4.2. Budget constraint

1. 4.2. Budget constraint • Definition: combinations of real income-leisure that the ican achieve • Characteristics: • Line  “price takers” • Slope = wage rate (w) • Maximization of U: • Subjective or psychological preferences (IC) and objective or market preferences (BC)  highestIC, tangent to BC • The individual and the market “are in agreement” • Wage rate = MRS  tangency • Over and underemployment

2. 4.2. IC, BC, & Max. of U • IC: all combinations of L-l desired by the i with U; subjective or psychological preferences  slope MRS • BC: all combinations of L-l achievable at certain w; objective or market information slope w • Max. of U: IC & BC together  tangency, same slope: MRS = w • Question: what happens if the slope of BC is steeper than that of the IC?

3. 4.2. IC, BC, & Max. of U • What do individuals do when w goes up? • Answer: L up … or l up (and L down)? • Derivation of the supply of labor curve • “Backward-bending”  changes from person to person • Again: incomeeffect and substitution effect • Substitution effect : ∆L due to ∆w with Y  > 0 • Income effect : ∆L due to ∆Y with w  < 0 (l: normal) • Total effect: depends on the “strength” of the other two

4. 4.2. IC, BC, & Max. of U The reasoning behind “backward-bending”: with ∆w ∆BC substitution > income; but as t goes by, ∆w ∆BC  substitution < income Supply curve: when leisure is abundant, how is the MRS? Different individual curves: men vs. women?