1.5 CompEcuVariation/ Labour Supply Flashcards
What is equivalent variation
Given a consumers choice before a price increase, how much money would we have to take away from that consumer to reduce their utility by as much as the price increase?
(graphed on page 13)
- Start on original bundle A
- Price increase moves budget constraint inwards to BC2 and utility to B. (without EV)
- Old budget constraint is then moved parallel to the new indifference curve where BC2 is after price increase
- The vertical difference between the original budget constraint and new budget constraint
What is compensating variation?
How much money is needed to pay to someone after a price increase in order to bring them back to their original utility level
- Start on original bundle A
- After price increase BC2 shifts inwards, new utility at B and new IC
- The new budget constraint is then pulled back outwards towards the first indifference curve (parallel)
- The vertical change in budget constraint is the compensating variation
What are the differences between EV and CV?
Both based on different relative prices
Compensating variation is how much money required to compensate consumer given new prices
Equivalent variation is how much is needed to be taken away from the consumer given the old prices
Application of EV
Housing subsidies from the government
Originally at budget constraint BC1, adding the subsidy reduces prices, shifts BC out to BC2, utility shifts from A to B on new Indifference curve
The difference between BC1 and BC2 at B is the size of the subsidy
BC3 also shifts out parallel to B1, so equivalent variation is difference between BC3 and B1
How is the subsidy example explained through calculus?
- Price with subsidy = Ph
Price without subsidy = (1-s)Ph
- Cost of subsidy is s x Qh x Ph
- This makes BC2 - BC1 different since:
BC without sub: q(other) = income - phqh
BC with sub: q^s(other) = income - (1-s)phqh
- So the vertical difference is:
income - (1-s)phqh - (income-phqh)
= -(1-s)phqh + phqh = sphqh
And so subsidy cost is BC2 - BC1
Since EV is BC3-BC1 (benefit to consumers), benefits < costs and so a direct income transfer to consumers would be cheaper
What are the properties of consumer surplus?
The area shows the price people would be willing to pay and the benefit they get from it being lower
- Changes when equlibrium changes
Demand curve shows marginal valuation declines as more is consumed
It is only an approximate measure of welfare:
Ignores income effect:
- Income held constant, spend more on A, less to spend on B
- Marginal valuation argument assumes utility from consuming A doesnt depend on how much left for B
- Usually is a good assumption though, only if A accounts for a small amount of total expenditure
What may make consumer surplus more accurate?
- Compensated demand function gives exact welfare due to removing the income effects - done same way as before
- Uncompensated curves are used but can be hard to measure income effect - usually not important so using uncompensated demand curves good approximation
What are assumptions of the labour supply model?
People choice whether to work or not
If they work, they choose the number of hours their work per week - in reality dont have that mch of a choice - influneced by changing jobs, overtime, holidays etc.
If they dont work, remain home in leisure - no market activity
- Choice between income (=consumption) and leisure
- Seven days of 24 hours available - time endowment T = 168
- Labour homogenous and wages - no skill diferences
- Individuals take the wage rate w as given
How is labour supply choice modelled?
Can be modeeled with budget constraints and indifference curves
(page 15)
Budget constraint:
- No work done then 168 hours of leisure, consumption is 0
- If workers work one hour then leisure declines by 1 and consumption rises to 1w
- Maximum consumption as such is 168w
- Slope is -w
It is modelled by c = w x (T-n)
Where c is consumption, n is number of hours per week and T is time endowment
- Sometiems rewritten as c+wn=wT - similar to standard budget constraints
How does the labour supply curve change with wage changes and other incomes
Rotates like normal budget constraint with wage changes
If we have other sources of income there is a parallel shift in budget constraint
How are ICs illustrated on supply choice?/
Indifference curves illustrated as normal - leisure against consumption
- Indiviudals value both, creating standard curves
- Optimal leisure where IC tangental to BC
How do people react to changes in wages?
Substitution effect - wages rise, people work more and substitute leisure for work as opportunity cost of leisure rises
Income effect - wages rise, person works less as income risen allowing them to spend more time on leisure
As before, substitution effect determined by shifting the budget constraint to keep utility constant:
(illustrated on page 16)
- Originally on budget constraint of w
- wages rise to w’, substitution effect moves a up the indifference curve to c
- Income effect moves up to new budget constraint as incomes rise and people start to work less
Note they work in opposite directions - for normal goods work in same direction
Here workers are selling a good (labour), so price increases make people richer not poorer.
How do we determine a labour supply curve - what are the 3 types?
Basically done by flipping the leisure against consumption curve, changing leisure to work hours and consumption to £/hour
There is an upward sloping supply curve
Downward supply curve
and backward bending supply curve - past certain wage work less
What is elasticity of labour supply?
%change in labour / %change in wages
dL/dW * w/L
Always positive (>0)
How does elasticity differ between groups?
US and UK men - low ELs - labour supply curve almost vertical (below 0.15)
For women curve is flatter - between 1.25 and 5.6
