4.2. Budget constraint Definition: combinations of real income-leisure that the i can achieve Characteristics: 1.Line  “price takers” 2.Slope = wage rate (w) Maximization of U: I.Subjective or psychological preferences (IC) and objective or market preferences (BC)  highest IC, tangent to BC II.The individual and the market “are in agreement” III.Wage rate = MRS  tangency IV.Over and underemployment

4.2. IC, BC, & Max. of U IC: all combinations of L-l desired by the i with U; subjective or psychological preferences  slope MRS BC: all combinations of L-l achievable at certain w; objective or market information  slope w Max. of U: IC & BC together  tangency, same slope: MRS = w Question: what happens if the slope of BC is steeper than that of the IC?

What do individuals do when w goes up? Answer: L up … or l up (and L down)? Derivation of the supply of labor curve “Backward-bending”  changes from person to person Again: income effect and substitution effect Substitution effect : ∆L due to ∆w with Y  > 0 Income effect : ∆L due to ∆Y with w  < 0 (l: normal) Total effect: depends on the “strength” of the other two 4.2. IC, BC, & Max. of U

The reasoning behind “backward-bending”: with ∆w  ∆BC  substitution > income; but as t goes by, ∆w  ∆BC  substitution < income Supply curve: when leisure is abundant, how is the MRS? Different individual curves: men vs. women? 4.2. IC, BC, & Max. of U