(2) Scarcity, Work and Choice PDF

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Semester 1, Lecture 2....

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Scarcity, Work and Choice

The graph shows the relationship between the growth of GDP, as the companies become richer and people are earning more, subsequently, people are working less. ! People take the benefits of economic prosperity by having more leisure time. ! Why?! Technological progress has raised the productivity of labour. ! Individuals make choices which allows them to trade-off increased prosperity for more free time. !

Productive Functions Production functions show how inputs (e.g. labour) translate into outpost (e.g. goods and services). ! (In a real life example a students production function: the number of hours spent studying into a percentage grade. The marginal product is the increase in his grade by studying for one hour.)! Diminishing productivity means that the graph levels off. ! Marginal and average product of study hour

• Marginal product !

- Change in output per unit change in input (Δy / Δh)! - Evaluated at a given point, holding other inputs constant

- This is the slope of the curve • Average Product !

- Overage output per unit of input (y/h)! - This is the line drawn out from the point !

20 15 10 5 0 0.0

6.0

12.0

18.0

Marginal return of study hour Average return of study hour

24.0

Opportunity Cost •

Choices dumped on constraints and involve tradeoffs. !

•

The opportunity cost of an action is the net benefit of the next best alternative cost !

•

For example, the opportunity cost of buying your mother a birthday present is that you cannot go out and enjoy yourself on a Saturday night !

•

Compare actions based on an economic cost !

- Economic cost = monetary cost e.g. transport + subjective costs e.g. effort of work ! - Accounting cost = monetary cost! A

Feasible Frontier The feasible frontier shows the maximum output that can be achieved input. !

C

Free time

13

14

19

20

Grade

84

81

57

50

MRT

3

The marginal rate of transformation (MRT) is the slope of the feasible frontier and represents the tradeoffs that an individual faces in terms of whats feasible.! Any of the combinations within the blue area are feasible. However anything along the feasible frontier the line - are the most efficient ways. ! In this example the marginal rate of transformation (MRT) is equal to the marginal product of labour; this is the extra marks that the student gets for an extra hour of work. !

Indifference Curves •

Choice also depends on preferences !

•

Indifference curves show all combinations of goods that give the same utility / level of satisfaction. !

The line travelling from A through E,F,G,H,D is called an indifference curve. ! B is on a separate indifference curve and has a low satisfaction. ! The further EAST the BETTER.

7

The marginal rate of substitution (MRS) is the slope of the indifference curve, and represents the tradeoffs that an individual faces it terms of whats preferred.

The extra marks the student is giving up increases as the move down the line to gain more free time. !

Decision Making Under Scarcity • A utility-maximising decision maker will choose where the preferred trade-off between the two goods (MRS) is equal to the feasible trade-off (feasible frontier) (MRT)! • MRS = MRT!

The optimum level is E. Although B and D product more efficiency they have a lower indifference curve and therefore a lower level of satisfaction. ! The graph crosses a feasible frontier with an indifference curve to shows the two optimum. !

When the feasible frontier changes, the optimum will also change. !

Income and Substitution Effects Budget constraints are the feasible frontiers for consumption choices. The optimal choice is where the slope of the indifference curve (MRS) equals the wage. ! The budget constraint is a straight line as it is represented by a price. The price remains constant. ! Where the indifference line meets this is the wage rate - OPTIMUM.! ! C = w (24 - t)!

Wage

(Hours in a day)

Free time

Outward shift in the budget constraint shows an impact of a $50 windfall, ! Income Effect = the change in optimal choice when income changes, keeping opportunity (the budget constraint slope) fixed. The income effect occurs between two parallel budget lines. ! On the graph below, A - C is the income effect. !

The change in the wage of the worker and an increase in free time and increase in consumption. !

Substitution Effect

! The Substitution effect = the change in optimal choice when the opportunity cost changes, at the new level of utility. !

Income Effect

Here, the workers wage has increased so therefore he is working less to earn the same wage. ! This is shown by the move from C - D, the Substitution effect.

The overall effect with income + substitution is the move from point A -> D this can be negative or positive. This depends on individual perspectives....