Unit 3 notes - core economy textbook PDF

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UNIT 3 – SCARCITY, WORK, AND CHOICE: How individuals do their best, and how they resolve the trade-off between earnings and free time: 3.1: LABOUR AND PRODUCTION: Labour is thought as an input in the production of goods/services. Labour is work, and is therefore often difficult to measure. Employers find it difficult to determine the exact amount of work employees are doing, and effort required. So labour is simply measured as numbers of hours worked by individuals. It is assumed, that as number of hours worked increases, the amount of goods produced also increases. Example: as a student you choose how many hours to spend studying. We assume a positive relationship between hours worked and the final grade. A study showed only a weak relationship. This is because factors such as condition in which student was studying was no considered. Now imagine a student, Alex. We assume that, the hours he spends studying over the semester will increase the percentage grade that he will receive at the end, ceteris paribus. This is Alex’s production function: it translates the number of hours per day spent studying into percentage grade. 

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Average product of labour at 4 hours of work, where he gets a grade of 50, is 12.5. Marginal product is the increase in his grade given in any one hour. Marginal product is the slope of the tangent, which at four hours is around 7. At 15 hours he reaches his maximum

grade, after that it won’t make a difference. Alex’s production function gets flatter the more he studies, so marginal product of an additional hour fallsmarginal product is diminishing. A production function with this shape is called concave. When comparing marginal and average products, we find that marginal product < average product. 3.2: PREFERENCES: According to Alex’s production function above, how many hours will he choose to work. This depends on preferences. Can assume: 

If two combinations both have 20 hours of free time, he prefers the one with a higher grade If Alex is indifferent between A and D, it means he would feel equally satisfied with either outcome, they give him the same utility. We know he prefers A to B, so B provides lower utility. The graph shows a downward sloping indifference curve.

Points on the same indifference curve give the same utility. The curve through C gives the lowest utility out of the 3 curves. Notice that:     

Indifference curves are downward sloping due to trade-offs: if you are indifferent between two combinations, the combination that has more of one good has less of the other good Higher indifference curves correspond to higher utility levels: As you move right and up in the diagram, you move to combinations with more of both goods. Indifference curves are usually smooth Indifference curves do NOT cross As you move to the right along an indifference curve, it becomes flatter (explaining last point) From A to E, we say Alex’s Marginal rate of substitution (MRS) is nine- he is willing to give up 9 percentage points for one additional hour of free time. Indifference curves become flatter because we assume as he gains more free time and his grade gets lower, he is less willing to sacrifice his grade. MRS is just the slope of the indifference curve

3.3: OPPORTUNITY COSTS: Alex wants to maximise both his free time and grade. But given his production function, he has to sacrifice one, free time is an opportunity cost. Accountants and economists see costs differently. Imagine they have been asked to report cost of going to a concert A, which has a $25 admission cost. There is also a concert B, but this is free. Accountant: cost of A is $25 paid Economist: You give up $25 plus the enjoyment of the free concert (opportunity cost) Suppose benefit of concert B was valued at $15, then total economic cost is $40. 3.4: THE FEASIBLE SET: Think back to Alex and his dilemma between free time and grade. Free time has the opportunity cost of lost percentage points in his grade. This time we will look at how the final grade depends on the amount of free time, rather than study time. Graph below represents his feasible frontier: highest grade given amount of free time he takes. 

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Under normal conditions he can’t take 20 hours of free time and expect to get a grade of 70 (point B)- it is infeasible D is feasible but is a waste of time or points, he could get a higher grade with the same hours

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Area within curve is called feasible set Movements along curve show opportunity cost The more free time he takes, the higher the marginal product of studying, so opportunity cost of free time increases.

The feasible frontier is a constraint on Alex’s choices. Represents the trade-off he must make between grade and time. In other words, this curve shows the marginal rate of substitution (rate at which Alex CAN transform free time into grade points). For example, slope of AE is -3, at Point A Alex could get more free time by giving up 3 grade points, opportunity cost is 3. The slope which is calculated by the tangent is the MRT. 

The marginal rate of substitution (MRS): In the previous section, we saw that it measures the tradeoff that Alexei is willing to make between final grade and free time.

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The marginal rate of transformation (MRT): In contrast, this measures the trade-off that Alexei is constrained to make by the feasible frontier.

3.5: DECISION MAKING AND SCARCITY: Now we need to determine the combination Alex will choose. This shows Alex’s indifference curves and his feasible frontier.  

All combinations between A and B are feasible because they lie in the feasible set. Moving to C or D would raise his utility, or even E, where utility is maximised as MRS = MRT

In constrained choice problems the optimal combination is where MRS =MRT on the feasible frontier.

3.6: HOURS OF WORK AND ECONOMIC GROWTH: Imagine a new scenario, Angela is a self-sufficient farmer who chooses how many hours to work. She produces grains to eat and doesn’t sell them, if she produces too little she starves. Her choice is constrained: producing grain takes labour time, and each hour of labour means Angela forgoes an hour of free time (opportunity cost of the grain produced). 

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An improvement in technology means more grain is produced at every number of working hours. Production function shifts upwards. The graph has a similar concave shape to Alex’s production function: marginal product of additional work, diminishes as hours increase. The new production function is steeper at EVERY point compared to the original one. New technology has increase Angela’s marginal product of labour.

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This shows Angela’s feasible frontier, which is a mirror image of the production functions. The slope of the frontier represents the MRT (rate at which free time can be transformed into grain), in other words opportunity cost of free time.

Highest utility she can gain is A, where MRT = MRS (initially) Technology expands the feasible set New optimal choice is E

3.7: INCOME AND SUBSTITUTION EFFECTS ON HOURS OF WORK AND FREE TIME: What would be your ideal number of working hours? We will write w for wage, t hours, for free time, so you work (24-t) hours, and so maximum consumption is, c is: C=w(24-t) This is called your budget constraint, as it shows what you can afford. 

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The area under the budget constraint is your feasible set, feasible frontier is a straight line (shows maximum amount of consumption) Indifference curves show that ideal job would be at A (MRS =MRT)

You then receive an email that an individual would like to give you an income of $50 a day- for life. New situation is shown below.

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Budget constraint is New ideal job is at B Notice that the extra income does not change your opportunity cost of time.

The effect of additional income on the choice of free time is called the income effect. Income effect is positive, if extra income raises your choice of free time (you consume more of something). For the above individual, income effect was zero. For most goods, income effect is either positive or zero- if your income increased, you would not choose to have less of something that you valued. Instead now imagine you are offered a pay rise of $10 an hour. Budget constraint is c = 25(24-t)  

New budget constraint is a steeper straight line with a slope equal to $25. Feasible set has expanded Utility is maximised at D

There are two effects of a wage increase: 

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More income for every hour worked: For each level of free time you can have more consumption, MRS is higher: so, you are now more willing to sacrifice consumption for extra free time This is the income effect, additional income makes you take more free time Budget constraint is steeper: Opportunity cost of free time is now higher. So MRT has increased. This means you have an incentive to work more, and decrease your free time, this is called the substitution effect.

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Substitution effect is the concept that when a good becomes more expensive relative to another, you substitute it. It is the effect that a change in opportunity cost has. When wage is $15, best choice is A After the increase, D gives highest utility Dotted line shows what would happen if income was enough to reach IC(4) without a change in the opportunity cost. The shift from A to C is called the income effect, it would make you take more free time

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Rise in opportunity cost makes the budget constraint steeper. Causing you to choose D rather than C, with less free time- this is the substitution effect A wage rise: raises your income for each level of free time, increasing the level of utility you can achieve increases the opportunity cost of free time So, it has two effects on your choice of free time: The income effect (because the budget constraint shifts outwards): the effect that the additional income would have if there were no change in the opportunity cost. The substitution effect (because the slope of the budget constraint, the MRT, rises): the effect of the change in the opportunity cost, given the new level of utility.

The income effect of a higher wage makes workers want more free time, while the substitution effect provides an incentive to work longer hours. If the income effect dominates the substitution effect, workers will prefer fewer hours of work. 3.8: IS THIS A GOOD MODEL: Flaws with our modelling:  Unrealistic to imagine individuals calculate where MRS = MRT  Assumption that employees choose working hours is unrealistic  Government has set restrictions on working hours too so feasible set is limited 3.9: EXPLAINING OUR WORKING HOURS: CHANGES OVER TIME: During 1600’s in Britain workers worked 266 days, this rose to 318 days during the revolution, but since 1870 working hours have fell in France, the US and Netherlands. This diagram gives estimates of average amounts of daily free time and goods per day for employees in 1900 and 2013.     

Overall effect is positive income effect

Predictions:

The solid red lines show the feasible sets Assuming workers chose the hours worked, we can infer approximate shape of their indifference curves Shift from A to C is the income effect of the wage rise, causing workers to take more free time Rise in opportunity cost of free time caused workers to choose D over C, with less free time

3.10: EXPLAINING OUR WORKING HOURS: DIFFERENCES BETWEEN COUNTRIES: Countries with higher income workers tend to have more free time, but there are big differences in annual hours of free time between countries with similar income levels.   

The solid lines show the feasible sets of free time and goods for the countries Point Q is the intersection of the indifference curves for US and South Korea. At this point Americans are willing to give up more units of daily goods for an hour of free time than South Koreans....