note9_n2 - Econ303 Why only some people go to work Income...

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Econ303 Why only some people go to work? 1 Income effect Income effect is what happens if there a parallel shift of the budget line (The intercept of the budget line is changed but the slope stays the same). The tangency point of the new budget line to a different indifference curve is the new optimal choice. Income effect moves households to a new indifference curve. If consumption of a good increases as income increases, this goods is called a normal good , otherwise it is called an inferior good . Suppose that we increase the non-wage income, π , of households. That results in a parallel upward shift of the budget constraint. (Left graph below) Households’ response to such change is an increase of consumption and a reduction of labor supply. (From point A to B) In another word, an increase of income leads households to enjoy both more good and more leisure. Under the assumption of diminishing marginal utility both consumption and leisure are normal goods. Otherwise the marginal conditions is not satisfied. 0 0.2 0.4 0.6 0.8 0 2 4 6 8 10 12 14 Income effect labor A B consumption 0 0.2 0.4 0.6 0.8 -5 0 5 10 15 Substitution effect labor consumption A B Substitution effect Substitution effect is what happens if the slope of the budget line changes (due to a change of the relative price) and at the same time the intercept is also changed so that households are kept on the same indifference curve. Under the law of diminishing marginal rate of substitution between two goods, households always substitute away from a relative expansive good and consume more of a relative cheap good when prices change. Suppose that we increase the wage rate w but at the same time reduce non-wage income so that the new budget line is still tangent to the old indifference curve, (Right graph above) The household’s reaction towards this compensated price change is an increase of consumption but a reduction of leisure. (From point A to point B).
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