Chapter 6 Flashcards
How to calculate Delta(little Triangle)
How to calculate Delta(little Triangle)
(X final- X initial)/x Initial
*100
Hours of work
Short run :
Long Run:
Hours of work
Short-run: the employers( demand) have the most power on hours of work
Long-run: employee preferences(supply) has more influence on long run
A theory of the decision to work
Demand for a good is a function of three Factors:
- t
- the Opportunity cost of an hour of leisure is equal to …
Total income indicator of
A theory of the decision to work
Demand for a good is a function of three Factors:
- The opportunity cost of the good:
- the Opportunity cost of an hour of leisure is equal to your wage rate( the extra earning a worker can take home form extra hour of work)
- One’s level of wealth
- One’s set of preferences
Total income indicator of total wealth
Income effect
- Based on the simple notion that
- the income effect is … because
Income effect
- If income increases while wages and preferences are held constant, number of leisure hours demanded will rise and desired hours of work will go down. and vise versa
- Based on the simple notion that as income rise people want to consume more leisure
- the income effect is negative because the sign of the fraction in equation (6.1) is negative.If income goes up , hours of work fall. If income goes down, hours of work increase. The numerator ( H) and denominator (Y ) in equation move in opposite directions, giving a negative sign to the income effect.
Substitution effect
- substitution effect occurs because
- the substitution effect is
Substitution effect
- if income is held constant, an increase in the wage rate will raise the price and reduce the demand for leisure, thereby increasing work incentives.
- substitution effect occurs because as the cost of leisure changes, income held constant, leisure and work hours are substituted for each other.
- the substitution effect is positive, Because the numerator (H) and denominator (W) always move in the same direction, at least in theory, the substitution effect has a positive sign.
Observing Income and Substitution Effects Separately
Usually, both effects are
Example, Receiving inheritance: Substitution or Income?
Substitution Effects Separately
Usually, both effects are simultaneously present, often working against each other.
Example, Receiving inheritance: Substitution or Income?
The bequest enhances wealth (income) independent of the hours of work. Thus, income is increased without a change in the compensation received from an hour of work. In this case, the income effect induces the person to consume more leisure, thereby reducing the willingness to work.
Both Effects Occur When Wages Rise
Consider the case of a person who receives a wage increase
The labor supply response to a simple wage increase will involve both an …. The income effect is the result … after the increase. For a given level of work effort, he or she now has a …. The substitution effect results from the fact that …. Because the actual labor supply response …, we … in advance; theory simply does not tell us which effect is stronger. If the income effect is stronger, the person will respond…. This decrease will be smaller than if the same change in wealth were due …, because the … However, as seen in Example 6.2, when the income effect dominates, …. It is entirely plausible, of course, that the substitution effect will dominate. If so, the actual response to wage increases …. Should the substitution effect dominate, the person’s labor supply curve— relating, say, his or her desired hours of work to wages—will be …. That is, l… will increase with the wage rate. If, on the other hand, the income effect dominates, the person’s labor supply curve ….. Economic theory cannot say which …, and in fact, individual labor supply curves could be p…
Both Effects Occur When Wages Rise
The labor supply response to a simple wage increase will involve both an income effect and a substitution effect. The income effect is the result of the worker’s enhanced wealth (or potential income) after the increase. For a given level of work effort, he or she now has a greater command over resources than before (because more income is received for any given number of hours of work). The substitution effect results from the fact that the wage increase raises the opportunity costs of leisure. Because the actual labor supply response is the sum of the income and substitution effects, we cannot predict the response in advance; theory simply does not tell us which effect is stronger. If the income effect is stronger, the person will respond to a wage increase by decreasing his or her labor supply. This decrease will be smaller than if the same change in wealth were due to an increase in nonlabor wealth, because the substitution effect is present and acts as a moderating influence. However, as seen in Example 6.2, when the income effect dominates, the substitution effect is not large enough to prevent labor supply from declining. It is entirely plausible, of course, that the substitution effect will dominate. If so, the actual response to wage increases will be to increase labor supply. Should the substitution effect dominate, the person’s labor supply curve— relating, say, his or her desired hours of work to wages—will be positively sloped. That is, labor supplied will increase with the wage rate. If, on the other hand, the income effect dominates, the person’s labor supply curve will be negatively sloped. Economic theory cannot say which effect will dominate, and in fact, individual labor supply curves could be positively sloped in some ranges of the wage and negatively sloped in others
Figure 6.1
When does substitution and income effect dominate?
In Figure 6.1, for example, the person’s desired hours of work increase (substitution effect dominates) when wages go up as long as wages are low (below W*). At higher wages, however, further increases result in reduced hours of work (the income effect dominates); economists refer to such a curve as backward-bending.
Graph 6.2
suppose a thoughtful consumer/worker were asked to decide how happy he or she would be with a daily income of $64 combined with 8 hours of leisure (point a in Figure 6.2). This level of happiness could be called …A. Our consumer/worker could name other combinations of money income and leisure hours that would also yield …A. Assume that our respondent named five other combinations. All six combinations of money income and leisure hours that yield… A are represented by heavy dots in Figure 6.2. The curve connecting these dots is called .., which … (The term indifference curve is derived from …) Our worker/consumer could no doubt achieve a higher level of happiness if he or she could combine the 8 hours of leisure with an income of $100 per day instead of just $64 a day. This higher satisfaction level could be called … B. The consumer could name other combinations of money income and leisure that would also yield this higher level of utility. These combinations are denoted by the Xs in Figure 6.2 that are connected by a second indifference curve
suppose a thoughtful consumer/worker were asked to decide how happy he or she would be with a daily income of $64 combined with 8 hours of leisure (point a in Figure 6.2). This level of happiness could be called utility level A. Our consumer/worker could name other combinations of money income and leisure hours that would also yield utility level A. Assume that our respondent named five other combinations. All six combinations of money income and leisure hours that yield utility level A are represented by heavy dots in Figure 6.2. The curve connecting these dots is called an indifference curve, which connects the various combinations of money income and leisure that yield equal utility. (The term indifference curve is derived from the fact that since each point on the curve yields equal utility, a person is truly indifferent about where on the curve he or she will be.) Our worker/consumer could no doubt achieve a higher level of happiness if he or she could combine the 8 hours of leisure with an income of $100 per day instead of just $64 a day. This higher satisfaction level could be called utility level B. The consumer could name other combinations of money income and leisure that would also yield this higher level of utility. These combinations are denoted by the Xs in Figure 6.2 that are connected by a second indifference curve
Indifference curves have certain specific characteristics
- Utility Level … represents more happiness than level …. Any such curve that lies to the … of another one is preferred to any curve to the … because …
- Indifference curves do not …. We assume …
- Indifference curves are … because if either income or leisure hours are increased, the other….. If the slope is steep, as at segment … in Figure 6.3, a given loss of income…..When the curve is relatively flat, however, as at segment … in Figure 6.3, a given decrease in income ….. Thus, when indifference curves are relatively steep, people d…as when such curves are relatively flat; when they are flat, a loss of income can only be compensated by …
- Indifference curves are ..—…. This shape reflects the assumption that…. At segment … in Figure 6.3, a great loss of income () can be compensated for by j…, whereas a little loss of leisure time would require a …. …
- Conversely, when income is low and leisure is abundant (segment… in Figure 6.3), income is more …. Losing income (by moving from ..to.., for example) would require a …. To repeat, what is relatively scarce is …
- Finally, different people have …. The curves drawn in Figures 6.2 and 6.3 were for one person. Another person would have a….
Indifference curves have certain specific characteristics
- Utility Level B represents more happiness than level A.el. Any such curve that lies to the northeast of another one is preferred to any curve to the southwest because the northeastern curve represents a higher level of utility.
- Indifference curves do not intersect. We assume our worker/ consumer is not so inconsistent in stating his or her preferences that this could happen.
- Indifference curves are negatively sloped because if either income or leisure hours are increased, the other is reduced in order to preserve the same level of utility. If the slope is steep, as at segment LK in Figure 6.3, a given loss of income need not be accompanied by a large increase in leisure hours to keep utility constant.When the curve is relatively flat, however, as at segment MN in Figure 6.3, a given decrease in income must be accompanied by a large increase in the consumption of leisure to hold utility constant. Thus, when indifference curves are relatively steep, people do not value money income as highly as when such curves are relatively flat; when they are flat, a loss of income can only be compensated for by a large increase in leisure if utility is to be kept constant
- Indifference curves are convex—steeper at the left than at the right. This shape reflects the assumption that when money income is relatively high and leisure hours are relatively few, leisure is more highly valued (and income less valued) than when leisure is abundant and income relatively scarce. At segment LK in Figure 6.3, a great loss of income (from Y4 to Y3, for example) can be compensated for by just a little increase in leisure, whereas a little loss of leisure time (from H3 to H4, for example) would require a relatively large increase in income to maintain equal utility. What is relatively scarce is more highly valued.
- Conversely, when income is low and leisure is abundant (segment MN in Figure 6.3), income is more highly valued. Losing income (by moving from Y2 to Y1, for example) would require a huge increase in leisure for utility to remain constant. To repeat, what is relatively scarce is assumed to be more highly valued.
- Finally, different people have different sets of indifference curves. The curves drawn in Figures 6.2 and 6.3 were for one person. Another person would have a completely different set of curves.
Figure 6.4
People who …. for example, would have had indifference curves that were generally steeper (see Figure 6.4a). People …. would have relatively flat curves (see Figure 6.4b).
Figure 6.4
People who value leisure more highly, for example, would have had indifference curves that were generally steeper (see Figure 6.4a). People who do not value leisure highly would have relatively flat curves (see Figure 6.4b).
Income and Wage Constraints
Everyone would like to …, which would be ideally done by …. Unfortunately, the resources anyone can command are …. Thus, all that is possible …. To see these resource limitations graphically requires…. Suppose the person whose indifference curves are graphed in Figure 6.2 had no source of income other than labor earnings. Suppose, further, that he or she could earn $8 per hour. Figure 6.5 includes the two indifference curves shown in Figure 6.2 as well as a straight line (ED) connecting combinations of leisure and income that are possible for a person with an $8 wage and no outside income. If 16 hours per day are available for work and leisure, and if this person consumes all 16 in leisure, then … (point .. in Figure 6.5). If 5 hours a day are devoted to work, income will be … (point …), and if 16 hours a day are worked, income will be … (point …). Other points on this line—for example, the point of 15 hours of leisure (1 hour of work) and $8 of income—are also possible. This line, which reflects… that are possible for the individual, is called the…. Any combination to the right of the budget constraint is …; the person’s command over resources is … to attain these …..
The slope of the …. is a graphical representation of t…. One’s wage rate is properly defined …
Wage rate=
Everyone would like to maximize his or her utility, which would be ideally done by consuming every available hour of leisure combined with the highest conceivable income. Unfortunately, the resources anyone can command are limited. Thus, all that is possible is to do the best one can, given limited resources. To see these resource limitations graphically requires superimposing constraints on one’s set of indifference curves to see which combinations of income and leisure are available and which are not. Suppose the person whose indifference curves are graphed in Figure 6.2 had no source of income other than labor earnings. Suppose, further, that he or she could earn $8 per hour. Figure 6.5 includes the two indifference curves shown in Figure 6.2 as well as a straight line (ED) connecting combinations of leisure and income that are possible for a person with an $8 wage and no outside income. If 16 hours per day are available for workand leisure,10 and if this person consumes all 16 in leisure, then money income will be zero (point D in Figure 6.5). If 5 hours a day are devoted to work, income will be $40 per day (point M), and if 16 hours a day are worked, income will be $128 per day (point E). Other points on this line—for example, the point of 15 hours of leisure (1 hour of work) and $8 of income—are also possible. This line, which reflects the combinations of leisure and income that are possible for the individual, is called the budget constraint. Any combination to the right of the budget constraint is not achievable; the person’s command over resources is simply not sufficient to attain these combinations of leisure and money income. The slope of the budget constraint is a graphical representation of the wage rate. One’s wage rate is properly defined as the increment in income ( y) derived from an increment in hours of work (h):
Wage rate=^Y/^H
Next part Income and Wage Constraints
Now ^y/^h is exactly the slope of the …(in absolute value). Figure 6.5 shows how the constraint rises $.. for every …-hour increase in work: if the person works 0 hours, income per day is …; if the person works 1 hour, $… in income is received; if he or she works 5 hours, … in income is achieved. The constraint rises $8 because the …. If the person could earn $16 per hour, the constraint would r…. It is clear from Figure 6.5 that our consumer/worker cannot achieve utility level …. He or she can achieve some points on the indifference curve representing utility level ….—specifically, those points between … and …. in Figure 6.5. However, if our consumer/worker is a utility maximizer, he or she will realize that a utility level above A is possible. Remembering that an …of indifference curves can be drawn between curves A and B in Figure 6.5, one representing …, we can draw a curve ( …) that is northeast of curve A and just tangent to the budget constraint at point …. Any movement along the budget constraint away from the tangency point places the person on an indifference curve lying … A’.
Workers who face the same budget constraint, but who have different preferences for leisure, will make different choices about hours of work. If the person whose preferences were depicted in Figure 6.5 had placed lower values on leisure time—and therefore had indifference curves that were comparatively …, such as the one shown in Figure 6.4..—then the point of tangency with constraint ED would have been to the … N (indicating more hours of work). Conversely, if he or she had steeper indifference curves, signifying that leisure time … (see Figure 6.4…), then the point of tangency in Figure 6.5 would have been to the … of point N, and … hours of work would have been desired. Indeed, some people will have indifference curves so steep (that is, preferences for leisure so strong) that there is no point of tangency with ED. For these people, as is illustrated by Figure 6.6, utility is maximized at the “corner” (point D); they desire no work at all and therefore are not in the labor force.
Next part Income and Wage Constraints
Now ^y/^h is exactly the slope of the budget constraint (in absolute value).11 Figure 6.5 shows how the constraint rises $8 for every 1-hour increase in work: if the person works 0 hours, income per day is zero; if the person works 1 hour, $8 in income is received; if he or she works 5 hours, $40 in income is achieved. The constraint rises $8 because the wage rate is $8 per hour. If the person could earn $16 per hour, the constraint would rise twice as fast and therefore be twice as steep. It is clear from Figure 6.5 that our consumer/worker cannot achieve utility level B. He or she can achieve some points on the indifference curve representing utility level A—specifically, those points between L and M in Figure 6.5. However, if our consumer/worker is a utility maximizer, he or she will realize that a utility level above A is possible. Remembering that an infinite number of indifference curves can be drawn between curves A and B in Figure 6.5, one representing each possible level of satisfaction between A and B, we can draw a curve ( a’) that is northeast of curve A and just tangent to the budget constraint at point N. Any movement along the budget constraint away from the tangency point places the person on an indifference curve lying below A’.
Workers who face the same budget constraint, but who have different preferences for leisure, will make different choices about hours of work. If the person whose preferences were depicted in Figure 6.5 had placed lower values on leisure time—and therefore had indifference curves that were comparatively flatter, such as the one shown in Figure 6.4b—then the point of tangency with constraint ED would have been to the left of point N (indicating more hours of work). Conversely, if he or she had steeper indifference curves, signifying that leisure time was more valuable (see Figure 6.4a), then the point of tangency in Figure 6.5 would have been to the right of point N, and fewer hours of work would have been desired. Indeed, some people will have indifference curves so steep (that is, preferences for leisure so strong) that there is no point of tangency with ED. For these people, as is illustrated by Figure 6.6, utility is maximized at the “corner” (point D); they desire no work at all and therefore are not in the labor force.
The Income Effect
Supose now that the person depicted in Figure 6.5 receives a source of income independent of work. Suppose further that this nonlabor income amounts to about $36 per day. Thus, even if this person worked 0 hours per day, his or her daily income would be …. Naturally, if the person worked more than 0 hours, his or her daily income would be equal to $36 plus …. (t…). Our person’s command over resources has clearly …, as can be shown by drawing a…. As shown by the darker blue line in Figure 6.7, the endpoints of the new … are point … (…) and point…(…). Note that the … is parallel t…. Parallel lines have the same …; since the slope of each constraint reflects …, we can infer that the increase in nonlabor income has not changed ….. We have just described a situation in which a …. should be observed. Income (wealth) has been increased, but …. The previous section noted that if wealth increased and the opportunity cost of leisure remained constant, the person would …. We thus concluded that the income effect was …, and this negative relationship is illustrated graphically in Figure 6.7. When the old budget constraint (ED) was in effect, the person’s highest level of utility was reached at point …, working …. With the new constraint (ed), the optimum hours of work are …). The new source of income, because …, has caused an income effect that results in …. Statistical analyses of people who received large inheritances (Example 6.3) or who won large lottery prizes support the prediction that labor supply …..
The Income Effect
Suppose now that the person depicted in Figure 6.5 receives a source of income independent of work. Suppose further that this nonlabor income amounts to about $36 per day. Thus, even if this person worked 0 hours per day, his or her daily income would be $36. Naturally, if the person worked more than 0 hours, his or her daily income would be equal to $36 plus earnings (the wage multiplied by the hours of work). Our person’s command over resources has clearly increased, as can be shown by drawing a new budget constraint to reflect the nonlabor income. As shown by the darker blue line in Figure 6.7, the endpoints of the new constraint are point d (0 hours of work and $36 of money income) and point e (16 hours ofwork and $164 of income—$36 in nonlabor income plus $128 in earnings). Note that the new constraint is parallel to the old one. Parallel lines have the same slope; since the slope of each constraint reflects the wage rate, we can infer that the increase in nonlabor income has not changed the person’s wage rate. We have just described a situation in which a pure income effect should be observed. Income (wealth) has been increased, but the wage rate has remained unchanged. The previous section noted that if wealth increased and the opportunity cost of leisure remained constant, the person would consume more leisure and work less. We thus concluded that the income effect was negative, and this negative relationship is illustrated graphically in Figure 6.7. When the old budget constraint (ED) was in effect, the person’s highest level of utility was reached at point N, working 9 hours a day. With the new constraint (ed), the optimum hours of work are 8 per day (point P). The new source of income, because it does not alter the wage, has caused an income effect that results in one less hour of work per day. Statistical analyses of people who received large inheritances (Example 6.3) or who won large lottery prizes support the prediction that labor supply is reduced when unearned income rises.
ncome and Substitution Effects with a Wage Increase
Suppose that instead of increasing one’s command over resources by receiving a source of nonlabor income, the wage rate were to be increased from $8 to $12 per hour. This increase, as noted earlier, would cause both an i…; workers would be .. and face a … opportunity cost of leisure. Theory tells us in this case that the substitution effect .. and the income effect toward f…, but it cannot tell us which effect will dominate. Figures 6.8 and 6.9 illustrate the possible effects of the above wage change on a person’s labor supply, which we now assume is initially 8 hours per day. Figure 6.8 illustrates the case in which the observed response by a worker is to …; in this case, the substitution effect is … than the income effect. Figure 6.9 illustrates the case in which the income effect is … and the response to a wage increase is to … The difference between the two figures lies solely in the shape of the …that might describe a person’s preferences; the budget constraints,…, are exactly the same
Figures 6.8 and 6.9 both show the old constraint, AB, the slope of which reflects the wage of $8 per hour. They also show the new one, AC, which reflects the $12 wage. Because we assume workers have no source of nonlabor income, both constraints are anchored at point …, where income is …. Point C on the new constraint is now at $192 (16 hours of work times $12 per hour). With the worker whose preferences are depicted in Figure 6.8, the wage increase makes utility level …the highest that can be reached. The tangency point at …. suggests that …. When the old constraint was in effect, the utility-maximizing hours of work were … (…). Thus, the wage increase would cause this person’s desired hours of work to increase by … per day. With the worker whose preferences are depicted in Figure 6.9, the wage increase would make utility level … the highest one possible (the prime emphasizes that workers’ preferences differ and that utility levels in Figures 6.8 and 6.9 cannot be compared). Utility is maximized at …,… hours of work per day. Thus, with preferences like those in Figure 6.9, working hours fall from … to … as the wage rate increases.
Income and Substitution Effects with a Wage Increase
Suppose that instead of increasing one’s command over resources by receiving a source of nonlabor income, the wage rate were to be increased from $8 to $12 per hour. This increase, as noted earlier, would cause both an income effect and a substitution effect; workers would be wealthier and face a higher opportunity cost of leisure. Theory tells us in this case that the substitution effect pushes them toward more hours of work and the income effect toward fewer, but it cannot tell us which effect will dominate. Figures 6.8 and 6.9 illustrate the possible effects of the above wage change on a person’s labor supply, which we now assume is initially 8 hours per day. Figure 6.8 illustrates the case in which the observed response by a worker is to increase the hours of work; in this case, the substitution effect is stronger than the income effect. Figure 6.9 illustrates the case in which the income effect is stronger and the response to a wage increase is to reduce the hours of work. The difference between the two figures lies solely in the shape of the indifference curves that might describe a person’s preferences; the budget constraints…, are exactly the same
Figures 6.8 and 6.9 both show the old constraint, AB, the slope of which reflects the wage of $8 per hour. They also show the new one, AC, which reflects the $12 wage. Because we assume workers have no source of nonlabor income, both constraints are anchored at point A, where income is zero if a person does not work. Point C on the new constraint is now at $192 (16 hours of work times $12 per hour). With the worker whose preferences are depicted in Figure 6.8, the wage increase makes utility level U2 the highest that can be reached. The tangency point at N2 suggests that 11 hours of work is optimum. When the old constraint was in effect, the utility-maximizing hours of work were 8 per day (point N1). Thus, the wage increase would cause this person’s desired hours of work to increase by 3 per day. With the worker whose preferences are depicted in Figure 6.9, the wage increase would make utility level U’2 the highest one possible (the prime emphasizes that workers’ preferences differ and that utility levels in Figures 6.8 and 6.9 cannot be compared). Utility is maximized at N’2, at 6 hours of work per day. Thus, with preferences like those in Figure 6.9, working hours fall from 8 to 6 as the wage rate increases