Lectures on Microeconomics -Week 4

Reference : SF, Chapter 5

We now apply the household or consumer utility maximisation framework to the
issues of
(i) Consumption-leisure choice
(ii) Taxation of Wages
(iii) Intertemporal budget constraint
1. Consumption-leisure Choice
The consumption-leisure choice affects household supply of labour. Consumer
allocates his time between working and leisure. By working, he earns a wage. With
his wage income, he can consume. So, simplistically, it is as if there are 2 goods consumption and leisure. The consumer gets utility from both consuming and leisure.
He has to allocate his total time available between working (supplying labour) and
leisure.
The Budget Constraint
Let:
w :wage rate in rupees per hour.
c : consumption
p : price of consumption
L : leisure.
T : total time available
l :number of hours worked
So, T = L + l.
wl : wage income
The consumers utility function is defined over pairs (L, c).
If consumer has no non-wage income, then
pc wl
That is, expenditure on consumption cannot exceed wage income. So, overall budget
constraint is
(1)

wL + pc wT

See Figure 5.1.

Questions
1. Explain why this makes sense.
2. Economists talk of the wage rate as being the opportunity cost of leisure.
1

Figure 5.2 introduces preferences in the consumption-leisure orthant. The indifference curves represent as usual the loci of consumption-leisure bundles over which
the consumer is indifferent.
Substitution and Income Effects
The consumer takes p and w as fixed - this is the analogue of price-taking behaviour. Maximisation of u(c, L) subject to the budget constraint given by equation
(1 ) gives demand functions c(w, p) and L(w, p). Once we know the leisure demand
function, the labour supply function follows easily
l(w, p) = T L(w, p)
If p is fixed and only the wage rate varies, then the labour supply function becomes
simply a function of wage, that is, l(w). The labour supply function can be graphed
in the conventional way with l on the horizontal axis and w on the vertical axis.
Should the labour supply curve be upward or downward sloping? An answer can be
given in terms of the income and substitution effects.
Suppose w changes. Of course, w is the opportunity cost or priceof leisure. But,
in this model, w is not simply the price of one commodity. To see this, compare the
standard budget constraint discussed in previous lectures
p 1 x1 + p 2 x2 M
with the one in equation1.
Notice that w appears on both sides of the budget constraint. Why?
Now suppose, wage rate goes up from w to w0 . Figure 3 shows the substitution
effect. This will cause the consumer to consume less leisure and supply more labour.
However, an increase in w also results in an increase in wage income. If leisure is
a normal good, then this causes the consumer to want to consume more leisure. The
two effects pull in opposite directions and the net effect is ambiguous.
Other types of Budget Constraints
Non-labour Income
Suppose consumer receives non-labour income of Rs M. Then, the budget constraint is
pc + wL wT + M
See Figure 5.5.
Suppose that the consumer initially has no non-labour income, and then he receives
some windfall gain of Rs M. The situation is shown in Figure 5.6. If leisure is a normal
good, then he must increase demand for leisure and reduce supply of labour.
Unemployment Benefits

Suppose government gives unemployment benefit of U provided the consumer does

not work (L = T ), Then, budget cnstraint is
pc + wL T if L < T
and
pc U
if L = T .
The situation is depicted in Figure 5.7.
Question : Why may large unemployment benefit result in zero labour supply?
Overtime
Overtime payment refers to a wage increase after a standard number of hours has
been worked, say from w to 1.5w.
See Figure 5.8.
2. Taxing Wages
A progressive tax system is one in which the average tax rises with income. That
is, if y is income and T (y) is the total tax paid at income level y, then average tax is
t(y) = T (y)/y. So, progressivity means that t(y) is increasing in income. Progressive
taxes are more equitable, but can have disincentive effects on labour supply.1
Consider a tax system with only two tax brackets -0 per cent for those with income
below a threshold and 50% for those with incomes above the threshold. Set the
threshold at wT /3 hours - the consumer pays no tax if her income does not exceed
wT /3.
Figure 5.9 depicts the budget constraint and a choice (L , c ) that implies an
income level at which the consumer does pay tax. Suppose now that this tax regime
is replaced with one where there is a single tax rate t. The new budget constraint
will be a straight line with intercept T on the horizontal axis and w(1t)T
on the
p
vertical axis. So, the slope is w(1t)
in absolute value. Also, assume that the tax rate
p
is chosen so that it is neutral for the consumer - she pays the same amount of tax in
the two regimes. So, the new budget line must pass through the point (L , c ) - so
she can can (if she wants to ) consume the same bundle.
The figure shows three things.
(i) The consumer is unambiguously better off with the single tax rate because the
new budget line intersects the point (L , c ) and so the point of tangency between
an indifference curve and the budget line must be at a higher indifference curve
1It

may also result in tax evasion. But this is a point that we dont consider here.

(ii) The consumer works more hours with the single tax rate because the new
optimum must be at a point like (L , c ) where L < L .
(iii) The government collects more taxes with the single tax rate. At (L , c ), the
consumer pays the same total tax revenue under the two tax regimes. But, the single
tax rate induces her to work harder and so gives her more gross income. The higehr
income meas that higher tax paid.
Question: Can you provide an explanation in terms of MRS and price ratio?
Question: The above argument suggests that single tax rates are better than
progressive tax rates. Given this, why do virtually all countries still use progressive
tax rates?
3. Intertemporal Choice of Consumption
This is a simple model of how the consumer interacts in the capital market.
Assume there are 2 time periods, say today and tomorrow or periods 1 and 2. Let
c1 and c2 denote the levels of consumption in periods 1 and 2. Let p1 = 1. We allow
for inflation by specifying that p2 = 1 + . So, is the rate of inflation. If the rate
of inflation is 5%, then = 0.05.
Let M1 , M2 denote levels of income in the 2 periods.
The Budget Constraint
Suppose the consumer does not save anything. Then, he spends exactly M1 in
period 1 and M2 in period 2. Then, c1 = M1 . What about period 2 consumption?
M2
Obviously, p2 c2 = M2 . Since p2 = 1 + , this means c2 = 1+
.
M2
Call the point (M1 , 1+ ) the zero savings point.
A consumer who saves in period 1 will have M1 > c1 so that M1 c1 will be the
amount of savings. Let the interest rate be i percent. Then, the budget constraint is
(1 + )c2 M2 + (1 + i)(M1 c1 )
Rearranging terms,
M2
1+
c2 M1 +
1+i
1+i
Consider now a consumer who borrows in period 1 and pays off the loan from
savings in period 2. Assume that the borrowing rate is also i%. Suppose he borrows
c1 M1 . Then,
(1 + )c2 M2 (1 + i)(c1 M1 )
Rearranging will give exactly the same formula as equation 2.
See Figure 5.10. The budget line goes through the zero savings point. Intercepts
1
1 +M2
on the horizontal and vertical lines must be M1 + ( 1+i
)M2 and (1+i)M
. The
!+
ratio of these two is the relative price of current consumption - the amount of future

(2)

c1 +

consumption that can be exchanged for one unit of current consumption. The higher
is this ratio, the more expensive is current consumption.
The ratio has another interpretation. The real interest rate is represented by
where
1
1+
(3)
=
1+
1+i
This gives
1+i
1
=
1+
This makes approximately equal to i .
So, the real rate of interest is roughly the nominal rate of interest minus the inflation rate.
Question: Why will an increase in the interest rate increase consumers utility if
and only of he saves in period 1? Explain using Figure 5.10.
Supply of Savings
Given M1 , M2 , i, , the consumer will choose optimal c1 , c2 . This gives the desired
savings s = M1 c1 .
If c1 > 0, he is saving. If c1 > M1 , he is actually dissaving or borrowing. So,
the consumers supply of savings is actually a function of the underlying variables
M1 , M2 , i, , as well as the utility function.
Lets focus on the dependence of s on the interest rate i. Assume first that
1+i
consumption in both periods is a normal good. This means that if the slope 1+
is
unchanged, and the budget line shifts outwards (for instance, M1 or M2 increases),
then consumption of both c1 and c2 increase. Suppose now, that i increases and all
other variables remain the same. The new budget line still passes through the zero
savings point, but is now steeper. (Figure 5.10). The point (c1 , c2 ) is now below
the new budget line. The increase in i has both an income and substitution effect.
The consumer who is a saver is now richer since his interest income is higher. This
induces him to consume more in both periods which means a fall in savings.
However, the slope of the budget line is steeper - this means the relative price of
current consumption is higher. So, the substitution effect causes a fall in current
consumption. So, for the saver, a rise in the interest rate has an ambiguous effect
on savings - the income effect has a tendency to lower savings while the substitution
effect tends to increase savings. The net effect is ambiguous.
What happens if the consumer is a borrower? Figure 12 shows this case. A rise in
the interest rate now means higher cost of paying back the loan. The consumer is now
worse off. This is shown by the fact that (c1 , c2 ) is now above the budget line - it is no
longer feasible. So, the fall in effective income means that the income effect causes a
fall in c)1 . So, M1 c1 (which is negative) rises - or what is the same thing borrowing

falls. The rise in the interest rate again makes present consumption relatively more
expensive. So, the substitution effect also tends to reduce borrowing. That is, for the
borrower, the income and substitution effect move in the same direction and causes
an unambiguous fall in borrowing.
Finally, whether a consumer is a saver or borrower depends on the steepness of the
1+i
. For a given , borrowing is
intertemporal budget line. That is, it depends ion 1+
maximised when i = 0. As i rises, borrowing will fall, until it becomes zero. Beyond
that point, savings will become positive and increase with i. But there may be a
point when an increase in i, causes savings to fall.
All figures are in a separate file named Chapter 5 Figures.