Consumer Theory Application - Labour Supply Flashcards
How can we derive a consumer decisions on Labour Supply?
- Assume income which is exogenous (m) comes from earned income (wL)
- W is hourly rate and L is labour supplied
- We lump all consumer goods to give (C) with price of P
Gives budget constraint of: pC ≤ wL
We can normalise P = 1 so,
C ≤ wL
From this how do we derive the final Budget Constraint into a consumer’s decision on Labour Supply?
- We know that consumers also constrained in hours they can provide (T) [Time Allocation]
- Time can either be spend working in labour (L) or leisure/Rest (R) so:
T = L + R - Implies that L = T-R, so by substitution of the last budget constraint (C ≤ wL) we get the last constraint:
C ≤ w(T - R)
What is the opportunity cost/sacrifice a consumer makes considering work?
Wage Rate (W) is the opp cost or the Cost of Leisure
How does this final budget constraint look diagrammatically and where is the optimal point on this diagram?
SEE IN NOTES
How do we calculate Labour Supply?
Using Lagrangian Function on the new found utility function and budget constraint
Will lead to finding R* but more interested in finding L* so L* = T = R*
SEE NOTES FOR EXAMPLE
AND SEE LEC 13 FOR MORE WORKED EXAMPLES ON IT
What does the Substitution Effect do to work/ leisure when there are an increase in wages?
An increase in the wage rate will, as with an increase in price, generate income and substitution effects.
Using the same logic, we know that the substitution effect will always generate less leisure (more work) if the budget constraint is linear and the ICs are convex to the origin.
(SEE DIAGRAM IN NOTES)
What does the Income Effect do to work/ leisure when there are an increase in wages?
Can generate more/less leisure depending on whether leisure is a normal/inferior good
- If the sub effect dominates, then labour supply will be increasing in the wage rate (forward sloping)
- If the income effect dominates, then labour supply could be decreasing in the wage rate (Backwards sloping)
What are the general demographics for the Income Effect?
Men - Perfectly inelastic whatever the wage rate
Married Women - Slightly backward bending in the US
Slightly forward bending in Europe
Single Women - Forward Sloping
How do we denote Income Tax Rates?
Income Tax Rate (t) reduces the effective wage rate, from w to (1-t)w
Why does the Income Tax Rate reduce the effective wage rate?
The government collects tw in revenue per unit of labour, and leaves the worker with (1-t)w.
The government will collect a total tax revenue of
Z= twH,
if H is the total labour supplied across all individuals.
What is the Laffer Curve?
As the tax rate increases from zero, revenue increases directly and workers may actually increase their labour supply (with the inc effect dominating the sub effect).
But when the tax rate gets higher, workers will start
reducing their labour supply (with the sub effect dominating the inc effect) to such an extent that revenue begins to fall.
SEE DIAGRAM
What was the Controversy in the 80’s revolving around the Laffer Curve?
In the 80’s, there was much controversy about the exact level of the revenue maximising tax-rate. Conservative governments in the US and UK argued that their existing top level tax rates of 60-90% were higher than t*, and so
suggested tax cuts could increase output
What is a modern example revolving around the Laffer Curve?
In a more modern example, Sajid Javid recently said that he would consider scrapping the top rate of income tax in a bid to boost the economy:
“I think [cutting taxes] can pay for itself, it leads to more dynamism in business.”
Sajid Javid pointed to George Osborne’s move to cut the top rate of tax from
50p to 45p, which saw tax revenues increase
How can we analyse Policy effects via Consumer Theory?
We allow for ‘unearned’ income, MU, as well as earned income, wL.
This could result from existing wealth, or from welfare payments and benefits.
This gives a new budget constraint of
C ≤ wL + MU
