Learn Basic EconomicsLesson 7: Appling consumer theory: Labour

If the price increases and the utility function remains constant, then you will buy less of that good. (utility falls as the consumer is effectively poorer).

Budget = £9.60, Donuts = £0.80 and Coffee = £1.60. (BC1)

Point A shows optimal solution. A

BC1

In this example Donuts have increased in price from £0.80 BC1 to £1.20 BC2

(income remains £9.60)

With this price increase the new optimal solution to maximise utility will be at C, as there is now insufficient income for solution A. Donuts are a normal good.

BAC

BC1BC2 BC*

Substitution effect

Income effect

BC1 = Chicken costs £2.50, Rice costs £0.50 and income is £12.50.

Point A shows optimal utility.

A

BC1

If the price of Rice increases to £1.50, then consumer moves to point C.

Substitution effect from AB

Income effect from BC

This means the consumer is effectively poorer so must consume a greater ratio of Rice to Chicken than you may predict given an increase in price.

This means rice is an inferior good.

A

B

C

BC1BC2

BC*

Substitution effect

Income effect

Theoretically, the income effect could be so significant that it offsets the substitution effect

and could increase the quantity bought if the price increases. These are called Giffen goods.

However there are few examples of Giffen goods and their existence is contested, there

have been some studies to show rice and wheat/noodles have the properties of a Giffen

good in parts of China [1].

Giffen goods have an upward sloping demand curve.

[1] Source: “The impact of food price increases on caloric intake in China”. Agricultural Economics

Substitution effect Income effect Total effect

Normal Good:

Price increase = Negative Negative Negative

Price decrease = Positive Positive Positive

Inferior Good:

Price increase = Negative Positive ?

Price decrease = Positive Negative ?

Labour

Leisure is a normal good, we shall denote leisure as N.

In order to model an undesirable quantity (such as hours worked), the

complimentary good is modelled instead.

Hours worked = 24 – N (leisure)

By modelling leisure and consumption the amount of labour can then be

worked out.

Wage = W per hour

(Price of Goods = 1)

A trade off is made between leisure and consumption.

Opportunity cost: By not working, you are missing put on wage therefore the price of leisure is the same as the wage per hour.

Slope of budget constraint = -W

BC

Income and substitution effects for labour supply: Income effect does not dominate

BC1 optimal solution is point A,

Leisure = N1,

Goods quantity = C1.

BC1

A

B

C

Income and substitution effects for labour supply: Income effect does not dominate

Wage increases so there is new budget constraint BC2.

Substitution effect, incentive to work harder for more wage.

Income effect, as leisure is a normal good, the more income increases the more leisure the consumer can afford.

Leisure = N3,

Goods quantity = C3.BC1

A

B

C

BC2

Substitution effect Income effect

Income and substitution effects for labour supply: Income effect dominates

Wage increases so people do not have to work as hard as they have a greater income and can afford more leisure.

Substitution effect from AB

Income effect from BC

Target income = If wage goes up they can work less hard.

A

B

C

BC1 BC2

Substitution effectIncome effect

Substitution effect Income effect Total effect

Leisure:

Wage increase = Negative Positive ?

Wage decrease = Positive Negative ?

Labour:

Wage increase = Positive Negative ?

Wage decrease = Negative Positive ?

Income effect does not offset substitution effectDemand for Leisure

Supply of Labour

This graph shows the more wage increases the greater supply of labour there is.

(It is possible for there to be a downward slopping supply curve if when the wage increases people decide they can afford to work less.)

Case Study: What happens when the wage increases for married Men and Women over

the age of 40?

Substitution effect Income effect

Married Men Less Greater

Married Women Greater Less

The table shows the changes in substitution and income effects when wage increases.

The more you are in the market (married men in this case, as women are usually involved more in child care) the greater the income effect.

Married MenMarried Women

Married Men have a vertical Labour supply, inelastic.

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