Public Economics Lectures Part 1: Introduction

Chetty 2006: Graphical Intuition
Assume y = 0.
At initial wage w 0 , agent works l 0 hours
Consider effect of increasing w by 1% to w 1
Shifts wu c curve up by 1% (substitution effect)
Shifts wu c curve down by ∂ log u c
∂ log w
= γ% because γ is elasticity of MU
w.r.t. c (income effect)
Therefore, γ < 1 ⇐⇒ ε l,w > 0
If u cl ̸= 0, then −u l curve shifts when w changes
But the shift is −u l relatively small, so change in l can still be used
to get a bound on γ
Public Economics Lectures ()Part 5: Income Taxation and Labor Supply 214 / 217