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PROFESSOR: All right.
So today we are going to start
by reviewing income and
substitution effects.
Because that's a pretty hard
concept and pretty central to
a lot of what we'll do for
the rest of the semester.
And then we're going to dive
in and talk about an
application, a more interesting
application, of
income and substitution effects
which is the effects
of wages on labor supply.
So let's review.
If you take the handout, grab
the handout and look at the
first figure, it's the same
as the last figure of the
previous lecture.
To review, remember, whenever
the price changes, a price
change can be decomposed into
two effects, the substitution
effect and the income effect.
The substitution effect is the
change in the quantity
demanded when the
price changes,
holding utility constant.
And as we proved last
time, that is always
negative, 0 or negative.
It is always non-positive.
It's always true that when
a price goes up, the
substitution effect
is negative.
We proved that both
mathematically and graphically
last time showing that if you're
going to hold utility
constant, and the price of a
good is going to go up, you're
going to shift away
from that good.
OK.
That's the substitution
effect.
In our example, we showed
graphically how you measure a
substitution effect.
You draw a new imaginary budget
constraint, BC3, which
is parallel to the new budget
constraint, BC2.
So it's got the new price ratio
but tangent to the old
indifference curve.
So the key thing to understand
is the imaginary budget
constraint, BC3, where
it comes from.
It's parallel to the new
budget constraint.
That is it's got the new
marginal rate of
transformation, the new slope,
but it's tangent to the old
indifference curve.
That gets you to point B. And so
the movement from A to B is
the substitution effect.
Then we have an income effect
which is, in fact, utility
isn't held constant when
prices change.
In fact, utility falls, because
you're effectively poorer.
You're effectively poorer.
Utility is falling.
And since you're effectively
poorer, that further reduces
demand if the good is normal.
So if it's a normal good, if
it's a good where lower income
causes less consumption of
it, the fact that you're
effectively poorer further
lowers the consumption from
point B to point C.
So the total price effect is the
one we demonstrated at the
beginning of the last lecture.
We raised the price of movies
from $8 to $12.
And we saw the number
of movies consumed
fell from 6 to 4.
But what we can see now to
understand what's underneath
that is two things, an effect of
the fact that prices change
holding utility constant,
and the fact that you're
effectively poorer.
And that's the key thing.
No, your income hasn't
actually gone down.
But that $96 your parents gave
you can buy you less.
Your opportunity set has
been restricted.
And that makes you effectively
poorer.
And so you buy less
for that reason.
And so you get the total
movement from A to C.
Now, as we emphasized last time,
this will be the case if
it's a normal good.
So substitution effects
are done.
Substitute effects are
always negative,
nothing fun about that.
Income effects are a little
more interesting, because
goods can be not normal
but inferior.
We have inferior goods which
are ones such that they're
crummy stuff that as your
income goes up, you
want less of it.
And that can change
the analysis.
So if we look at Figure 7-2,
now we're talking about the
price change with an
inferior good.
And now imagine someone
choosing
between steak and potatoes.
So now the choice is between
steak and potatoes.
And steak costs $5 a pound,
initially, and potatoes cost
$1 a pound.
Initially, you have
an income of $25.
So someone has an income
of y equals $25.
The price of steak is $5, and
the price of potatoes is $1.
So your budget constraint, your
original BC1, runs from
you can either have 5 steak, or
25 potatoes, or something
in between.
And so individuals choose
point A where they're
consuming 8.3 potatoes.
They choose point A.
I don't know what the
number of steaks is.
We probably also ought to label
that, the number of
steaks that comes from that.
But whatever.
It comes out of the
utility function.
So then we say, now let's
imagine that the price of
potatoes rises to $3 a pound.
There's a blight on the potatoes
like there was in
Ireland in the 1800s.
There's a potato blight, and
that shifts in the supply
curve for potatoes raising the
price of potatoes from $1 a
pound to $3 a pound.
Now, what we know is that that
will move consumers, given the
utility function that we've
chosen here, that will move
consumers from point A to point
C. Once again, that's
not labeled, but some lower
amount of potatoes.
That will move them from point
A to point C. So, ultimately,
they'll choose fewer potatoes
and fewer steaks.
But, in fact, what we can see is
that's the composition of a
substitution effect which is
negative, and an income effect
which is positive.
So if we do our standard
decomposition, we draw a new
monetary budget constraint
BC3.
It's parallel to the new budget
constraint, BC2, so the
same price ratio.
It's parallel.
But it's tangent to the old
indifference curve at point B
which is actually to the left
of the ultimate choice at
point C.
So the substitution effect
takes us from A to B. The
income effect actually takes us
back from B to C. That is
as that budget constraint shifts
from BC3 to BC2, as you
get poorer, you choose
more potatoes.
So the substitution effect would
say that from the price
change of potatoes alone, we go
all the way to point B. We
massively reduce our consumption
of potatoes.
But because we're poorer,
effectively, we now consume
more potatoes.
Because we're effectively
poorer, we now
consume more potatoes.
And so, on net, you get
a reduction in potato
consumption.
But it offsets the substitution
effect.
So that's when income effects
can be a little more
interesting.
It's going to be a little more
interesting exercise.
When you think about substitute
effects in the same
way, it's not that
interesting.
It's just look, quantity fell.
It doesn't really matter why.
You don't see, in
the real world,
substitution income effects.
What's interesting is when
they're opposed to each other.
That's when it gets
more interesting.
And so you see this small
reduction you get from the
substitution effect alone.
By the way, there's
two handouts.
Right?
Jessica, is there
two handouts?
There should be.
There's tables as well.
I didn't actually get it.
Jessica, grab me one of those.
There's tables as
well as graphs.
So make sure you have
both handouts.
Anyone else need tables?
Am I the only one who
didn't get it?
OK, good.
So, in principle, the income
effect could be so large it
could offset the substitution
effect.
There's no reason,
theoretically,
that couldn't happen.
That is, in principle, you could
derive preferences such
that the income effect is
so large it offsets the
substitution effect--
thank you--
and the price increase actually
leads to more
potatoes being consumed.
That is what we'd call
a Giffen good as I
talked about last time.
So if you look at the table,
the top table, this sort of
lays out our possibilities.
So look at the top table.
It sort of maps out the possible
sets of things that
can happen.
So if we have a normal good,
and the price of that good
rises, then we know that the
substitution effect is negative.
The income effect is negative.
So the total effect
is negative.
Quantity falls.
That's the law of demand.
We talked about that
last time, downward
sloping demand curves.
Likewise, if the price
falls, the
substitution effect is positive.
The income effect is positive.
You're now richer because the
price of the good fell.
And so, therefore,
demand goes up.
Quantity consumed goes up, once
again, downward sloping
demand curve.
Price rises, you consume
less of it.
Price falls, you consume
more of it.
That's what we learned about
in the first lecture.
However, once goods are
inferior, all bets are off.
Because now the income effect
is the opposite sign of the
substitution effect.
It's possible it could
be larger.
So the total effect
is ambiguous.
You could actually get an upward
sloping demand curve.
You could actually get that a
price rise leads to more of a
good, and a fall leads
to less of a good.
Now will you?
Only if it's a Giffen good.
And, in fact, there's a lot of
controversy in economics about
whether any good in the world
has ever been a Giffen good.
At most, there's maybe one or
two examples people can find.
Even then, it's controversial.
So I think it's fine in life to
assume that demand curves
slope down.
I think, in fact, I don't see
convincing evidence that any
subset or set of goods
are Giffen goods.
I think it's just generally fine
it life to assume demand
curves slope down.
Nonetheless, it's important to
understand this theoretical
possibility even if it's
just theoretical.
Because it's important to
understand income and
substitution effects.
OK.
Questions about that, either
on substitution effect or
price changes?
OK.
So now, armed with that, let's
go onto the more interesting
case which is labor supply.
It's more interesting, because
as I'll come to in a few
minutes, we talk about labor
supply, labor is typically
going to be an inferior good.
So things are going to get a
little more interesting.
So let's talk about that.
So the question you want to ask
here is how hard do folks
decide to work?
How many hours of labor do
folks decide to provide?
As we talked about when we
talked about minimum wage,
just as we all have to decide
between consuming pizza and
consuming movies, or consuming
steak and consuming potatoes,
we also have to decide between
how much labor we're going to
provide and how much we're
going to consume.
The more labor you provide to
the market, the more you
consume, but the less
fun you get to have.
Fun, we call leisure.
The less labor you provide to
the market, the more fun you
get to have, the more leisure
you get, but the less you get
to consume, because you
have less income.
And that's the trade-off we
talked about when we talked
about the effect of
minimum wage.
Now let's come back and
get underneath that
labor supply curve.
So we talked about
the minimum wage.
We talked about the labor supply
curve which was how the
hours you provide respond to
the wage and a labor demand
curve, which was how the
hours that firms want
respond to the wage.
Now let's get underneath
the supply curve.
A minute ago, we were talking
about the demand curves and
getting underneath the demand
curve for consumers.
Well, now let's get underneath
the supply curve for labor.
Now, the key thing is that when
we talk about labor, it's
not a good, it's a bad.
The typical person doesn't
want to work.
The typical person is
not in this room.
You guys like to work.
The typically person actually
doesn't like to work.
Leisure is a normal good.
For the typical person, leisure
is a normal good.
They like time off.
Leisure is a good, which
means labor is a bad.
They don't like to work.
The problem is we don't
know how to
model bads in economics.
It's just we're used to
trading off between
two things you want.
When I used to trade-off, we
know how to model something
you want to get something
you don't want.
Indifference curves wouldn't
work, because
more wouldn't be better.
If you drew an indifference
curve for labor, it would
violate the more is
better assumption.
Because you wouldn't
want more.
You'd want less.
So the modeling trick we're
going to use whenever we're
modeling bads, is to model the
complementary good and then,
in the end, solve for the bad.
We're not going to
model labor.
We're going to model leisure.
And given the total amount of
hours you have to supply, the
total hours minus the
amount of leisure is
the amount of labor.
So we're going to
model leisure.
We're going to model the
good and then solve for
labor at the end.
So, in other words, if you have
24 hours a day you can
work, then your amount of hours
of work is 24 minus the
amount of leisure N. Call it N
or call it L. We'll call it N
because L, typically, we
think of as labor.
Let's call leisure N for
reasons I don't quite
understand.
Let's just use that.
Basically the amount
of hours you can
work is 24 minus leisure.
So if we solve for the optimal
amount of leisure you want, we
can obviously get the amount
of labor you supply.
So the trick when modeling a bad
is not to model the bad.
It's to model the complementary
good.
In this case, the complementary
good is leisure.
So we're going to model the
trade-off between leisure and
consumption and use the result
of that to solve for the
amount of labor you supply.
So it's the general modeling
trick you need to understand,
which is turn a bad
into a good.
That's the modeling trick.
Because we know how
to model the
trade-off between two goods.
We don't know how to model
the trade-off with a bad.
So to think about that, let's
go to Figure 7-3, and let's
talk about what's underneath
a labor supply curve.
What's underneath a labor supply
curve is the trade-off
between how much leisure you
want and how much consumption
you can have. So you see here,
here's a trade-off.
On the y-axis is the amount
of goods you can have. You
earn a wage, w.
The y-axis is the amount of
goods you can have from a
day's work.
So you earn w per hour.
That means the most goods
you can have from a
day's work is 24w.
If you worked all 24 hours
at that wage, you
can have 24w goods.
On the other hand, if you work
not at all, then you take 24
hours in leisure and have no
consumption from that day.
So we see as you move
to the right on the
x-axis, that's leisure.
That's the good.
As you move to the left,
that's labor.
That's the bad.
OK?
That's just illustrating.
But we're going to
model the good.
We're going to model leisure.
Your trade-off is between how
much you want to consume and
how much leisure you
want to take.
Now, here's what's
interesting.
In general, what determines
the slope of a budget
constraint?
What determines the slope
of a budget constraint?
AUDIENCE: Marginal rate
of transformation.
PROFESSOR: Which is what?
AUDIENCE: Ratio between
prices.
PROFESSOR: Ratio
between prices.
Prices determine the slope
of the budget constraint.
But here's what's tricky.
What's the price of leisure?
AUDIENCE: Wage.
PROFESSOR: The wage.
Why?
AUDIENCE: Because for every hour
you take having leisure,
you are effectively using
money that you
could gain at work.
PROFESSOR: Exactly.
The key is the economic concept
of opportunity cost,
which we've talked about and
will continue to talk about
this semester, opportunity cost.
By not working, you are
forgoing earning a wage.
So that is the price
of leisure.
You may not think of it this
way, but, once again, that's
why we're the dismal science.
When you go home today, and you
sit on the couch, and you
watch TV for an hour, you
have just paid a price.
And that price is what you
could have earned by
working that hour.
Every action has a price.
And the price of leisure is the
wage you forgo, The wage
you forgo by sitting around
is the price of leisure.
Let's assume here that the price
of goods is $1, that the
goods you're going
to buy cost $1.
Whatever your consumption,
it costs $1.
That's the trick we always
use with modeling.
Make as many things
$1 as you can.
That makes the model easy.
So let's assume that the price
of the goods you're going to
buy are $1.
So the slope of the budget
constraint is minus w over 1.
The slope of the budget
constraint is just the price
of leisure which is minus w .
So the trade-off with the price
of goods of $1, the
trade-off between taking leisure
and consuming is that
if you take leisure,
an hour of leisure,
you get w fewer goods.
And if you work an hour, you get
w more goods, but you lose
an hour of leisure.
And that gives you the trade-off
between how much you
consume and how much leisure you
take which determines how
much you work.
OK.
Questions about that?
Now let's take this framework
and ask, what happens when the
wage changes, Figure 7-4.
So we have an original
outcome with the
budget constraint BC1.
We have an original budget
constraint, BC1.
Now imagine the wage goes
up, so we move to BC2.
BC2 is a budget constraint
with a higher wage.
The wage goes up.
So what we're going to see is
you're going to move from
point A where you work N1 hours
to point C where you
work N3 hours.
That's where your indifference
curves are tangent with the
new budget constraint.
Not work, take leisure.
I'm sorry.
We take leisure of N1 hours
to leisure of N3 hours.
The wage going up
has reduced your
leisure which makes sense.
If the wage goes up,
you work harder.
Right?
So your wage going up, we always
first take if there's a
leisure and then convert
to labor.
Wage goes up, leisure falls
from N1 to N3, which means
labor goes up.
But actually two things are
happening here, the
substitution and
income effect.
The substitution effect, which
we see by drawing the
imaginary budget constraint BC*
which is parallel to BC2
but tangent to the original
difference curve, the
substitution effect is a very
large reduction in leisure.
It moves all the way
from N1 to N2.
The substitution effect
is a very large
reduction in leisure.
The income effect is that
leisure is a normal good.
I'm now richer, because
my wage has gone up.
So I want to buy more of it.
So I buy more leisure.
And that moves me
from N2 to N3.
So, basically, now the income
effect offsets the
substitution effect even with
a normal good, or with a
normal good.
With a normal good, the income
effect offsets that
substitution effect.
And that's because the money
you're getting, you're using
to buy leisure.
So, in fact, if you flip to 7-5,
you can see a case where
the income effect dominates.
And you actually get that a
wage increase leads you to
work less hard.
Now, think about that.
If I'd said to you--
I probably should have
started with this--
if you increase the wage, will
people work more or less hard?
Your initial instinct would
have been more hard.
You would have thought, well,
if your wage goes
up, you work harder.
But that's because your instinct
was focused on the
substitution effect.
You're thinking about
the income effect.
Here's a case where
I started at N1.
The substitution effect
leads me to N2.
But I feel so much richer from
that higher wage that I
actually move all
the way to N3.
My leisure goes up, and
I work less hard.
Now, unlike a Giffen good, this
is totally plausible.
Why is it plausible?
Well, let me do give you
a simple intuition
for why it's plausible.
Let's say that you're someone
who has a certain amount of
things you want to
buy every week.
You don't save. You have a
certain amount of things you
want to buy every week.
You have to pay your rent, you
have to buy your food, you
have to buy your other goodies,
a certain budget.
A lot of people live
on a budget.
You have a certain budget.
And the truth is you're happy
with that budget.
That's kind of what
you want to do.
Now let's say I doubled
your wage.
Well, now to meet the budget you
can work half as hard and
still meet the same budget.
So you'll work less hard.
You could say, look, I can get
more leisure and consume the
same amount of goods
as I did before.
So I'll work less hard.
That's a totally
plausible case.
That's a case of what we
call target income.
If someone has a target income,
and their wage goes
up, they'll work less.
Now, that's not necessarily
the truth.
But it's, at least to me, sort
of a plausible case of how
people might behave. And that's
a case where income
effects can dominate.
So if we, once again, go to the
second chart on that page,
now we see the income
and substitution
effects for labor supply.
Once again, we're assuming
leisure is a normal good.
We're always going to assume
leisure is a normal good.
We're never going to assume
people don't like leisure.
Assuming leisure is a normal
good, then as the wage rises,
the substitution effect is
you take less leisure.
This table is a bit different
than the other table.
Instead of the first panel being
normal and the second
panel being inferior,
the first panel is
what happens to leisure.
The second panel converts it
to what happens to labor.
So for instance, in the first
cell, when the wage rises, the
substitution effect on leisure
is unambiguously negative.
You clearly take less leisure
when the wage rises.
So, likewise, you
have more labor.
So on the bottom panel, labor
is clearly greater than or
less than 0.
But the income effect is
positive for leisure.
You're rich, you take
more leisure.
Or, likewise, negative for
labor, you're richer, so your
work less hard.
And, therefore, the
net is ambiguous.
So with goods consumption, we
needed goods to be inferior
for there to be a Giffen
good type phenomena.
Here, even with leisure being
normal, you can have a Giffen
good type phenomena.
It's much less random.
And, in some sense, this
is why we learn income
substitution effects.
To be honest, they're just
not that interesting for
consumption.
The book makes a big deal out
of them and talks about
consumer price indices
and all that.
It's just not that important
for consumption.
Because we know in consumption
if prices goes
up, you consume less.
It's just not that
interesting.
It's much more interesting for
things like labor supply.
And we talk about savings
in a number of lectures.
It's the same thing.
There, it's more interesting.
Because now they can often
offset each other in
meaningful ways.
And so now this is why the
tools of income and
substitution effects become
much more important.
OK?
So if we put this together, if
we go to Figure 7-6, we can
now think about deriving where
labor supply comes from.
Where does labor supply
come from?
Well, first, you've got the
consumer's decision of how
hard to work.
So here's a case.
It's sort of small, but
you can take a look.
Here's a case where you've got
someone initially working,
taking 16 hours of leisure and,
therefore, working eight
hours, at a wage of W1.
Now their wage goes up to W2.
They choose to take 12 hours
of leisure and, therefore,
work 12 hours.
This is someone who works harder
when the wage goes up.
That is, the income effect
does not offset the
substitution effect.
Now, we can take that to draw
a demand for leisure curve
just like we drew any
other demand curve.
It's the same technique
as last time.
Just bring those point and say,
look, at a wage of W1,
leisure is 16.
At a wage of W2,
leisure is 12.
We have a downward sloping
demand for leisure, standard
downward sloping demand
for leisure.
But we can convert that to a
supply of labor, which is what
we care about.
Nobody cares about the demand
for leisure curve.
We care about the supply
of labor curve.
You just subtract
these from 24.
You use the supply of labor
curve which is upward sloping.
So as long as substitution
effects dominate income
effects, we'll get an upward
sloping labor supply curve.
But it's certainly possible
that if income effects
dominates substitution effects,
you could get a
downward sloping supply curve,
if you will, what we call in
labor economics, a
backward-bending supply curve,
a supply curve that goes
the wrong way.
Instead of sloping up like
supply curves are supposed to,
it goes the wrong way
and slopes down.
And we can see that's
plausible.
The target income case I
just described to you
would deliver that.
The target income case I just
described to you would deliver
a downward sloping
supply of labor.
As the wage rose, people would
work less and less.
That's a totally
plausible case.
And that's why income and
substitution effects are
interesting.
Because they can deliver
this weird result.
They can get the wrong
signed supply curve.
Questions about income
and substitution
effects or labor supply?
So what I want to spend the
rest of the lecture on is
talking about well,
what is the case?
Do labor supply curves
slope up or down?
And what do we know
about that?
Well, this is probably the major
focus of a field we call
labor economics.
And there's an excellent course
on labor economics,
14.64 taught by Josh Angrist,
which goes into much detail in
the entire field.
But one of the main focuses of
the field is understanding the
elasticity of labor supply,
and is it positive or
negative, and how big is it.
So, basically, measuring the
slope of the labor supply
curve is the focus of this
literature, the elasticity of
the labor supply.
Now, what I want to do is start
with a historical fact,
and then I'll come to
the modern age.
Let's think about
30 years ago.
30 years ago, all men
worked and less than
half of women worked.
It was more normal for women
not to work than to work,
married women.
I'm sorry.
Less than half of married
women worked.
Now, married women could work.
I'm not talking 60 years ago
or 80 years ago when there
were marriage bars.
Literally, firms wouldn't hire
you if you were married.
It's true.
If you're interested in
that, you can actually
read Claudia Goldin.
She's a labor historian who's
written about the early 20th
century when, literally,
women could be
fired for being married.
We're not talking
about that era.
I'm talking about 30 years ago
when you could work if you
were married.
It's no problem.
But most women chose not to,
maybe 40 years ago now.
So, in that case, let's think
about two groups.
Let's think about married
men, and let's think
about married women.
And let's just posit,
hypothetically, how big we
think their substitution and
income effects would be.
Let's start with substitution
effect.
Do we think the substitution
effect would be bigger?
This is the change in the wage
holding utility constant.
Do we think that would have a
bigger effect on leisure and,
therefore, labor for men
or for women and why?
Don't yell it out.
Somebody, raise their
hand and tell me.
Do we think that the
substitution effect would be
bigger for men or
women and why?
Remember the name.
It's the substitution effect.
That's the key to the answer.
Yeah.
AUDIENCE: I think it would be
the same, because they each
have equal use for the goods.
Maybe their income effect
would be different.
PROFESSOR: OK.
[UNINTELLIGIBLE PHRASE].
They each have equal
use for the goods.
Well let's deal with where
the substitution
effect comes from.
Let's break it down.
So you're someone
who's deciding.
You've got you and your wife,
and you're each deciding how
to respond to a change
in the wage.
Now, you both value the
goods the same.
But it's goods versus leisure.
What's the other feature
that you're going
to be thinking about?
Think about a married man
40 years ago, and
the wage goes down.
AUDIENCE: They have
to work more.
PROFESSOR: No.
We're just doing substitution
effects.
That's unambiguous.
If the goes down,
they work less.
We're just doing substitution
effects.
That's ambiguous.
The question is, if they work
less, what do they do?
Whereas think about a married
women 40 years ago.
If she works less,
what does she do?
What does a married man do?
Nothing.
There's nothing to do.
Your friends are all at work.
You can't go play golf.
You can't do anything.
You don't take care of kids,
because men didn't take care
of kids 40 years ago.
What do you do?
There's nothing to do.
Whereas a woman, married woman,
if the wage goes down
40 years ago, you can take
care of kids instead.
You can hang out with other
women who aren't working.
There's plenty to do.
Based on that, now change
your answer.
Where do you think
the substitution
effect would be bigger?
AUDIENCE: [INAUDIBLE PHRASE].
PROFESSOR: In women,
it would be bigger.
Because men, there's less of
a substitution effect.
Because it's all about
substitutability of options.
There's no good alternative
option to work for
men 40 years ago.
It's either work or nothing.
Basically, everybody worked.
So, basically, there's
no good substitution
effect option for men.
For women, there's lots
of outside options.
There's sociability, there's
child rearing, et cetera.
The substitution effect will
be larger the more things
there are you can
substitute to.
Men don't have anything to
substitute to from work.
Women have options to substitute
to from work.
For men, this is going
to be very small.
For women, this will be big.
We know the sign.
The smallest this can be is 0.
We know the sign.
But it's going to be a very
small substitution effect,
because I don't have
a lot else to do if
my wage goes down.
Women, if it's a low
wage, why work?
You can be much more effective
taking care of the kids or
hanging out with your friends.
Why work for a low wage?
Men, there's nothing
else to do.
So that's the relative size to
the substitution effects.
Now, the income effect, I think,
is a little bit harder.
And let's come back and
think about what
drives an income effect.
We talked about the income
effect as being delta q over
delta y, how much a
quantity changes
when your income changes.
But, in reality, what's going
to matter for your income
effect given when you start
today, is going to be not only
delta q over delta y, how your
taste for work changed or
income changes, but also how
hard you worked to start.
Think of it this way.
The income effect is how much
richer you feel if your wage
goes up, or how much
poorer you feel if
your wage goes down.
If you are working 0 hours,
the income effect is 0.
You don't feel any richer if the
wage goes up, because you
don't earn any money.
The more hours you work the
bigger the income effect is,
because the bigger that
shock is to you.
So we can think of the income
effect, a shorthand for the
income effect, is going to be
h times dh/dy, the hours you
work times how your hours
change with your income.
OK?
Now, to prove this it involves
using complicated algebra.
We're not going to get into
it in this course.
I worked hard last night to
see if I could make the
algebra less complicated,
and I can't.
I just have to try to work
intuitively on this.
The notion of the income effect
is bigger the more
you're in the market.
You can think about
it for goods too.
Think about the income effect
of a change in the price of
something you buy a lot
of for something you
buy very little of.
So let's say you're someone
who's buying two Starbucks a
day, and you very rarely
go see a movie.
Well, if the price of a movie
goes up 10%, or the price of
Starbucks goes up 10%,
which is going to
make you feel poorer?
The price of Starbucks
going up, because you
buy a lot of Starbucks.
So how much poorer you'll feel,
or the income effect,
will depend on your
starting point.
The more you're in a market,
the more you'll feel the
income effect.
Now, based on that, who's going
to have a bigger income
effect, men or women?
Same person, what
do you think?
The income effect is going to be
stronger the more you're in
the market.
So who's going to have a
bigger income effect?
AUDIENCE: Married men would have
a bigger income effect.
PROFESSOR: Exactly.
Married men would have a bigger
income effect, because
they're in the market.
Married women, most of
them don't work.
So there's no income effect.
So this is going to be big for
men and small for women.
There's another issue,
which is does dh/dy
differ for men and women?
I'll leave that alone.
Let's assume they both have
the same underlying income
elasticity.
But, certainly, the initial
hours are much bigger from men
than for women.
So what does this mean in terms
of the labor supply
curves you would see for married
men and married women
40 years ago?
Based on these facts, what
would you think?
Yeah?
AUDIENCE: They would have
opposite slopes.
PROFESSOR: Yeah.
So, in particular, the female
labor supply curve
would look like what?
It would slope up or down?
AUDIENCE: It would slope up.
PROFESSOR: It would slope up.
You'd have an upward sloping
curve, because you'd have
these big substitution effects
and small income effects.
So it would look much more
like Figure 7-4.
You'd have the big substitution
effect when the
wage goes up and a small
offsetting income effect.
Think about the woman who
is not working at all.
She's now working at
all at $8 an hour.
You raise her wage
to $12 an hour.
She's like, hey, I wasn't
working at all.
So there's no income effect.
But now I'm going to go to
work and make some money.
So it's upward sloping.
But for men, it's going to look
more potentially like
Figure 7-5.
There's a small substitution
effect but a potentially big
income effect or bigger
than women.
Now, how big it is,
that's not clear.
Because, once again, men
have nothing to do
if they don't work.
So it could be this ends up
being bigger and smaller.
It's not clear how big
this ends up being.
But it's at least possible that
you could have men having
a backward-bending or downward
sloping labor supply curve.
Because the income effect could
even more than offset
the substitution effect.
But, in reality, given the way
I set up the example, you'd
think men would basically
have a pretty
inelastic labor supply.
You'd think, 40 years ago, these
things would basically
both be 0, both offset.
And, basically, you'd have a
situation where the change in
the wages didn't matter
much for men.
And, in fact, that's
what people found.
This is a wonderful case of the
convergence of truth with
theory and a wonderful chance
to see the power of some
pretty simplistic theory.
The intuition is exactly borne
out in the data, which is
males, 40 years ago,
would have a very
inelastic labor supply.
Their labor supply curves were
virtually vertical and maybe
backward-bending.
There's some controversy
on that.
Some estimates got
backward-bending.
Some didn't.
But there were certainly
not upward sloping.
It was basically vertical.
Women had a very few elastic
labor supply.
The elasticity is estimated
to be around 1.
That is every 1% change
in the wage lead to
1% more labor supply.
So that's a fairly elastic
labor supply for women.
Where, for men, the estimate
was basically 0.
And that's kind of neat, because
we're actually getting
confirmation in the data
of what the theory
would have told us.
Now, someone else tell me what
do you think has happened over
the last 40 years relative to
these elasticities of married
men and married women.
Yeah.
AUDIENCE: The elasticity of
married women has gone down in
the last 40 years--
PROFESSOR: Why?
Speak up so the class
can hear you.
Why is that?
AUDIENCE: Because women
work more often now
than they did before.
PROFESSOR: Women work
more often now.
So the income effect is going to
be getting bigger for them.
So the income effect is going
up, because their
initial h is bigger.
Plus there's actually now,
in some sense, less good
opportunities if you're
not working.
So when we had our first kid,
and we lived in Brookline,
which is sort of an urban city,
and my wife decided to
stay at home, she didn't have
moms to hang out with.
It was just nannies
at the park.
And it wasn't that much fun.
And so, basically, the
substitution effect is
shrinking, because the outside
options aren't quite as good
as they were, as the norms
shift towards work.
Whereas for men, actually it's
becoming more normal for men
to be engaged in child care.
My best friend is a
stay-at-home dad.
It's becoming more normal
for that to happen.
And so the substitution
effect is rising.
It's not implausible that if
you cut a man's wage down,
he'll just say forget it.
My wife's going to work.
I'm taking care of the kids.
That would be socially
ostracizing 40 years ago.
But it's not that odd now.
And, likewise, as men are less
engaged in the labor force and
spending more time at home,
their income effects are
falling, because their
initial h is smaller.
So you're getting a convergence
in these labor
supply elasticities.
What really seems to be
happening is mostly
convergence down for women,
not much up for men.
So men are maybe going
from 0 to 0.1.
Women are coming from
like 1 to 1/2.
So what you're seeing is that
men aren't actually working
that much less.
There's a few stay-at-home
dads.
But they're still not
the majority.
Women are working a lot
more, and kids are in
child care a lot more.
So what you're seeing over
time is you're seeing men
being a little more responsive,
but not that much
more responsive.
They're still, basically,
working all the time.
Women are working a lot
more and being more
responsive to wages.
And there's a reduction coming
in both women's leisure and
production of child
care at home.
Now, that raises a very
interesting question of is
this is a good thing?
Now this is a very deep
and hard topic.
In economics, we think if people
do something it's good,
or they wouldn't have done it.
It is true that if you look
at data on self-reported
well-being or happiness data,
married women report a general
decline in happiness, over the
last 40 years, as they've
entered the labor force
more and more.
And the issue is, is this
something which is a good way
for society to spend
its resources, to
have everyone working?
We're consuming more.
Consumption has gone up.
We're consuming more, but
we're getting less
leisure as a family.
Because the men aren't working
that much less.
The women are working
a lot more.
So we're getting less
leisure as a family.
How do we feel about
that outcome.
That's an interesting
question.
And we'll talk about that some
more later on in the semester.
OK.
Questions about this?
Yeah.
AUDIENCE: [INAUDIBLE PHRASE].
PROFESSOR: That's a really
good question.
And let me talk about that
for a couple of minutes.
The definition of unemployment
is those employed
over looking for work.
If the number of people employed
does not change, and
women suddenly want to work, and
they report to surveyors
that they're looking
for work--
that's the employment rate.
I'm sorry.
The unemployment rate--
I'm sorry--
is going to be those looking
over employed.
My bad.
The unemployment rate
is going to be those
looking over those employed.
So the unemployment rate is how
many people are looking
for work over how many
are employed.
If women start suddenly looking
for work, and there's
no jobs to be had, that will
raise the unemployment rate.
So one thing that's been a focus
of a lot of research has
been do increases in the
supply of labor lead to
increases in unemployment?
What you've expressed is what's
often called the lump
of labour view.
The lump of labour view is
basically the view that
there's a fixed box of
production in the economy.
And as more workers come in to
fill that box, there will be
more unemployment.
The alternative view is that
the economy is dynamic.
And as more women are working,
and earning income, and buying
stuff, that makes more jobs.
So our standard of consumption
is way higher
than 40 years ago.
We all have much cooler stuff
than 40 years ago.
You have no idea how bad life
sucked 40 years ago.
We have way better stuff.
We have that stuff, because
women are working and making
the income to buy it, which
means people have to make it
which makes jobs.
So, in fact, the existing
evidence is labor supply
shocks do not cause unemployment
increases.
This is something I've
worked a lot on.
What you see, a very interesting
case is in Europe.
In the US and all over the
world, we have assistance of
what we call Social Security,
a term you've
all heard, I'm sure.
The Social Security program is
a program which provides
income when you're retired.
So it provides income when
you're retired to help you
deal with the fact that you
don't have a source of labor
income anymore.
And that's a program that
virtually every country, and
all developed countries
have a very generous
social security program.
But they're different in the
US than in other countries.
In the US, the way the social
security program works is when
you hit 62, you get a choice.
You can stop working and get
your benefits from Social
Security, and then you get them
every year until you die.
Or you can keep working, delay
getting your benefits, but
they'll increase what you
get to offset the delay.
So, in other words, if I retire
at 63 rather than 62,
given that I'm going to die at
the same date, I'm going to
get one fewer year of
benefits in my life.
But they raise them by 6.7%
to compensate for that.
So I get one fewer year of
benefits, but every year it's
6.7% higher.
And it turns out, given life
expectancy, that works out to
be a roughly fair deal.
So, basically, at 62, your
choice is I can get one more
year of benefits or I
get higher benefits
for one fewer years.
And that's a choice that's
a roughly fair deal.
OK.
Questions about that?
Am I making sense of that?
In Europe, it's not
a fair deal.
In Europe the way it works is
they say, you can get one more
year of benefits.
But if you decide to work this
year, we're not given you any
more in the future.
So let me describe how it works
in the Netherlands.
At age 55, the Netherlands says,
if you decide to retire
this year, we will replace 90%
of your wages in social
security payments to make sure
your income doesn't suffer
when you retire.
If you don't retire and work,
you're going to give up
sitting at home earning
90% of your wage.
That is the opportunity
cost of working.
It's that you have forgone the
ability to sit at home and get
90% of your wage.
So what is your net
wage if you work?
10% of what you would
have earned.
So if you're earning $20 an
hour, then your choice is you
can sit at home for $18 or
work for $20 an hour.
So your net wage for working
is $2 an hour.
The return to work, the
opportunity cost of leisure is
only $2 an hour.
You're only forgoing $2 an
hour by sitting at home.
But wait, there's more.
If you sit at home, you don't
have to pay the payroll taxes
of financing the system
that are almost 50%.
If you work, you have to
pay the payroll taxes.
Which means that if you
work, you lose money.
Because if you work, you forgo
getting to sit at home at 90%
of your wage, and you
pay a tax that's
about 40% of your wages.
So, actually, you will lose 30%
of your salary by working
relative to sitting at home.
Guess what people do in
the Netherlands at 55?
They sit at home.
No one works after 55 in the
Netherlands on the books.
They work off the books
painting houses
and doing odd jobs.
No one works on the
books after 55.
Economics works, guys.
If you pay your guys to stay
at home, they stay at home.
Now, if you ask European
politicians, why do you have
this screwed up system?
They'll say, well, it's easy.
We want to get those old
guys out to make jobs
for the young guys.
We need to pay those old guys
to stay at home to make jobs
for the young guys.
And then you point out, have
you noticed that Europe has
higher unemployment than
American, even though we don't
do that and you do?
And that's because
you're wrong.
It doesn't work that way.
Because by paying the old guys
to sit at home, you have to
have such high taxes that no
one makes new businesses.
And so there's not jobs for
the young guys to have.
So it's true.
In theory, you've made jobs for
the young guys by leaving
the old guys at home.
But by imposing the 40% tax rate
that you've had to impose
to make it possible to pay the
old guys to sit at home,
you've killed job creation
in your country.
And, as a result, there's
not the jobs for
young guys to get.
That's a very long-winded way
of answering your question
that supply, in substance,
creates its own demand.
So more labor supply will not
necessarily cause more
unemployment.
And we're going to talk about
one more thing before we stop.
I've just talked about a vast
empirical literature in how
people understand the effects
of wages on labor supply.
Well, how do they do it?
Well, you could say, look, we
can just look at how you earn
a higher wage than you do.
And we'll ask, do you work
harder than you?
And we'll say, the guys who earn
higher wages work harder.
If guys who earn higher wages
work harder, that means labor
supply slopes up.
If guys who earn higher wages
don't work harder, that means
labor supply slopes down.
What's wrong with that?
Yeah.
AUDIENCE: Those who are getting
paid more probably are
getting paid because they
want to work harder.
PROFESSOR: Yeah.
Maybe you guys are different.
Maybe you're talented,
and you're not.
And maybe because you're
talented, maybe you're driven,
and you're not.
And because you're driven, you
work harder and get paid a
higher wage.
So I'm not learning anything
about the causal effect of the
wage on your labor supply.
I've just documented a
correlation between wage and
labor supply.
How can we get the causal effect
of your wage on your
labor supply?
Well, once again, ideally
we'd run an experiment.
We'd assign you a higher wage.
We'd find someone
just like you.
Not you, you're not driven.
We find someone just like you.
No offense.
You know I'm joking.
We'd find someone just like you
and, randomly, by a flip
of a coin, assign them
a lower wage.
And we'd see how your labor
supply differed.
Now, it seems like you
couldn't do that.
But, in fact, the US did that.
In the 1970s, we ran what was
called the negative income tax
experiment where we literally
assigned people different wage
rates through taxing them
by different amounts.
And that was part of what gave
us this very convincing
evidence from 40 years ago
of these responses.
So where we get this is from
a real experiment we
ran 40 years ago.
The problem is that's a pretty
hard experiment to run.
It's pretty expensive, and
there's some ethical issues.
So what do you do today
to estimate that?
What you can do today is say,
well, we can't run the
experiment.
But the government runs
it for us every time
they change tax rates.
Because if you take two people
that are identical--
so let's say you and you
were identical--
and I change your tax rate
because you live in
Massachusetts.
I don't change your tax rate
because you live in New York.
I can see what happens to
you relative to you.
Because I've now essentially
run this experiment by the
government changing
someone's tax rate
and not someone else's.
That's the way we do it if we
can't run a true, randomized
experiment.
And that gives very, very
similar answers.
Let me stop there.
And we will come back.
Next lecture we'll talk about
applying this model.
So I guess in section
on Friday, we
review for the exam.
In section on Friday, we
review for the exam.
So show up to that.
And the exam is next week.
The exam will cover through
my next lecture.
