Microeconomics

Eighth Edition, Global Edition

Chapter 5
Applying
Consumer Theory
(continued)

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Learning Objectives for Chapter 5
5.1 Deriving Demand Curves. √
5.2 How Changes in Income Shift Demand Curves. √
5.3 Effects of a Price Change. √
5.4 Cost-of-Living Adjustments.
5.5 Deriving Labor Supply Curves.

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 3

Labour-Leisure Choice
• Leisure - all time spent not working.
• In the remainder of Ch. 5, we will
consider:
– the goods-leisure utility function
– the goods-leisure budget
constraint
– the optimal time allocation
– the derivation of an individual’s
labour supply curve
– substitution and income effects
Photo by Fons Heijnsbroek on Unsplash
of a wage change
– taxes and labour supply
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Labour-Leisure Choice
• The number of hours
worked per day, H, equals
24 minus the hours of
leisure or nonwork, N, in a
day:
H = 24 − N.
Photo by Danielle MacInnes on Unsplash

What if you get paid by the hour?

The price of leisure is forgone earnings:
The higher your wage, the more an hour of leisure costs
you in unrealised earnings.
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Labor-Leisure Choice: Example
• Jackie spends her total income, Y, on various goods.
– The price of these goods is $1 per unit.
• Her utility, U, depends on how many goods and how
much leisure she consumes:
U = U (Y , N ) .
• Jackie’s earned income equal: wH.
• Her total income, Y, is her earned income plus her
unearned income, Y*:

Y = wH + Y*.
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 (a) Indifference Curves and Constraints

Figure 5.6 Demand Time constraint

Y , Goods per day

for Leisure
I1

Budget Line, L1
1
24w1 L
Y = w1H –w1
1 e1
Y
1
0 N1 = 16 24 N, Leisure hours per day

Y = w1(24 − N). 24
(b) Demand Curve
H1 = 8 0 H,Work hours per day

Each extra hour of leisure w, Wage per hour

she consumes costs her w1

goods.

w1 E1

0 N1 = 16 N, Leisure hours per day

H1 = 8 H, Work hours per day

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 (a) Indifference Curves and Constraints

Figure 5.6 Demand for Time constraint

Y, Goods per day

I2

Leisure (cont.) 24w2 L2

–w2
1
I1
e2
Y2

Budget Line, L1
24w1 L1

Y = w1H –w1
1 e1
Y1

0 N2 = 12 N1 = 16 24 N, Leisure hours per day

Y = w1(24 − N). 24
(b) Demand Curve
H2 = 12 H1 = 8 0 H,Work hours per day

w, Wage per hour

Budget Line, L2
E2
w2
Y = w2H

Y = w2(24 − N). w1 E1

Demand for leisure

w2 > w1 0 N2 = 12 N1 = 16 N, Leisure hours per day

H2 = 12 H1 = 8 H, Work hours per day

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Figure 5.7 Supply Curve of Labour

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SE & IE of a wage change
How does a wage increase affect leisure demand – and thus
labour supply?
• Depends on substitution effect & income effect
• Because leisure is being sold, income effect can be big

• Substitution effect of a wage increase is to

– reduce hours of leisure and thus
– increase hours of work
• The size of the total effect will depend on the income effect

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Figure 5.8 Income and Substitution
Effects of a Wage Change
Y, Goods per d ay

I2 Time const raint

L2

Since income effect is positive,

I1 leisure is a normal good.

L* e2
e*

L1 e1

0 N* N1 N 2 24 N, Leisure hours per d ay

24 H* H1 H2 0 H, Work hours per d ay
Substitution effect Total effect
Income effect

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IE & SE of a wage change
• Note difference to ‘ordinary’ g&s: consumer is a seller of
leisure
• So an increase in its price makes her better off

• If the wage goes up the budget line gets steeper…

• …but it pivots out around the (fixed) intercept on the
horizontal axis, not in (around the vertical intercept) as in ‘2
ordinary goods’ examples

• Her opportunity set increases

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Three cases of SE and IE of a wage
change

Photo by Pierre Gui on Unsplash

• Leisure is an inferior good

• Leisure is a normal good and SE > IE
• Leisure is a normal good and IE > SE
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 Case 1: If leisure is an inferior good:
• If consumer views leisure as an inferior good, the income effect of a
rising wage is also to reduce leisure
• Substitution & income effects reinforce each other (individual definitely
works more when wage rises).

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 If leisure is a normal good:
• In this case the income effect acts in the opposite
direction to the substitution effect
• The income increase embodied in higher wages is
enjoyed as more leisure
• But which effect is stronger? Two possibilities…
• If SE > IE, then a higher wage
– reduces hours of leisure and thus
– increases hours of work

Photo by Adam Dillon on Unsplash

• If IE > SE, then a higher wage
– increases hours of leisure and thus
– reduces hours of work

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 Case 2: leisure normal, SE>IE
• Direction of total effect is the same as in the inferior leisure case
(w ↑, work hours ↑), but size of the total effect is smaller.
Case 3: leisure normal, IE>SE (Fig 5.8)
• Total effect: higher wage reduces hours of work

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Solved Problem 5.6
• Enrico receives a no-strings-attached scholarship that
pays him an extra Y * per day.
How does this scholarship affect the number of hours
he wants to work? Does his utility increase?

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Solved Problem 5.6: Answer

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One more recap:
• Leisure normal: IE & SE work in opposite directions. Total effect
depends on which is larger.
• If IE > SE, she will DD more leisure - & work fewer hours – as w
rises, i.e. her labour SS curve is backward bending.
• Leisure inferior: SE & IE work in the same direction; hours of
leisure ↓ (& hours of work ↑) as w rises.

Shape of the L SS curve depends on the income elasticity of

leisure.
Real world evidence: Labour SS curves close to vertical; may be
slightly backward bending for men, slightly forward sloping
(stronger SE) for women.

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Figure 5.9 Labor Supply Curve That
Slopes Upward and Then Bends Backward
(a) Labor-Leisure Choice (b) Supply Curve of Labor

Supply curve of labor

Y, Goods per day

w, Wage per hour

L3 I3 Time const raint E3

I2
E2
I1
e3
L2
e2 E1

L1 e1

24 H2 H H1 0 0 H1 H3 H2 24
3
H, Work hours per day H, Work hours per d ay

butlow
At at high
wages,
wages,
an increase
an increase
in the
in the
wage causes the worker to work
more….
less….
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Two reasons labour supply MIGHT be backward
bending:

Leisure always normal,

Leisure normal but:
IE > SE here

SE > IE here
Leisure inferior

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 Income taxes and labour supply
• Labour supply interacts with tax system
• Taxes directly affect take-home wages, so how will change
in tax rates affect hours worked?
• If L SS curves are upsloping, higher taxes will cause ppl to
work fewer hours (↓ production & less revenue).
• If backward bending, a small ↑ in tax can ↑ revenue AND
induce ppl to work more hours.

Photo by Adeolu Eletu on Unsplash

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Marginal tax rate & total tax revenue

• Fig 5.10 (aka Laffer curve): inverted U-shape – why?

• Slopes up initially at low tax rates because:
(i) govt collecting more cents per $ earned;
(ii) income effects - ppl work more to keep income levels up
(they’re on the backward-bending part of their L SS).
• Then slopes down, because further tax ↑s discourage ppl
from working (substn effects outweigh i & ii – leisure is
relatively cheaper; ppl are in the upsloping part of their
L SS curves).

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Individual Backward- Figure 5.10 The Relationship of
bending Labour U.S. Tax Revenue to the Marginal
Supply Curve Tax Rate

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Tax rates cont’d
In SA: after 1994, tax
rates ↓ (& thresholds
↑); yet ratio of tax
revenue:GDP has
increased a lot. (Due
to improved collection
systems – but also
Laffer curve effects?)

More recent: tax rates ↑ (up from 41 to

45% in 2019)
At what point will higher tax lead to
lower revenue collection? Or ‘tax
revolt’? (e.g. Ngwenya opinion piece
on ECON202 moodle.ukzn page fyi)

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