Unit 3 Flashcards
What is a scarce good?
A good is scarce if it is valued and there is an opportunity cost of acquiring more of it.
Describe the initial model of a worker’s working hours.
The worker’s income is on the y axis and hours of work per day on the x axis. The line represents the worker’s wage which has a constant slope as the wage is constant. The line is upward sloping as income increases with hours worked.
What choice does the worker face?
The worker faces a scarcity problem between free time (less hours worked but less income) and consumption (more income but more hours worked). The worker would like to enjoy a high amount of free time and consumption but the choice is constrained by the relationship between hours and income.
How can the worker’s preferences be modelled?
We assume the worker only cares about free time and consumption and consider them both as goods. Diagrammatically, consumption is on the y axis and free time on the x axis.
We also assume that for a given level of consumption, the worker prefers a combination with more free time.
If two combinations have the same number of hours of free time, we assume the worker prefers the one with higher consumption.
How can we draw indifference curves for the worker?
By plotting points on the diagram that show the combinations of free time and consumption, we can then find out which combinations give the worker the same utility and then join them together.
What are indifference curves?
Indifference curves show us all the combinations of two goods (ie free time and consumption) that yield the same utility to an individual. All points on the same indifference curves provide the same utility.
What are key characteristics of indifference curves?
- They slope downward due to trade offs. To maintain an equal level of satisfaction, an individual must consume less of one good to consume more of the other.
- Higher indifference curves correspond to higher utility. This is because the individual can get a higher combination of both goods.
- Indifference curves are usually smooth. Small changes in the amounts of goods don’t cause big jumps in utility.
- Indifference curves never cross and become flatter as you move rightwards.
Why do indifference curves become flatter as you move rightwards?
Because the marginal rate of substitution decreases as the more hours of free time the worker has, the less consumption they are willing to give up for an extra hour of free time as consumption becomes scarce relative to free time.
What is the marginal rate of substitution?
MRS tells us how much consumption the worker is willing to give up for an extra hour of free time. It is equal to the absolute value of the gradient of the indifference curves.
What is the worker’s feasible set and budget constraint?
The worker’s feasible set shows all of the possible combinations of free time and consumption available to the worker. The worker cannot work more than 24 hours in a day, and the worker’s consumption is constrained by their fixed wage.
If the worker takes t hours of free time, they work for (24-t) hours per day. The worker’s consumption will therefore be w(24-t).
The budget constraint is the downward sloping line with equation w(24-t). At any point on the line, a free time increases by one hour, maximum possible consumption decreases by w. All points on and below the budget constraint are feasible.
What is marginal rate of transformation?
MRT measures the trade off that a worker is constrained to make by the feasible frontier, the rate at which they transform free time into consumption. It differs from MRS which is the trade off a worker is willing to make. MRT is equal to the wage.
How can we use indifference curves and the budget constraint to analyse the worker’s best option?
By bringing together the worker’s indifference curves and feasible frontier on the same diagram, we can assess which feasible combinations the worker would prefer.
All combinations under the feasible frontier are available. Combinations on higher indifference curves provide more utility so the worker prefers them.
The worker maximises utility by choosing the point on the indifference curve that is tangential to the feasible frontier as this is the highest indifference curve within the worker’s feasible set.
At this point, the indifference curve and feasible frontier have the same gradient, so MRS=MRT.
If the worker’s wage were to increase, how would the worker respond, using the constrained-choice model?
The worker would choose the combination on a new indifference curve which is tangential to the new budget constraint, where MRS=MRT.
Explain the income and substitution effect following an increase in the worker’s wage.
The income effect states that the worker will take more free time. This is because the budget constraint and feasible set expand, and so the worker can choose combinations of higher consumption and free time which were not before available.
The substitution effect states that the worker will take less free time. This is because the opportunity cost of free time has increased, giving the worker greater incentive to work.
Why is it unclear whether free time will increase following a wage rise?
The income and substitution effects work in opposite directions. The effect on free time depends on which effect dominates the other. An increase in wage therefore always increases utility but may not increase free time.
How do the income and substitution effects dominate each other when a worker is given a sum of money vs when their wage increases?
When given a sum of money, the budget constraint shifts up but the slope doesn’t change because the wage is still the same. The worker’s MRT remains unchanged and so the opportunity cost of free time is constant. There is no substitution effect, only an income effect as the worker has no reason to substitute consumption for free time. The income effect dominates the substitution effect.
When the wages increases, the slope budget constraint becomes steeper and so MRT increases. The opportunity cost of free time is greater so there is an incentive to work more. The feasible set expands and so at each level of consumption the worker can have more free time The substitution effect outweighs the income effect.
What are some issues with this constrained choice model?
- Workers do not make de is ions like these using calculations such as MRT and MRS
- The assumption that workers only care about consumption and free time isn’t accurate. Workers also value experience gained from working to help future career aspirations.
- The model isn’t suitable for explaining the behaviour of large groups of workers where each has different preferences and feasible sets.
- Workers do not always choose their working hours. Employers can choose them through contracts and the government can limit working hours by law.
How can the income and substitution effects be used to explain the trend in working hours in many countries in the last hundred years?
Working hours have come down in most countries over the years. This is due to wages increasing.
Before 1870, there was a low level of consumption and workers’ willingness to substitute free time for goods did not increase much when rising wages made higher consumption possible. Workers became more productive and were paid more so each hour of work increased the opportunity cost of free time and increased the incentive to work longer hours. The substitute effect dominated before 1870 .Since the Industrial Revolution, workers had a higher level of consumption ans valued free time relatively more. Their MRS was higher so the income effect of a wage rise was higher. The income effect dominated since 1870, so working hours fell.
