Transcript Economics 311-Chapter 2-The Robinson Crusoe Economy

Economics 311
Money and Income
Chapter 2-Work Effort, Production, and Consumption-The Economics
of Robinson Crusoe
Department of Economics
College of Business and Economics
California State University-Northridge
Professor Kenneth Ng
Saturday, July 18, 2015
Administrative Details
First Homework.
Due 2/14/2002 in class.
Available on website—ng.csun.edu
The Basic Market Clearing Model
 Want to build a theoretical model of the economy.
 Basic Market Clearing Model in Barro.
 Use the model to analyze the real world.
 Will construct this model by concentrating on 3 key decisions made by a
household.
 Work/Leisure-Chapter 2
 How much to produce
 Real GDP.
 Consumption Now vs. Consumption Later-Chapter 3
 Whether to borrow or lend
 Interest rates
 Money-Chapter 4
 How much money to hold.
 Demand for money
 These three key decisions will be analyzed with three graphs.
 Combine all three into the Basic Market Clearing Model-Chapter 5.
The Robinson Crusoe Economy
 Start out considering a person in isolation: no access to goods
markets, no access to financial markets, and no money.
 Whatever he consumes he must produce.
 Whatever he produces he must consume now (no saving).
 Consider, in this simplest of economies, what determines output of
goods-combination of two factors.
 If he works how much will he produce
 Production Function or Production Possibilities Frontiershows the tradeoff between consumption and leisure.
 How much does he value leisure vs. consumption.
 Indifference curves between consumption and leisure—
shows his preferences between consumption and leisure.
 A firm understanding of these two theoretical constructs is a precursor
to using the model for analysis.
The Production Function
Work Effort-L
Output-F(L)=Y
1 hour
5 units
2 hours
9 units
3 hours
12 units
4 hours
15 units
 The production
function relates the
amount of time
worked to the amount
of goods produced.
 Built in to any
production function is
the level of
technology.
 These numbers can
be graphed.
Production Function: Relates Work Effort to
Output. A Form of Production Possibilities
Frontier (PPF).
y t  f (l t )
The production
function shows how
much output (Y) will
be produced by a
household with a
given amount of work
effort (L) in a given
time period (t).
The shape and
position of the PF
contain information.
Production Function: Relates Work Effort to
Output. A Form of Production Possibilities
Frontier (PPF).
y t  f (l t )
Why is the production
function upward
sloping?
As you work more
you produce more.
Position of the PF Represents
Technology or Productivity.
Suppose the state of
technology improved.
For instance, suppose
Robinson Crusoe was
given an ax or a
technological advance
like the moving
assembly line was made.
Or alternatively, the state
of technology
worsened—when we
bombed Iraq.
What would happen to
the PF?
Position of the PF Represents
Technology.
•An improvement in
technology would cause an
upward shift of the
production function.
•Any level of work effort
now produces more output.
•The higher the PF for a
given work effort, the higher
the level of technology.
Analyzing Changes in the World-The
First Step.
The purpose of the
model is to use it analyze
how changes in the real
world will affect
economic performance.
The first step in the
analysis to be able to
figure out how a given
change in the world will
shift the production
function.
Suppose a country was
subject to a natural
disaster.
How would this affect
the Production Function?
Analyzing Changes in the Worldthe First Step.
Suppose a country was
subject to a natural disaster.
How would this affect the
Production Function.
It would shift the production
function downward.
The loss of electricity,
running water, etc. means
that each hour worked
produces less output.
Slope of the Production Function Represents
the Marginal Product of Labor.
Marginal
product of Labor:
Given the amount a
person is working how
much extra output will a
person get if he works
one more hour.
–MPL = slope of
production function
–Slope of Production
Function = rise/run =
change in output/change
in labor.
–MPL equals how much
more output a person
will get if he works one
more hour.
Slope of the Production Function Represents
the Marginal Product of Labor.
rise
MPL 
run
 output

 labor
3 1
 or
1 1
The steeper the
production function the
greater the MPL or the
reward to work.
Change in Technology.
Suppose the state of
technology improved.
For instance suppose you
took away a secretaries
typewriter and gave her a
personal computer with a
laser printer.
What would happen to
the MPL or the slope of
the production function.
Change in Technology.
What would happen to
the MPL or the slope of
the production function?
The production function
would shift upward.
Not only would more
output be produced at
each level of work effort,
but each additional unit
of work would produce
more additional output.
The slope of the PF
would increase so MPL
would increase.
Shape Production Function Represents the
Diminishing Marginal Product of Labor.
Diminishing Marginal
Product of Labor.
Show relationship
between MPL and
level of work.
MPL decreases as
work effort increases.
As a person works
more hours, his
marginal output falls.
Curved production
function.
Indifference Curves Between Work
Effort and Consumption
Labor
Consumption
A
1
hour
1
B
2
hours
2
C
3
hours
3
 Consider a person choosing
between three combinations of
leisure/labor and consumptionA, B and C.
 Suppose he was indifferent
between these three
combinations, i.e. if given a
choice between them he
wouldn’t care which he
received.
 We could graph the
combinations of work and
leisure between which the
person is indifferent.
 This graph is called an
indifference curve.
Position of the Indifference Curve
Denotes Happiness or Utility
Labor
Consumption
A
1 hour
1
B
2 hours
2
C
3 hours
3
D
2 hours
1
E
2 hours
5
Consider combinations D
and E.
Could they be on the same
IC as combinations A, B,
and C?
Explain.
Position of the indifference curve
denotes happiness utility
Labor
Consumption
A
1 hour
1
B
2 hours
2
C
3 hours
3
D
2 hours
1
E
2 hours
5
E must be preferred to B.
B must be preferred to D.
As you move to IC upward
and the the left, you are
getting happier or a moving
to a more preferred
combination of labor and
consumption.
Position of the Indifference Curve
Denotes Happiness or Utility
There are a whole
family of IC’s which
represent a persons
preferences for labor
vs. consumption.
When the person is
able to move to an
IC higher and to the
left, the person is
increasing his
happiness or utility.
Slope of the IC represents Marginal Rate
of Substitution
Marginal Rate of
Substitution (MRS):
MRS measure the value of
leisure.
The value of leisure is
measured as the amount of
consumption that is needed
to get a person to voluntarily
work one additional hour.
MRS is equal to the slope of
a persons IC at a point.
Slope of the IC represents Marginal Rate
of Substitution
Marginal Rate of Substitution
(MRS):
What is the value of leisure or
the MRS of between labor and
consumption when the person
depicted in the graph to the left
is working 5 hours?
rise
run
 consum ption

 leisure
1

1
MRS 
Slope of the IC Represents
Marginal Rate of
Substitution
Consider the two people
depicted in the graph.
Which one is lazier—blue or
green?
Answer the question first by
simple inspection.
At point B whose IC is
steeper?
What does the slope of the IC
represent?
The blue IC represents a
lazier person because the
slope of the IC is greater, the
MRS is higher, and the
amount of consumption
needed to get the person to
voluntarily work an additional
hour is greater.
Slope of the IC represents Marginal
Rate of Substitution
Which one is lazier—blue or
green?
Now answer the question using
the MRS.
What is the slope of the green
IC from B to D?
Answer—1
What is the slope of the blue IC
from B to C
Answer—7
Who values leisure more—
green or blue?
A Person’s Choice Between Leisure
and Consumption.
Consider the person depicted in
the graph.
The blue line is one of his IC’s.
The brown line is his PF or PPF.
Suppose the person is at point B.
At that combination of labor and
leisure what is his MRS and
MPL?
MRS=7, MPL=1
If the MRS>MPL can the person
be as happy as he can be at point
B? Why or why not?
A Person’s Choice Between Leisure
and Consumption.
He would be happier working
less and consuming less.
The MPL of labor is 1. That
means if gives up 1 hour of
leisure he would get one more
unit of consumption.
The MRS of labor is 7. That
means that you would have to
give the person 7 units of
consumption to get him to
voluntarily give up 1 unit of
leisure.
Therefore, the value of leisure
(MRS=7) is greater than the
price of leisure (MPL=1) so the
person would be better off
consuming more leisure (less
labor) and less consumption.
A Person’s Choice Between Leisure
and Consumption.
Another way of stating the
answer is the following:
The person will try to get to the
highest IC that has at least one
point in common with his PF.
At point B in the graph the
person is on the blue IC.
What would happen to his level
of utility or happiness if he
moved to point F?
Because point F is on a higher
IC, it means that F gives the
person a higher level of utility
than B and, therefore, F is
preferred to B.
Changes in Production
Function (1)
 Each production function
has two features position
and slope.
 A change in the world can
change either of these
features individually or it
may change them both
simultaneously.
 When the position of the
production function
changes but it’s slope
remains the same, the
effect on the choice of
leisure is called a wealth
effect.
 In the graph, a given
amount of labor produces
more output but an
additional unit of labor
produces the same
additional output on the
blue and red production
functions.
Wealth Effects (1)
 A parallel shift in the
PF causes a positive
wealth effect.
 The positive wealth
effect can have
different effects on
work/leisure and output
depending on the
preferences of the
workers, i.e. his IC’s.
 Leisure is a normal
good if a wealth
increase causes an
increase in leisure
consumption.
 Leisure is an
inferior good if a
wealth increase
causes a decrease
in consumption.
Wealth Effects (2)
 Consider a person who starts out
on the brown PF.
 He chooses the optimal
combination of labor/leisure and
consumption, i.e. the point on the
PF which on the highest IC.
 Point A.
 Now suppose there is a change in
the world and the person’s PF
shifts from brown to orange.
 What kind of shift is this?
 Parallel shift.
 If the point on the new PF is B,
what has happened to the amount
of leisure as he has gotten
wealthier?
 Is leisure normal or inferior?
 If the point on the new PF is C,
what has happened to the amount
of leisure as he has gotten
wealthier?
 Is leisure normal or inferior?
 How has the increase in wealth
affected the person’s standard of
living?
Changes in Production Function (2)
 When the slope of the
the production function
changes but it’s position
at a certain level of work
effort remains the same,
this is called a
substitution effect.
 In the graph, a given
amount of labor produces
the same output output at
a given level of work
effort, but an additional
unit of labor produces
more additional output on
the red production
function.
Substitution Effects
 A rotation of the PF
causes a substitution
effect.
 The substitution effect
causes a shift in the
optimal labor/leisure
consumption bundle
chosen by an
individual.
 Consider the shift of
the PF from blue to
red.
 What has happened
to the MPL at work
effort L?
 The person will adjust
his work effort now
that his MPL has
increased.
 Moving from A to B,
what has happened to
GDP?
Summary
 A parallel shift of the production function means a given level of
work effort produces more output but additional work effort
produces the same additional output (MPL stays the same).
 A parallel shift causes a wealth effect.
 A parallel shift can cause an increase or decrease in
labor/leisure depending on whether a leisure is a normal or
inferior good to a person.
 A rotation of the production function at a point means a given
level of work effort produces the same output but additional work
effort produces more additional output (MPL has changed).
 A rotation causes a substitution effect because the reward to
work has increased.
 A rotation that increases the slope of the production function
always causes a decrease in leisure, an increase in work
effort, and an increase in output, consumption, and GDP.
A Proportionate Shift in
the Production Function
 A proportionate shift of the
production function causes a
change in slope (a rotation or
change in MPL) and a change
in the position for a given
amount of labor.
 Example: Every level of work
effort produces 20% more
output.
 A proportionate shift of the
production function causes a
wealth and substitution effect.
 The overall effect of a
proportionate shift in the PF
depends on net effect of the
substitution and wealth effects.
 The substitution effect
causes work effort to
increase.
 The wealth effect, if leisure
is normal, causes work
effort to decrease.
 The wealth effect, if leisure
is inferior, causes work
effort to increase.
A Proportionate Shift in
the Production
Function
 Consider the change in the PF
from blue to red.
 Is this a proportionate shift?
 Yes. Both slope and
position at L are changing.
 The substitution effect is
shown as the movement from
A to B.
 The dotted red PF has the
new slope but the same
position as the solid red
PF.
 Therefore it shows the
effect of the change in
slope (MPL) only.
 The income effect is shown as
the movement from B to C.
 The movement from
dashed red to solid red is
a parallel shift in the PF.
 Therefore it shows only
the wealth effect.
A Proportionate Shift
Production Function
 Is leisure normal or inferior
for the person depicted in
the graph?
 Explain.
 Leisure is normal because
when you look at the pure
wealth effect (B to C),
leisure increases and work
effort decreases as wealth
increases.
 Can you depict a person for
whom leisure is inferior?
 Is it possible for a
proportionate shift in the PF
causes a decrease in work
effort (employment)?
A Proportionate Shift
Production Function
 In the graph at the left,
the total change from the
wealth and substitution
effect (A to C) is a
reduction in work effort.
 The person is being paid
a higher hourly rate but
chooses to work fewer
hours.
 This is the result of the
substitution effect, which
increases work effort, and
the wealth effect, which
reduces work effort.
 The total effect is a
reduction in work effort
because the wealth effect
overwhelms the
substitution effect.
Changes in
Preferences.
 The slope of the
indifference curve is the
MRS between leisure and
consumption.
 When the slope of an
indifference curve
increases, is leisure
becoming more or less
valuable?
 The steeper the IC,
the greater the slope,
the more valuable
leisure is to the
individual.
 If a person IC shifted from
green to orange what
would happen to the value
of leisure? Explain.
 Leisure has become
less valuable because
the amount of
consumption needed
to get the person to
voluntarily give up an
hour of leisure has
decreased.
How to use the production function and indifference
curves to engage in economic analysis.
 Identify change in the world.
 Proposed change in government policy
 Taxes and regulation.
 Natural events.
 Weather, war, etc.
 Does the change in the world affect the production function or
indifference curves?
 Production Function.
 Wealth effect? Substitution Effect? Both?
 Net effect?
 Indifference curve
 Leisure more or less valuable? IC steeper or shallower?
 How does the shift in the PF or IC effect the equilibrium choice of
labor/leisure and consumption?
 Does the tangency of the IC and PF occur at a higher or lower level
of labor/leisure?
 Is the amount of goods produced at the new equilibrium higher or
lower than before?
Example 2
 Consider a worker in the a coal mine.
OSHA promulgates a new worker safety rule that
regulation that requires him to wear protective
clothing.
It takes an hour at the beginning and the end of
his shift to don the protective clothing.
What effect will this have on work effort?
Assume that leisure is a normal good.
Example 2-Answer
 The protective
clothing doesn’t
effect the amount of
output he produces
in an hour, but for
any work shift,
because he has to
put the protective
suit on and off, he
produces less total
output.
 Therefore, the OSHA
regulation causes
parallel shift in the
PF (red to blue).
 If leisure is a normal
good, the OSHA
regulation causes a
negative wealth
effect and a
reduction in the
amount of leisure.
Example (3)
Consider a single mother who has a
child.
What effect will this have on GDP and
unemployment?
Example (3)-Answer
 The birth of her child
does not effect the PF.
If she goes to work,
she will get paid the
same.
 The birth of her child
effects the value of
leisure (or non-work).
 Leisure is now
more valuable.
 Slope of the IC
(green) is steeper.
 Because leisure has
become more
valuable, the single
mother consumes
more leisure (A to B).
 Because she is
working fewer hours,
GDP has decreased
and the
unemployment rate
will rise.
Example (1)
 Consider a person who makes $24,000 a year before
taxes, works 2000 hours a year and pays a 10%
income tax.
 Two tax cut proposals are proposed.
A cut in his income tax rate to 5%.
A lump sum tax rebate of $1200.
 Draw the PF for both plans.
 Will the effect of these two tax cuts on GDP be the
same? Explain and show graphically.
 Which plan is more likely to increase employment and
reduce the unemployment rate?
 Turn in Tuesday. Will count as a homework.
Example 1-Answer
 The red PF shows
the reward to work
before taxes.
 The blue PF
shows the
proportionate shift
caused by the 10%
income tax rate.
Example 1-Answer
 The proportionate shift
to the green PF shows
the effect of the
decrease in the
income tax rate to 5%.
 The parallel shift to the
purple PF shows the
effect of the $1200
lump sum tax rebate.
 Under either tax plan,
if the person continues
to work the same
hours (L) they will get
the same output (B to
C).
Example 1-Answer
 The proportionate
shift in the PF
causes a change
in the slope of the
PF.
 The change in
the slope or MPL
will cause an
increase in work
effort, an
increase in output
and a reduction in
unemployment.