Optimal Consumption, Income & Substitution Effects

What did John Maynard Keynes predict for 2030

People would only work 15 hours because output would grow rapidly

Notes on labour-leisure graph with budget constraint

Some indifference curves pass into feasible set, but can be utility maximised

Optimality

When certain slope equals the budget constraint

MRS = MRT

Willingness to trade off consumption for leisure equals wage here

Constrained optimisation

Maximand is utility (typically profits for a firm)

What is the MRT of a labour-leisure trade off?

Negative ratio of the prices -Px/Py

What happens to a labour-leisure graph when wage increases

Budget constraint relaxes

It rotates upwards because to find a new solution we need to find an indifference curve

What happens if the persons preferences change from leisure to more labour

Indifference curve with a tangency at a different point

Income effect

Budget constrain relaxes. Expands feasible set. Akin to having greater income. As income increases we consume more goods (consumption and leisure). The effect is positive on consumption of both

Substitution Effect

Increased wage has increased opportunity cost of leisure. Relative price of leisure in terms of consumption has increased. Consumers naturally substitute their consumption to the cheaper good. Substitution effect is consume less leisure and work more

What decides on the net effect of income and substitution

Which is strongest depending on preference

Pure income effect

Budget constraint moves upwards

Positive pure income effect

Wage is unchanged

Increase in leisure and consumption?

Why would income and substitution decompose

Budget constraint

What is the effect of income and substitution on consumption when the pure income graph has a budget constraint

Both effects increase optimal level of consumption

Do people really make their labour supply decisions using MRS = MRT?

Trial and error decision making may better describe actual behaviour. But the model may not be a bad description of outcomes

Does the model employing the ceteris paribus assumption that holds all else equal make it a good model?

No, it’s not representative of a dynamic world when many things change concurrently especially in the long run. It’s helpful in isolating the consequence of a single change

Can individuals really choose the hours we work? How does this affect the model?

Not really, we choose the job for the hours we want. Model represents collective choices regarding working hours, including labour legislation and trade union agreements

Why might Keynes have been so wrong?

We keep working long hours possibly due to social competitive tendency to demonstrate status (this varies across societies and might explain work hour differences) or because important sources of wellbeing are in limited supply so we must compete to attain them