3. Scarcity, work, and choice

Income and working hours across time and countriesScarcity and choice: key concepts

Decision-making under scarcityConcluding remarks and summary

Principles of Economics1

3. Scarcity, work, and choice

Giuseppe Vittucci Marzetti2

SCORDepartment of Sociology and Social Research

University of Milano-Bicocca

A.Y. 2018-19

1These slides are based on the material made available under Creative Commons BY-NC-ND4.0 by the CORE Project©, https://www.core-econ.org/.

2Department of Sociology and Social Research, University of Milano-Bicocca, Via Bicoccadegli Arcimboldi 8, 20126, Milan, E-mail: [email protected]

Giuseppe Vittucci Marzetti Principles of Economics 1/26

https://www.core-econ.org/



Layout

1 Income and working hours across time and countries

2 Scarcity and choice: key conceptsProduction function, average productivity and marginal productivityPreferences and indifference curvesOpportunity costFeasible frontier

3 Decision-making under scarcityConstrained choices and optimal decision makingLabor choiceIncome effect and substitution effectEffect of technological change on labor choices

4 Concluding remarks and summaryConcluding remarksSummary




Income and free time across countries

Figure: Annual hours of free time per worker and income (2013)




Income and working hours across time and countries

Figure: Annual hours of work and income (18702000)

Living standards have greatly increased since 1870.

There are disparities in free time and income across countries.




Labor productivity, income and free time

Labor is an input in the production of goods and services.

New technologies raise labor productivity.

How would that affect living standards?How would that affect the free time and working hours chosen byindividuals?

Modeling individual choices to explain the differences in work hoursacross countries and over time.




Production function, average productivity and marginal productivityPreferences and indifference curvesOpportunity costFeasible frontier

A simple production function

Production functions show how inputs (e.g. labor) translate intooutputs (e.g. goods and services), holding other factors constant.Example: a production function of a student shows how study hoursproduce the final grade.





Average and marginal productivity

Marginal product (or productivity): change in output per unitchange in input (evaluated at a given point, holding other inputsconstant).Average product (or productivity): average output per unit of input.





Diminishing marginal productivity: the law of diminishingmarginal returns





Choices, preferences and indifference curves

Choices depend onpreferences.

Indifference curves:combinations of goods thatgive the same utility.

The Marginal Rate ofSubstitution (MRS):

is the slope of theindifference curve;represents the trade-offsthat an individual faces.





Preferences and indifference curves

The curves we have drawn capture our typical assumptions aboutpeople’s preferences between two goods.

Indifference curves slope downward due to trade-offs: if you areindifferent between two combinations, the combination that hasmore of one good must have less of the other good.

Higher indifference curves correspond to higher utility levels: as wemove up and to the right in the diagram, further away from theorigin, we move to combinations with more of both goods.

Indifference curves are usually smooth: small changes in theamounts of goods don’t cause big jumps in utility.

Indifference curves do not cross.

As you move to the right along an indifference curve, it becomesflatter : it is reasonable to assume that the more free time and thelower the grade the student has, the less willing she is to sacrificefurther percentage points in return for free time, so her MRS islower.





Opportunity cost

Opportunity cost

The opportunity cost of an action is the net benefit of the next bestalternative action.

Opportunity costs are relevant whenever choices are limited byconstraints and involve trade-offs, i.e. alternative and mutuallyexclusive courses of action (e.g. higher grades vs. more free time).

Compare actions based on economic cost:

Economic cost = Direct (monetary and non-monetary) costs +Opportunity costs

If the benefit from an action exceeds the economic costs, you receivean economic rent from choosing it.





Opportunity cost: example





The feasible frontierThe feasible frontier shows the maximum output that can beachieved with a given amount of inputThe Marginal Rate of Transformation (MRT):

is the slope of the feasible frontier;represents the tradeoffs that an individual faces.




Constrained choices and optimal decision makingLabor choiceIncome effect and substitution effectEffect of technological change on labor choices

Constrained choice problem

Model of how individuals choose, given their preferences and theconstraints they face, when the things they value are scarce.

Studying example: Free time and exam score are scarce becausethey are both goods, each with an opportunity cost.





Optimal decision making

The utility-maximizing choice is where the amount of one good theindividual is willing to trade off for the other good (MRS) equals theactual tradeoff between the two goods (MRT)

MRS = MRT





Another example: grain production

(a) Production function (b) Feasible frontier

Tradeoff between grain produced and free time.

Technological change shifts the production function upwards, andexpands the feasible frontier.





Effect of the technological change on individual choices

Technological progress makes it feasible to both consume more andhave more free time.Choice of free time/consumption depends on relative preferencesand willingness to substitute one good for another.





Choice between income and free timeBudget constraints are the feasible frontiers for consumption choices.The optimal choice is where the slope of the indifference curve(MRS) equals the wage (MRT).





Income effect and substitution effect

Wage changes affect the slope of the budget constraint (MRT).

A wage increase has two effects:

income effect: total earnings increase, holding working hours fixed;substitution effect: the opportunity cost of free time increases.





Income effect

The optimal choice changes when income changes, keepingopportunity costs (the budget constraint slope) fixed.A wage increase gives more income per hour worked⇒ incentive to decrease working hours.





Substitution effect

The optimal choice changes when the opportunity cost changes, atthe new level of utility.A wage increase raises the opportunity cost of free time⇒ incentive to increase hours worked.





Overall effect on labor choice

Income effect is negative.Substitution effect is positive.Which effect dominates depends on individual preferences.

Overall effect = Income effect + Substitution effect





Working hours: differences over time

Income and substitution effects can explain trends in working hours.

E.g. In the US, the income effect dominated the substitution effect,so consumption and free time both increased.





Working hours: cross-country differences

Differences in working hours can be explained by preferences thatdiffer across countries.

There are other possible explanations.




Concluding remarksSummary

Is this a good model?

Not realistic:

People don’t actually do MRS/MRT calculations.Most people cannot choose their working hours.

But still a good approximation:

Over time, people learn what combination of working hours and freetime suits them best.Working hours can change due to culture and politics (indirectchoice).People can choose which jobs to apply for.

It helps us understand real-world phenomena:

Preferences and income/substitution effects can explain differencesin working hours across countries and over time.




Concluding remarksSummary

Summary

Economics is the science that studies human behaviour as a re-lationship between given ends and scarce means which have al-ternative uses.

(Robbins, 1932)

Simple model of decision-making under scarcity

Indifference curves represent preferences;Feasible frontier represents choice constraints;Utility-maximizing choice where MRS = MRT.

Used model to explain effect of technological change on labor choices

Overall effect = Income effect + Substitution effect

Limitations of model: it omits important factors


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3. Scarcity, work, and choice