4.2. Budget constraint

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# 4.2. Budget constraint - PowerPoint PPT Presentation

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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## 4.2. Budget constraint

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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

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?

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

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?