Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Applications of Consumer Choice Theory 1.Labour Supply: The Income-Leisure Trade-off Leisure Income IC 1

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Leisure Income IC T max Time Constraint: T max 0 Labour Supply 0 2

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Leisure Income T max Wage Constraint: w (wage per hour) 0 Labour Supply 0 w 3

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Leisure Income T max Wage Constraint: w (wage per hour) And Non-labour income, N. 0 Labour Supply 0 w N 4

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Leisure Income IC T max Optimisation, given w, N and Tastes. Total Income = Labour Income + Non-Labour Income Total Income = Y + N 0 Labour Supply 0 w N L*L* N Y 5

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Leisure Income IC T max Optimisation, given w, N and Tastes. What happens to optimal Labour Supply if N rises (why might it?)? 0 Labour Supply 0 w N L*L* N Y 6

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Leisure Income IC T max What happens to optimal Labour Supply if N rises 0 N 7

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Leisure Income IC T max What happens to optimal Labour Supply if N rises? Under what assumption? Why? 0 N IC* a b 8

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: The Income-Leisure Trade-off Leisure Income IC T max 0 Labour Supply 0 w N L*L* N Y w L, Labour Supply What happens to optimal Labour Supply if w rises? a a L*L* w 9

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income IC T max 0 Labour Supply 0 w N L*L* w L, Labour Supply What happens to optimal Labour Supply if w rises? a a L*L* 10

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income IC T max 0 Labour Supply 0 w L*L* w L, Labour Supply What happens to optimal Labour Supply if w rises? a a L*L* a* 11

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income IC T max 0 Labour Supply 0 L*L* w L, Labour Supply What is the implied shape of the Labour Supply curve in this case? a a L*L* a* 12

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income IC T max 0 Labour Supply 0 L*L* w L, Labour Supply What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply? a Ls L*L* a* 13

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income IC T max 0 Labour Supply 0 L*L* To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects. To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve... a a* 14

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income T max 0 Labour Supply 0 L*L* To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects. To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve... a a* 15

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income T max 0 Labour Supply 0 L*L* To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects. To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve... with the move from ‘a’ to ‘a*’ split into: ‘a’ –> ‘b’; Substitution Effect, ‘b’ –> ‘a*’; Income Effect. a a* b S I 16

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income T max 0 Labour Supply 0 L*L* a a* b S I ‘a’ –> ‘b’; Substitution Effect, ‘b’ –> ‘a*’; Income Effect. When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen. 17

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income T max 0 Labour Supply 0 L*L* ‘a’ –> ‘b’; Substitution Effect, ‘b’ –> ‘a*’; Income Effect. How would you interpret the Income Effect in words? And the Substitution Effect (Hint: exploit the concept of the Opportunity Cost) a a* b S I 18

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income T max 0 Labour Supply 0 L*L* ‘a’ –> ‘b’; Substitution Effect, ‘b’ –> ‘a*’; Income Effect. When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen. What about if the Substitution Effect dominates? What is the shape of the Labour Supply curve in this case? a a* b S I 19

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income T max 0 Labour Supply 0 L*L* w L, Labour Supply What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply? a Ls L*L* a* I S When the S-effect dominates the I-effect a a* 20

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income T max 0 Labour Supply 0 L*L* w L, Labour Supply What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply? a Ls L*L* a* I S When the S-effect dominates the I-effect a a* 21

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Leisure Income T max 0 Labour Supply 0 L*L* w L, Labour Supply What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply? a Ls L*L* a* I S When the I-effect dominates the S-effect a a* 22

Robin Naylor, Department of Economics, Warwick Topic 1 Lecture 9 Labour Supply: the evidence... And for most people? And the implication for income tax cuts? w L Ls 23

Robin Naylor, Department of Economics, Warwick Topic 1: Lecture 9 24 Now read B&B 4 th Ed., pp (but don’t worry about issues (especially the mathematical material) which go beyond what you have seen in lecture notes or seminar exercise sheets)