ENDOGENOUS INCOME

Modifying the consumer´s problem

- Let´s assume there is no additional exogenous income.
- Consumer´s income: It is the market value of their
initial endowment (𝑥̅ , ̅𝑦)
- Given market prices 𝑝𝑥 and 𝑝𝑦 , the consumer´s budget
constraint is 𝑝𝑥 . 𝑥 + 𝑝𝑦 . 𝑦 ≤ 𝑝𝑥 . 𝑥̅ + 𝑝𝑦 . 𝑦̅

Changes in prices
 - The impact of price changes in the consumer´s budget
set is now subtler: the increase of a price may make
the consumer “relatively richer” if they are “relatively
rich” in that good (i.e., if the consumer´s endowment
of this good is large)
- Notice that, independently of market prices, the
endowment is always a feasible bundle (consumer
always can avoid trade and consume her own
endowment)

Ordinary demand functions

Consumer´s problem
𝑀𝑎𝑥 𝑢(𝑥, 𝑦)
𝑠. 𝑡. 𝑝𝑥 . 𝑥 + 𝑝𝑦 . 𝑦 ≤ 𝑝𝑥 . 𝑥̅ + 𝑝𝑦 . 𝑦̅
𝑥 ≥ 0; 𝑦 ≥ 0

This problem, when the indifference map is convex, yields

an interior solution:
 𝑝
𝑀𝑅𝑆 = 𝑝𝑥
𝑦

𝑝𝑥 . 𝑥 + 𝑝𝑦 . 𝑦 ≤ 𝑝𝑥 . 𝑥̅ + 𝑝𝑦 . 𝑦̅
𝑥̃(𝑝𝑥 , 𝑝𝑦 ) = 𝑥 ∗ (𝑝𝑥 , 𝑝𝑦 , 𝑝𝑥 . 𝑥̅ + 𝑝𝑦 . 𝑦̅)
𝑦̃(𝑝𝑥 , 𝑝𝑦 ) = 𝑦 ∗ (𝑝𝑥 , 𝑝𝑦 , 𝑝𝑥 . 𝑥̅ + 𝑝𝑦 . 𝑦̅)

Example: 𝑢(𝑥, 𝑦) = 𝑥 √𝑦; (𝑥̅ , 𝑦̅) = (2,1)

Firstly, let´s calculate the ordinary demands with
exogenous income:

∗
2𝐼 ∗
𝐼
𝑥 (𝑝𝑥 , 𝑝𝑦 , 𝐼) = ; 𝑦 (𝑝𝑥 , 𝑝𝑦 , 𝐼) =
3𝑝𝑥 3𝑝𝑦
Now, let´s substitute the endogenous income:
𝐼̃ = 𝑝𝑥 . 𝑥̅ + 𝑝𝑦 . 𝑦̅ = 2𝑝𝑥 + 𝑝𝑦

2(2𝑝𝑥 + 𝑝𝑦 ) 4 2𝑝𝑦
𝑥̃(𝑝𝑥 , 𝑝𝑦 ) = = +
3𝑝𝑥 3 3𝑝𝑥
(2𝑝𝑥 + 𝑝𝑦 ) 1 2𝑝𝑥
𝑦̃(𝑝𝑥 , 𝑝𝑦 ) = = +
3𝑝𝑦 3 3𝑝𝑦
Income and substitution effects
Let´s assume the price of good x increases, ↑ 𝑝𝑥
SE: the substitution effect is the same as in the case with
exogenous income: always negative.
IE: given the consumer has an initial endowment of goods,
the income effect now involves two components:
(1) It makes the consumer poorer as it becomes more
expensive buying the optimal amount of the good.
This is the ordinary income effect.
(2) It modifies the value of the consumer´s
endowment. In this case, this value would be
greater. This is the endowment effect.
The total income effect is now: IE = (1) + (2) and its sign
depends on whether the consumer is a net seller (negative)
or a net buyer (positive) of the good whose prices has
increased.
Formally, we can study the signs with the following
equation:
𝜕𝑥̃ 𝜕𝑥 ∗ 𝜕𝑥 ∗
= 𝑆𝐸 + 𝐼𝐸 = | + [− (𝑥 − 𝑥̅ )]
𝜕𝑝𝑥 𝜕𝑝𝑥 𝑢̅ 𝜕𝐼

𝜕𝑥 ∗
- 𝑆𝐸 = 𝜕𝑝 | < 0
𝑥 𝑢̅
𝜕𝑥 ∗
- 𝐼𝐸 = − (𝑥 − 𝑥̅ )
𝜕𝐼
The sign of the total income effects depends on the type of
good with respect to the income, and if the consumer is a
net seller or a net buyer of the good.
𝜕𝑥 ∗ 𝜕𝑥 ∗
- > 0 normal good; < 0 inferior good.
𝜕𝐼 𝜕𝐼
- (𝑥 − 𝑥̅ ) > 0 net buyer; (𝑥 − 𝑥̅ ) < 0 net seller.

Graphically,
THE CONSUMPTION – LEISURE MODEL: LABOR
SUPPLY
Two goods:
Leisure (x – axis), denoted by ℎ and measured in hours.
The wage per hour (or price of leisure) is denoted by 𝑤.
Consumption (y – axis), denoted by 𝑐. Its price is 𝑝𝑐 .
When consumption is measured in euros, 𝑝𝑐 = 1.

Initial endowment is (𝑴, 𝑯), where:

𝑀 is the initial exogenous wealth (or non – labour
income).
𝐻 is the number of hours available for leisure and work
𝐻 = ℎ + 𝐿. (𝐿 is the number of hours of work)

Budget set:
The consumer has two types of income to pay their
consumption:
- Labour income 𝑤𝐿
- Non – labour income 𝑀
So, expenditure ≤ income:
𝑝𝑐 . 𝑐 ≤ 𝑀 + 𝑤𝐿
As 𝐿 = 𝐻 − ℎ, the budget set is: 𝑝𝑐 . 𝑐 ≤ 𝑀 + 𝑤(𝐻 − ℎ)
- Also 𝑤ℎ + 𝑝𝑐 . 𝑐 ≤ 𝑀 + 𝑤𝐻
- If 𝑝𝑐 = 1 → 𝑐 ≤ 𝑀 + 𝑤(𝐻 − ℎ)
Representation, BL: 𝑝𝑐 . 𝑐 = 𝑀 + 𝑤(𝐻 − ℎ)
Intersections with axes
𝑀+𝑤𝐻
If ℎ = 0 𝑐 = 𝑝𝑐
𝑀
If ℎ = 𝐻 𝑐 = 𝑝
𝑐
𝑤
Slope: −𝑝
𝑐

Change in w Change in M
Solution to the consumer´s problem:
It can be solved as usual but watch out for additional
constraints.
𝑀𝑎𝑥ℎ,𝑐 𝑢(ℎ, 𝑐)
𝑠. 𝑡. 𝑝𝑐 . 𝑐 ≤ 𝑀 + 𝑤(𝐻 − ℎ)
0 ≤ ℎ ≤ 𝐻; 𝑐≥0

Example: 𝑢(ℎ, 𝑐 ) = 𝑐 + 2𝑙𝑛ℎ; 𝑀 = 4; 𝐻 = 16; 𝑝𝑐 = 1.

Calculate ℎ(𝑤); 𝑐 (𝑤); 𝐿(𝑤)
LABOUR SUPPLY. EFFECT OF CHANGES IN WAGES
Let´s use the SE and IE equation to understand the effect of
changes in wages on the leisure demand and therefore, on
the labour supply.
𝜕ℎ̃ 𝜕ℎ∗ 𝜕ℎ∗
= | + [− ̅ )]
(ℎ − 𝐻
𝜕𝑤 𝜕𝑤 𝑢̅ 𝜕𝐼
𝜕ℎ∗
SE: | <0
𝜕𝑤 𝑢
̅
𝜕ℎ∗
IE: − ̅)
(ℎ − 𝐻
𝜕𝐼
𝜕ℎ∗
If leisure is a normal good, ̅) is
> 0, and as (ℎ − 𝐻
𝜕𝐼
always negative (or zero), the total income effect is positive.
TE: Is ambiguous (it depends on the shape of the utility
function)
- If |𝑆𝐸 | > |𝐼𝐸 | → 𝑇𝐸 < 0
In this case, the relation between the leisure demand
and the wage is negative, therefore, the relation
between the labour supply and the wage is positive.
The labour supply has a positive slope.
- If |𝑆𝐸 | < |𝐼𝐸 | → 𝑇𝐸 > 0
In this case, the relation between the leisure demand
and the wage is positive, therefore, the relation
between the labour supply and the wage is negative.
The labour supply has a negative slope.
APPLICATION: a tax on income
1. A non – labour income tax, 𝑇: 𝑀1 = 𝑀 − 𝑇
The non – labour and the total income decreases; hence,
the BL translates parallel towards the origin.
If both goods are normal, then the optimal quantities will
decrease, and so the level of utility.
2. A labour tax, 𝑡.
The wage decreases, 𝑤´ = 𝑤 − 𝑡, and the BL rotates on its
endowment bundle towards the origin.
The new optimal bundle depends on the total effect, and
the size of the income and the substitution effect. But, as
the initial bundle is not reachable, the level of satisfaction
decreases.