does not dominate
BC1 optimal solution is point A,
Leisure = N1,
Goods quantity = C1.
BC1
A
B
C
Income and substitution effects for labour supply: Income effect does not dominate
Wage increases so there is new budget constraint BC2.
Substitution effect, incentive to work harder for more wage.
Income effect, as leisure is a normal good, the more income increases the more leisure the consumer can afford.
Leisure = N3,
Goods quantity = C3.BC1
A
B
C
BC2
Substitution effect Income effect
Income and substitution effects for labour supply: Income effect dominates
Wage increases so people do not have to work as hard as they have a greater income and can afford more leisure.
Substitution effect from AB
Income effect from BC
Target income = If wage goes up they can work less hard.
A
B
C
BC1 BC2
Substitution effectIncome effect
Substitution effect Income effect Total effect
Leisure:
Wage increase = Negative Positive ?
Wage decrease = Positive Negative ?
Labour:
Wage increase = Positive Negative ?
Wage decrease = Negative Positive ?
Income effect does not offset substitution effectDemand for Leisure
Supply of Labour
This graph shows the more wage increases the greater supply of labour there is.
(It is possible for there to be a downward slopping supply curve if when the wage increases people decide they can afford to work less.)
Case Study: What happens when the wage increases for married Men and Women over
the age of 40?
Substitution effect Income effect
Married Men Less Greater
Married Women Greater Less
The table shows the changes in substitution and income effects when wage increases.
The more you are in the market (married men in this case, as women are usually involved more in child care) the greater the income effect.
Married MenMarried Women
Married Men have a vertical Labour supply, inelastic.
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