Chapter2 - Chapter 2 Static Consumption-Leisure Model In...

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© Sanjay K. Chugh 27 Spring 2008 Chapter 2 Static Consumption-Leisure Model In our study of consumer theory thus far, we have simply assumed that an individual has some given amount of labor income, which we denoted by Y , to spend on consumption goods. Doing so allowed us to focus attention on the tools and principles of consumer theory. Economics is at its core a set of theories about decision-making, and casual reflection reveals that individuals do have some control over how much labor income they earn. That is, at least to some degree, individuals “choose” how much income they earn just as they choose how much, say, good 1 and good 2 they consume. In this section, we extend our model of consumer theory to incorporate this feature of individual decision-making. As we will see, the tools of analysis and general principles of this extended model are ones with which we are already familiar – simply the tools of indifference curves and budget constraints. To simplify our introduction to this topic, we will use a “one-shot” model in which the individual has no savings decision to make – that is, there is no future, so that the only economic decisions to be concern the present. Once we understand how the one-period consumption-leisure model works and we study the consumption-savings model to come, we will bring the two models together to complete our analysis of macroeconomic consumer theory. In addition to considering the structure of the consumption-leisure model, we will embed within it from the beginning a consideration of government tax policy. We will have much more to say later about the role of macroeconomic tax policies, and it will turn out that one of the major schools of tax policy thought to have emerged in the past 30 years crucially hinges on the main features of the consumption-leisure model. The Two “Goods”: Consumption and Leisure In our initial look at consumer theory, we supposed that there existed two broad categories of consumption goods, “good 1” and “good 2.” We will now condense these two categories into just a single category called “consumption.” That is, consumption is any and all “stuff” that individuals might purchase in order to obtain utility (happiness). Thus, consumption, which we will denote by c (without any subscripts), is an argument to individuals’ utility functions. Because we are interested in studying how consumers “choose” their income, we must specify how consumers in fact earn their incomes. One seemingly obvious way of proceeding is to suppose that consumers obtain their income by working. An individual can choose to work some number of hours (per day or per week or per month, etc – we will specify this more carefully below) for which he receives pre-tax pay of W dollars per hour. That is, W dollars per hour is the individual’s gross wage rate, which in general is not what the individual actually gets to keep as the result of his efforts. In most countries, individuals are subject to a variety of government taxes – of the many
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© Sanjay K. Chugh
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This document was uploaded on 11/01/2011 for the course ECON 325 at Maryland.

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Chapter2 - Chapter 2 Static Consumption-Leisure Model In...

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