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1 Changes in income After we build our initial model of labor/leisure choice we add ideas about how a person might react to change.

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Presentation on theme: "1 Changes in income After we build our initial model of labor/leisure choice we add ideas about how a person might react to change."— Presentation transcript:

1 1 Changes in income After we build our initial model of labor/leisure choice we add ideas about how a person might react to change.

2 2 definition and example You may recall the budget constraint in generic terms is C = wT + V – wL. Remember V is nonlabor income and let’s say V 0 is one level and V 1 is a higher level of nonlabor income. These two V’s are just numbers (like 25 and 50, for example). The higher the V value the farther out in a parallel fashion is the budget constraint. Similarly, the lower the V the farther in is the budget constraint.

3 3 Change in nonlabor income C L The endowment points with Vo and V 1. The vertical intercepts with Vo and V 1 Vo V1V1

4 4 Change in nonlabor income C L The endowment points with Vo and V 1. The vertical intercepts with Vo and V 1 Vo V1V1 A B

5 5 Initial position Using previous slide as our reference, at V 0 say the person here picks point A on the budget because that is where the highest indifference curve attainable is tangent to the budget. (You have to imagine the indifference curves here - I didn’t want the graph to get too messy.) If the nonlabor income amount rises to V 1 the budget shifts out. I put in a vertical line above point A because I want to think about the amount of leisure taken after the increase in nonlabor income and the line is my reference point. Note point B has the same amount of leisure as point A.

6 6 Leisure is normal What we are investigating here is what happens to the amount of leisure taken when nonlabor income changes. In some sense economic theory does not have a lot to say about how much leisure will be taken. But, if on the new budget if the highest indifference curve is tangent at a point to the right of B then an increase in nonlabor income would mean this person takes more leisure. When we have more income and we take more of something we say that thing is a NORMAL good. In this scenario leisure would be a normal good. Note also if income falls less leisure would be taken.

7 7 Leisure is inferior If on the new budget if the highest indifference curve is tangent at a point to the left of B then an increase in nonlabor income would mean this person takes less leisure (this could be the case instead of a normal good). When we have more income and we take less of something we say that thing is an INFERIOR good. In this scenario leisure would be an inferior good. Note also if income falls more leisure would be taken.

8 8 Same amount of leisure It could very well be that when nonlabor income changes we end up with the same level of leisure taken. The book is silent on this point and we don’t have a name for this situation.

9 9 Income effect So, the change in nonlabor income may have an impact on the amount of leisure taken (and hence on amount of labor supply) and in general we talk about an income effect. In theory the income effect can be negative with an inferior good (thus income and leisure move in opposite direction), or positive with a normal good (income and leisure move in the same direction). In practice the income effect is thought to only be positive and leisure is thought to be a normal good.

10 10 Summary when leisure is a normal good In the context of leisure being a normal good 1) When nonlabor income rises, the budget shifts out, a higher level of utility is reached, more leisure is taken and less labor is supplied, 2) When nonlabor income falls, the budget shifts in, a lower level of utility is reached, less leisure is taken and more labor is supplied.


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