[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

CONSUMPTION
Figure 8.9
Indifference
curves
E
Budget constraint
(slope = wage)
LEISURE
INDIFFERENCE CURVES AND
LEISURE-INCOME CHOICES
An individual will choose the combination of
leisure and income at E. Point A would be more
desirable, but it is not feasible. Other points on
the budget line or inside it are feasible, but they
lie on lower indifference curves and are therefore
not as desirable.
A
Appendix: Indifference Curves
and the Labor Supply Decision 2
This appendix investigates the labor supply decision using the indifference
curve approach applied in the appendix to Chapter 5 to the consumption
decision.
Figure 8.9 shows Tom’s budget constraint between leisure and consumption.
The slope of the budget constraint is the wage. The figure also shows
two indifference curves; each gives the combination of leisure and consumption
choices toward which Tom is indifferent. As usual, since people prefer
more of both consumption and leisure if that is possible, Tom will move to
the highest indifference curve he can attain—the one that is just tangent to
his budget constraint.
The slope of the indifference curve is the marginal rate of substitution
between leisure and consumption. It measures the amount of extra consumption
Tom requires to compensate him for forgoing one additional hour of
leisure. At the point of tangency between the indifference curve and the
budget constraint, point E, both have the same slope. That is, the marginal rate
of substitution equals the wage at this point.
As in the appendix in Chapter 5, we can easily see why Tom chooses this
point. Assume his marginal rate of substitution is $15 (dollars per hour), while
his wage is $20 (dollars per hour). If he works an hour more—gives up an
hour’s worth of leisure—his consumption goes up by $20. But to compensate
him for the forgone leisure, he requires only $15. Since he gets more than he
requires by working, he clearly prefers to work more.
DECIDING WHETHER TO WORK
Figure 8.10 shows how to use indifference curves to analyze how people decide
whether or not to work. Consider a low-wage individual facing a welfare system
that provides a fixed level of benefits to those whose income is below a threshold.
Benefits are cut off once income exceeds a certain level. The indifference curve I 0
is tangent to the budget constraint without welfare, and the point of tangency
is E 0 . The curve I 1 is the highest indifference curve consistent with the person
receiving welfare.
The three possible cases are illustrated in panels A, B, and C. In panel A, the
indifference curve through point E 0 , I 0 , is higher than the curve I 1 . The individual
chooses to work at E 0 and is unaffected by the welfare program. In panels B and C,
the person works sufficiently little to be eligible for welfare; that is, I 1 is higher than
I 0 , and so he chooses point E 1 . In panel B, the individual realizes that if he works
more, he will lose his welfare benefits. He earns just (little) enough to be eligible for
welfare. In panel C, the welfare system has only an income effect. If the welfare
benefits are large enough, the individual may choose not to work at all.
2 You will need to have read the appendix to Chapter 5 in order to follow this appendix.
188 ∂ CHAPTER 8 LABOR MARKETS