Consumption -Applications The Labour Supply Curve As wages increase the budget line becomes steeper as in the diagram below. Indifference curves are again suppressed. en> aI Leisure L? Li L the wage rate consumer to supply However as wages rise further from az to w'g, labour supply falls from L? back to Li. A wage increase consumer to supply less labour to the market. The price effect can be decomposed to show how this happens. The endowment income effect of the wage rise outweighs the substitution effect. The consumer chooses to work less. "taking advantage"of the higher wage. chard bending labour supply Consumption-Applicatiorsa Intertemporal Budgets There are two goods, consumption today and consumption tomorrow. The consumer buys c units today and cy tomorrow at a constant price level of 1.(This will be allowed to vary later). The consumer receives an income of mi today and mz tomorrow but can save(and borrow) at an interest rater. The amount that can be consumed next period is c2 <m2+(I+r)(m1-cn) So the budget line is given by Ca Slope =-(1+r) (1+r)m1+mN Slope=-(1+r) m21 m1+m2/(1+r) Present value The first graph shows the budget set with no borrowing. The second shows the budget set when there isConsumption — Applications 7 The Labour Supply Curve • As wages increase the budget line becomes steeper as in the diagram below. Indifference curves are again suppressed. ..................................................................................................... ... ... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... .... .............................................................................................................................................................................................................................................................................................. ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ........ ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... .... ................................................................................................................................................................................................................................................................................ ..................................................................................................... ............... ..................... ..................................................................................................... ...... ...... ... ...... ...... ...... ... ........................................................................................................................................................... ............... ..................... .......................................................................................................................................................... ...... ...... ... ...... ...... ...... 0 ... 0 c w Leisure L L ∗ 1 L ∗ 2 L ∗ 1 L ∗ 2 w1 w2 w3 • • • • • • • . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ......... ............. ............. ............. ............. ......... • As wages increase from w1 to w2, choice of L rises initially (as might be expected) from L ∗ 1 to L ∗ 2 . An increase in the wage rate causes the consumer to supply more labour. • However as wages rise further from w2 to w3, labour supply falls from L ∗ 2 back to L ∗ 1 . A wage increase causes the consumer to supply less labour to the market. • The price effect can be decomposed to show how this happens. The endowment income effect of the wage rise outweighs the substitution effect. The consumer chooses to work less, “taking advantage” of the higher wage. • A backward bending labour supply curve is generated in the second graph. Consumption — Applications 8 Intertemporal Budgets • The model developed so far can be used to analyse choices over time — intertemporal choice. • There are two goods, consumption today and consumption tomorrow. The consumer buys c1 units today and c2 tomorrow at a constant price level of 1. (This will be allowed to vary later). • The consumer receives an income of m1 today and m2 tomorrow but can save (and borrow) at an interest rate r. • The amount that can be consumed next period is c2 ≤ m2 + (1 + r)(m1 − c1). So the budget line is given by: c1 + c2 1 + r = m1 + m2 1 + r ................................................................................................................................................................................................................................................................................ .................................................................................................................................................................................................................................................................................. . . . . .................... 0 0 • • c2 c1 c2 c1 m1 m2 m1 m2 BS BS Endowment Slope = −(1 + r) Slope = −(1 + r) m1 + m2/(1 + r) (1 + r)m1 + m2 (Future value) (Present value) . . . . . ......... ............. ............. ............. ............. ......... ............. ............. ............. ............. • The first graph shows the budget set with no borrowing. The second shows the budget set when there is