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4.2. Budget constraint. Definition: combinations of real income-leisure that the i can achieve Characteristics: Line  “price takers” Slope = wage rate (w) Maximization of U:

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slide1

4.2. Budget constraint

  • Definition: combinations of real income-leisure that the ican achieve
  • Characteristics:
    • Line  “price takers”
    • Slope = wage rate (w)
  • Maximization of U:
    • Subjective or psychological preferences (IC) and objective or market preferences (BC)  highestIC, tangent to BC
    • The individual and the market “are in agreement”
    • Wage rate = MRS  tangency
    • Over and underemployment
slide2

4.2. IC, BC, & Max. of U

  • IC: all combinations of L-l desired by the i with U; subjective or psychological preferences  slope MRS
  • BC: all combinations of L-l achievable at certain w; objective or market information slope w
  • Max. of U: IC & BC together  tangency, same slope: MRS = w
  • Question: what happens if the slope of BC is steeper than that of the IC?
slide3

4.2. IC, BC, & Max. of U

  • What do individuals do when w goes up?
    • Answer: L up … or l up (and L down)?
  • Derivation of the supply of labor curve
    • “Backward-bending”  changes from person to person
  • Again: incomeeffect and substitution effect
    • Substitution effect : ∆L due to ∆w with Y  > 0
    • Income effect : ∆L due to ∆Y with w  < 0 (l: normal)
    • Total effect: depends on the “strength” of the other two
slide4

4.2. IC, BC, & Max. of U

The reasoning behind “backward-bending”: with ∆w ∆BC substitution > income; but as t goes by, ∆w ∆BC  substitution < income

Supply curve: when leisure is abundant, how is the MRS?

Different individual curves: men vs. women?