Introduction to Economics (607.

110)

3. Scarcity, work, & choice

paul.schweinzer@aau.at

October 7, 2022

1 / 26
3. Scarcity, work, & choice

Textbook: core-econ, unit 3.

A. Introduction
B. Scarcity and choice: Key concepts
C. Decision-making under scarcity
D. Income and substitution effects
E. Application to technological change

2 / 26
The context of this topic

Unit 1. Labour is work.

Unit 2. Labour is an input in the production of goods and services.
New technologies raise the productivity of labour:
Ï How would that affect living standards?
Ï How would that affect the free time and working hours chosen
by individuals?

3 / 26
The current topic

3,400
Annual hours worked

2,800

2,200

1,600

1,000
1,000 8,000 15,000 22,000 29,000
GDP per capita

For most countries, living standards have greatly increased since 1870.
But there are disparities in free time & income across countries.

4 / 26
This unit

80,000

60,000
GDP per capita ($PPP)

40,000

20,000

0
6,500 6,600 6,800 7,000 7,200 7,400
Free time per capita

Use a model of individual choice to explain the differences in work

hours across countries and over time. (This figure shows 2020.)
5 / 26
B. Example: Grades and study hours

Consider this data on study choices from 84 students at Florida

State University:

Average GPA High study time Low study time

Both environments 3.43 (42 students) 3.36 (42 students)
Good environment 3.63 (11 students) 3.43 (31 students)
Poor environment 3.36 (31 students) 3.17 (11 students)
Source: Plant et al (Contemporary Educational Psychology, 2005).

Ï Students choose how many hours to study, which affects their

grade point average (GPA).
Ï We assume a positive relationship between GPA & the number
of hours studied (evidence that this is true, ceteris paribus).

6 / 26
Production function
Now let’s represent the relationship between study time and final
grade for a particular student—called Alexei—in the table below.
Study hours 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 ≥15
Grade 0 20 33 42 50 57 63 69 73 78 81 84 86 88 89 90
A production 100
function shows 90

how inputs (e.g., 80

labour) translate Final grade

70

into outputs (e.g., 60

50
goods & services),
40
holding other 30
factors constant 20
(e.g., production 10

environment). 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Hours of study per day

Average product & marginal product are shown in the graph and
explained on the next slide. Please make sure you understand them!
7 / 26
What can production functions tell us?

1. Marginal product:
Change in output
per unit change in
input (evaluated at
a given point,
holding other inputs
constant).
2. Average product:
Average output per
unit of input. Slope 1 = Marginal product (4 hours of study)

Slope 2 = Average product (10 hours of study)

Notice that studying becomes less productive, the more you study:
its marginal product diminishes. Moreover, at each point, the
marginal product is lower than the average product (concavity).

8 / 26
Indifference curves: Choices depend on preferences
A E F G H D
Alexei’s indifference curves: Hours of free time 15 16 17 18 19 20
Ï show all combinations Final grade 84 75 67 60 54 50

of goods that 100

Ï give him the same B A

84
utility (“satisfaction”). 75
E
F
The marginal rate of G
H
Fi n a l g r a d e
substitution is the slope of 50
D

the indifference curve, and

represents the tradeoffs that
an individual makes.
The right-above table is C
based on Alexei’s interview 0
data. 0 15 16 20 24
H o urs o f free t im e p er d ay

9 / 26
Indifference curves & opportunity cost
Choices are limited by constraints and involve tradeoffs:
Ï The fact that no-one can have more than 24 hours of free time
represents a constraint in our example. That higher grades can
be exchanged for more free time represents a tradeoff.
Ï The opportunity cost of an action is the net benefit of the next
best (foregone) alternative action.
Ï Compare actions based on economic cost: Economic costs
consist of monetary costs (e.g., transport) and subjective costs
(e.g., effort of work), including opportunity costs.

Hence, the indifference curves on the previous slide:

Ï Slope downwards because of trade-offs between goods.
Ï Exhibit increasing utility as we go (“uphill”) north-east.
Ï Are usually smooth because small changes don’t matter much.
Ï Can never cross for a single decision maker.

10 / 26
Opportunity cost: Example
Economic choice between going to a concert, A, in a theatre, which
costs $25. In a nearby park there is concert B, which is free but
happens at the same time.
A high value on A low value on the
the theatre choice theatre choice
Out of Pocket cost $25 $25
(price of ticket for A)
Opportunity cost (foregone $15 $15
pleasure of B, park concert)
Economic cost (sum of out of $40 $40
pocket & opportunity cost)
Enjoyment of theatre (A) $50 $35
Economic rent (enjoyment $10 -$5
minus economic cost)
Decision: A: Go to theatre B: Go to park concert

If the benefit from an action exceeds the economic costs, you

receive an economic rent from choosing it. Seeking this rent is the
driving force behind all economic decision making.
11 / 26
The feasible frontier
The feasible frontier shows the maximum output that can be
achieved with a given amount of inputs. In the example, A, C, D,
E, and F are feasible (though D is not on the frontier).
B is not feasible. A E C F
Free time 13 14 19 20
Grade 84 81 57 50
The marginal rate MRT 3 7
of transformation 100
90
(MRT) is the 80
slope of the 70
D B
Final grade

feasible frontier, 60
50
and represents the
40
constraints that an 30

individual faces. 20

10
0
0 13 14 19 20 24
Hours of free time per day

12 / 26
C. Constrained choice problem
The trade-off Where is it on It is equal to. . .
the diagram
Marginal rate of substi- The slope of The value of an
MRS, or tution: The number of the indifference hour of free
preference percentage points Alexei curve. time.
between grade is willing to trade for an
and free time. hour of free time.
Marginal rate of trans- The slope of The marginal
MRT, or formation: The number the feasible product of
technological of percentage points frontier. labour.
opportunity Alexei would gain (or
cost of free lose) by giving up (or
time. taking) another hour of
free time.

Ï Model of how individuals choose, given their preferences &

constraints, when the things they value (“goods”) are scarce.
Ï Studying example: Free time and exam score are scarce
because they are both goods, each with an opportunity cost.
13 / 26
Optimal decision making

In the final step of our decision problem, we combine the ideas of

the indifference map and the feasible frontier into a single diagram.
100

The utility-maximising 90
Feasible frontier B
MRS = MRT
choice is where the D

amount of one good

the individual is willing Fi n a l g r a d e
57
E
to trade off for the C
IC4
other good (MRS) IC3
IC2
equals the actual A IC1

tradeoff between the

two goods (MRT):
0
MRS = MRT. 0 19 24

Hours of free time per day

14 / 26
Another example: Grain production
100 1

ne
PFnew
d C 

C
PF 74

ce
74
ce

u 
d D  B
D
64 4

ro
ro

B p

nt it y o f gr in
nt it y o f gr in

a 

a 
u 

Q
Q

0 
0 8 12 24  12 1 24
H o r s o f
o r k  er  y Hours of free time per day

Ï Tradeoff between grain produced and free time.

Ï Technological change shifts the production function (PF)
upwards, and expands the feasible frontier (FF).

15 / 26
Optimal decision making

What happens when the feasible frontier changes?

1

FFnew

Technological progress
makes it feasible to both

Quantity o grain produ ed

c
consume more and have 1
more free time. 55

f
Choice of free time/ IC4

consumption depends on
relative preferences and
willingness to substitute
one good for another. 
 1 17 24
our o ree time per day

16 / 26
D. Example: Working hours
Hours of work 0 2 4 6 8 10 12 14 16
Free time, t 24 22 20 18 16 14 12 10 8
Budget constraints are the Consumption, c($) 0 30 60 90 120 150 180 210 240
feasible sets/frontiers for 3

consumption choices.
The optimal choice is 225

where the slope of the )

($
indifference curve (MRS)

C o n su m p t i o n
15

equals the wage (MRT).

The equation of the 75

budget constraint is
c = w(24 − t)for a wage of

w = 15.  1 12 14 1 1 2 22 24

 o  r o f free t im e

At A, your willingness to swap consumption for time (MRS) equals

the wage of 15 (opportunity cost of time, MRT, the frontier slope).

17 / 26
Two important effects

Relative price changes affect the slope of the budget constraint

(MRT).
Consider a wage increase—it will have 2 effects:
Ï Income effect: your total earnings increase, holding working
hours fixed.
Ï Substitution effect: the opportunity cost of free time increases.

18 / 26
Income effect

The income effect is the 300 IC3

change in optimal choice IC2

when income changes, 225

keeping opportunity costs 


(the budget constraint
on umption
150

slope) fixed. 
C
A wage increase gives 75

more income per hour

worked → incentive to 0

decrease working hours. 8 10 12 14 16 18 20 22 24

our o ree time

19 / 26
Substitution effect

IC4
300

The substitution effect is

the change in the optimal IC2

225
choice when the oppor-
&
tunity cost changes, at the %#

on umption
new level of utility. 150

"
A wage increase raises the !
75
opportunity cost of free
time → incentive to
increase hours worked. 0
8 10 12 14 16 18 20 22 24

'our* o+ +ree time

20 / 26
Overall effect on labour choice
The overall effect consists of both the income effect and the
substitution effects. For a positive wage change:
IC4
344

The shown income S, b -tit , tion

effect
effect is positive, IC2

225
the substitution
effect is negative 3
12
on umption

(decrease hours of 154

free time). /

Which effect .
75
dominates depends
on individual
preferences. 4
; 14 12 14 1< 1; 24 22 24

7our9 o: :ree time

21 / 26
E. Working hours: Differences over time
2MM

15A S=b>tit =tion

L effect
JK
y

I
B
2A13
er

1AA D
E C
D Over?ll effect
B
oo

G Inco@e effect
5A
A
19AA

A
14 17 19 22 24
Free time per day
Income and substitution effects can explain trends in working hours
over time. E.g., in the US, the income effect dominated the
substitution effect, so consumption and free time both increased.
22 / 26
Working hours: Cross-country differences (2016)

Differences in working hours can be explained by preferences that

differ across countries. Other explanations?
200

Ï Differences in culture
(norms). 150

Go o d s p er d ay ($)
Ï Politics (legal limits US Netherlands
100 South Q
on hours). Korea

Ï Social preferences 50
Turkey
(e.g., “Keeping up Mexico

with the Joneses.”) 0

14 17 19 22 24
Free time per day (hours)

At Q, the indifference curves of South Korea and the US intersect

with the latter steeper than the former. This is consistent with the
idea that South Koreans work exceptionally hard.

23 / 26
Is this a good model?

Ï Not realistic: People don’t actually do MRS/MRT

calculations. Most people cannot choose their working hours
(in the short run).
Ï BUT still a good approximation: Over time, people learn what
combination of working hours and free time suits them best.
Working hours can change due to culture and politics (indirect
choice); people can choose which jobs to apply for.
Ï Helps us understand real-world phenomena: preferences and
income/substitution effects can explain differences in working
hours across countries and over time.

24 / 26
Summary

1. Simple model of decision-making under scarcity:

Ï Indifference curves represent preferences.
Ï Feasible frontier represents choice constraints.
Ï Utility-maximising choice where MRS = MRT.
2. Used model to explain effect of technological change on labour
choices:
Ï Overall effect = Income effect + Substitution effect.
Ï Limitations of model—omits important factors.

25 / 26
In the next unit

Ï Models of individual choice that include other important

factors.
Ï The role of social interactions in individual choice.
Ï The effect of individual choice on social outcomes.

26 / 26