We will work in terms of daily average free time and consumption, as we did for Angela. We will assume that your spending—that is, your average consumption of food, accommodation, and other goods and services—cannot exceed your earnings for example, you cannot borrow to increase your consumption. We will call this your budget constraint , because it shows what you can afford to buy. In the table in Figure 3.
When we plot the points shown in the table, we get a downward-sloping straight line: this is the graph of the budget constraint. The equation of the budget constraint is:. The area under the budget constraint is your feasible set. Remember that for Angela the slope of the feasible frontier is both the MRT the rate at which free time could be transformed into grain and the opportunity cost of an hour of free time the grain foregone.
What would be your ideal job? Your preferred choice of free time and consumption will be the combination on the feasible frontier that is on the highest possible indifference curve. Work through Figure 3. The straight line is your budget constraint: it shows the maximum amount of consumption you can have for each level of free time. This is your MRT the rate at which you can transform time into consumption , and it is also the opportunity cost of free time.
The budget constraint is your feasible frontier, and the area below it is the feasible set. If your indifference curves look like the ones in Figure 3. Your optimal combination of consumption and free time is the point on the budget constraint where:. While considering this decision, you receive an email. You realize at once that this will affect your choice of job.
The new situation is shown in Figure 3. Your budget constraint is now:. Your new ideal job is at B, with Someone with different preferences might not choose to increase their free time: Figure 3. The effect of additional unearned income on the choice of free time is called the income effect.
Your income effect, shown in Figure 3. For the person in Figure 3. We assume that for most goods the income effect will be either positive or zero, but not negative: if your income increased, you would not choose to have less of something that you valued.
You suddenly realize that it might not be wise to give the mysterious stranger your bank account details perhaps it is a hoax. With regret you return to the original plan, and find a job requiring 6 hours of work per day. Now your budget constraint is:. With 24 hours of free time and no work , your consumption would be 0 whatever the wage.
Your feasible set has expanded. And now you achieve the highest possible utility at point D, with only 17 hours of free time. So you ask your employer if you can work longer hours—a 7-hour day. Compare the outcomes in Figure 3.
With an increase in unearned income you want to work fewer hours, while the wage increase in Figure 3. Why does this happen? Because there are two effects of a wage increase:. Leibniz: Mathematics of income and substitution effects. The substitution effect captures the idea that when a good becomes more expensive relative to another good, you choose to substitute some of the other good for it.
It is the effect that a change in the opportunity cost would have on its own, for a given utility level. We can show both of these effects in the diagram. Before the wage rise you are at A on IC 2. The higher wage enables you to reach point D on IC 4.
Point D on IC 4 gives you the highest utility. The dotted line shows what would happen if you had enough income to reach IC 4 without a change in the opportunity cost of free time. You would choose C, with more free time. The shift from A to C is called the income effect of the wage rise; on its own it would cause you to take more free time. The rise in the opportunity cost of free time makes the budget constraint steeper. This causes you to choose D rather than C, with less free time.
This is called the substitution effect of the wage rise. The overall effect of the wage rise depends on the sum of the income and substitution effects. In this case the substitution effect is bigger, so with the higher wage you take less free time. You can see in Figure 3. The overall effect of a wage rise depends on the sum of the income and substitution effects.
If you look back at Section 3. We used the model of the self-sufficient farmer to see how technological change can affect working hours. Angela can respond directly to the increase in her productivity brought about by the introduction of a new technology. Employees also become more productive as a result of technological change, and if they have sufficient bargaining power, their wages will rise.
The model in this section suggests that, if that happens, technological progress will also bring about a change in the amount of time employees wish to spend working. The income effect of a higher wage makes workers want more free time, while the substitution effect provides an incentive to work longer hours.
If the income effect dominates the substitution effect, workers will prefer fewer hours of work. We have looked at three different contexts in which people decide how long to spend working—a student Alexei , a farmer Angela , and a wage earner. In each case we have modelled their preferences and feasible set, and the model tells us that their best utility-maximizing choice is the level of working hours at which the slope of the feasible frontier is equal to the slope of the indifference curve.
Billions of people organize their working lives without knowing anything about MRS and MRT if they did make decisions that way, perhaps we would have to subtract the hours they would spend making calculations. So how can this model be useful? Lack of realism is an intentional feature of this model, not a shortcoming. Milton Friedman, an economist, explained that when economists use models in this way they do not claim that we actually think through these calculations such as equating MRS to MRT each time we make a decision.
Instead we each try various choices sometimes not even intentionally and we tend to adopt habits, or rules of thumb that make us feel satisfied and not regret our decisions. In his book Essays in positive economics , he described it as similar to playing billiards pool :. Consider the problem of predicting the shots made by an expert billiard player. It seems not at all unreasonable that excellent predictions would be yielded by the hypothesis that the billiard player made his shots as if he knew the complicated mathematical formulas that would give the optimum directions of travel, could estimate accurately by eye the angles, etc.
Our confidence in this hypothesis is not based on the belief that billiard players, even expert ones, can or do go through the process described. It derives rather from the belief that, unless in some way or other they were capable of reaching essentially the same result, they would not in fact be expert billiard players. Similarly, if we see a person regularly choosing to go to the library after lectures instead of going out, or not putting in much work on their farm, or asking for longer shifts after a pay rise, we do not need to suppose that this person has done the calculations we set out.
If that person later regretted the choice, next time they might go out a bit more, work harder on the farm, or cut their hours back.
Eventually we could speculate they might end up with a decision on work time that is close to the result of our calculations.
That is why economic theory can help to explain, and sometimes even predict, what people do—even though those people are not performing the mathematical calculations that economists make in their models. A second unrealistic aspect of the model: employers typically choose working hours, not individual workers, and employers often impose a longer working day than workers prefer.
As a result, the hours that many people work are regulated by law, so that beyond some maximum amount neither the employee nor the employer can choose to work. In this case the government has limited the feasible set of hours and goods. Although individual workers often have little freedom to choose their hours, it may nevertheless be the case that changes in working hours over time, and differences between countries, partly reflect the preferences of workers.
Or they may bargain as members of a trade union for contracts requiring employers to pay higher overtime rates for longer hours. This explanation stresses culture meaning changes in preferences or differences in preferences among countries and politics meaning differences in laws, or trade union strength and objectives.
They certainly help to explain differences in working hours between countries:. Cultures seem to differ. Some northern European cultures highly value their vacation times, while South Korea is famous for the long hours that employees put in. Legal limits on working time differ. In Belgium and France the normal work week is limited to 35—39 hours, while in Mexico the limit is 48 hours and in Kenya even longer. But, even on an individual level, we may influence the hours we work.
For example, employers who advertise jobs with the working hours that most people prefer may find they have more applicants than other employers offering too many or too few hours. Remember, we also judge the quality of a model by whether it provides insight into something that we want to understand. In the next section, we will look at whether our model of the choice of hours of work can help us understand why working hours differ so much between countries and why, as we saw in the introduction, they have changed over time.
During the year , the average British worker was at work for days. This statistic did not change much until the Industrial Revolution. Then, as we know from the previous unit, wages began to rise, and working time rose too: to days in Meanwhile, in the US, hours of work increased for many workers who shifted from farming to industrial jobs.
In the US abolished slavery, and former slaves used their freedom to work much less. From the late nineteenth century until the middle of the twentieth century, working time in many countries gradually fell. The simple models we have constructed cannot tell the whole story.
Remember that the ceteris paribus assumption can omit important details: things that we have held constant in models may vary in real life. As we explained in the previous section, our model omitted two important explanations, which we called culture and politics. Our model provides another explanation: economics. Look at the two points in Figure 3.
The slopes of the budget constraints through points A and D are the real wage goods per hour in and in This shows us the feasible sets of free time and goods that would have made these points possible.
Then we consider the indifference curves of workers that would have led workers to choose the hours they did. We cannot measure indifference curves directly: we must use our best guess of what the preferences of workers would have been, given the actions that they took.
How does our model explain how we got from point A to point D? You know from Figure 3. In this case, the income effect outweighs the substitution effect, so both free time and goods consumed per day go up. Work through the steps to see the income and substitution effects.
We can interpret the change between and in daily free time and goods per day for employees in the US using our model. The solid lines show the feasible sets for free time and goods in and , where the slope of each budget constraint is the real wage.
Assuming that workers chose the hours they worked, we can infer the approximate shape of their indifference curves. The shift from A to C is the income effect of the wage rise, which on its own would cause US workers to take more free time. The rise in the opportunity cost of free time caused US workers to choose D rather than C, with less free time.
In this case the income effect is bigger, so with the higher wage US workers took more free time as well as more goods.
During the twentieth century we saw rising wages and falling working hours. Our model accounts for this change as follows:. We should also consider the possibility that preferences change over time.
If you look carefully at Figure 3. Hours of work also rose in Sweden during this period. At the time, he was describing the habits only of the upper classes. But increasing disposable income during the twentieth century means the term is now applied to anyone who ostentatiously consumes expensive goods and services as a public display of wealth.
Thorstein Veblen. Theory of the Leisure Class. Oxford: Oxford University Press. Perhaps Swedes and Americans came to value consumption more over these years. This may have occurred because in both the US and Sweden the share of income gained by the very rich increased considerably, and the lavish consumption habits of the rich set a higher standard for everyone else.
As a result, many people of lesser means tried to mimic the consumption habits of the rich, a habit known as conspicuous consumption. The Joneses got richer, leading everyone else to change their preferences. The combined political, cultural and economic influences on our choices may produce some surprising trends. Juliet Schor: Why do we work so hard? The wage rate is shown to have increased between the two years. What about the future?
The high-income economies will continue to experience a major transformation: the declining role of work in the course of our lifetimes. We go to work at a later age, stop working at an earlier age of our longer lives, and spend fewer hours at work during our working years. Robert Fogel, an economic historian, estimated the total working time, including travel to and from work and housework, in the past. He made projections for the year , defining what he called discretionary time as 24 hours a day minus the amount we all need for biological maintenance sleeping, eating and personal hygiene.
Fogel calculated leisure time as discretionary time minus working time. Robert William Fogel. Chicago: University of Chicago Press. In he estimated that lifetime leisure time was just a quarter of lifetime work hours. He predicted that lifetime leisure would be three times of lifetime working hours by the year His estimates are in Figure 3. We do not yet know if Fogel has overstated the future decline in working time, as Keynes once did.
But he certainly is right that one of the great changes brought about by the technological revolution is the vastly reduced role of work in the life of an average person. To analyse these differences using our model, we need a different measure of income that corresponds more closely to earnings from employment. The table in Figure 3. From these figures we have calculated annual free time, and the average wage by dividing annual income by annual hours worked.
Finally, free time per day and daily consumption are calculated by dividing annual free time and earnings by From the data in Figure 3. From Figure 3. South Koreans, Americans and Dutch people have about as much to spend per day, but South Koreans have three hours less of free time. Could it be that South Koreans have the same preferences as Americans, so that if the wage increased in South Korea they would make the same choice?
This seems unlikely: the substitution effect would lead them to consume more goods and take less free time, and it is implausible to suppose that the income effect of a wage rise would lead them to consume fewer goods.
More plausible is the hypothesis that South Koreans and Americans on average have different preferences. Notice that the indifference curves for the US and for South Korea cross. This means that South Koreans and Americans must have different preferences. Using the model to explain free time and consumption per day across countries We can use our model and data from Figure 3. The solid lines show the feasible sets of free time and goods for the five countries in Figure 3.
At this point Americans are willing to give up more units of daily goods for an hour of free time than South Koreans. Point Q in the last step of the figure is the point of intersection of the two indifference curves shown for South Korea and the US.
At that point the US indifference curve is steeper than the South Korean one. This means that the average American is willing to give up more units of daily goods for an hour of free time this is the MRS than the average South Korean, which is consistent with the idea that South Koreans work exceptionally hard.
So it may be important to take account of differences in preferences among countries, or among individuals. Suppose that the points plotted in Figure 3. The figure below illustrates what has happened to working hours in many countries during the twentieth century the UK is in both charts to aid comparison.
We have used a model of decision making under scarcity to analyse choices of hours of work, and understand why working hours have fallen over the last century. The choice that maximizes utility is a point on the feasible frontier where the marginal rate of substitution MRS between goods and free time is equal to the marginal rate of transformation MRT.
An increase in productivity or wages alters the MRT, raising the opportunity cost of free time. This provides an incentive to work longer hours the substitution effect. But higher income may increase the desire for free time the income effect.
The overall change in hours of work depends on which of these effects is bigger. John Maynard Keynes. Tim Harford. The Undercover Economist. First published by The Financial Times. Updated 3 August Milton Friedman. Essays in positive economics , 7th ed. Lionel Robbins. An essay on the nature and significance of economic science , 3rd ed. Robert Whaples. Net Encyclopedia. The fourth great awakening and the future of egalitarianism: The political realignment of the s and the fate of egalitarianism.
This ebook is developed by the CORE project. More information and additional resources for learning and teaching can be found at www. The Economy. Unit 3 Scarcity, work, and choice Themes and capstone units History, instability, and growth Global economy Innovation Politics and policy. History, instability, and growth. View the latest data at OWiD. Question 3. Your total number of working hours per week will be 30 hours. Your total number of free hours per week will increase by 6.
An increase in GDP per capita causes a reduction in the number of hours worked. Between and , French people have managed to increase their GDP per capita more than ten-fold while more than halving the number of hours worked. The negative relationship between the number of hours worked and GDP per capita does not necessarily imply that one causes the other.
The lower GDP per capita in the Netherlands may be due to a number of factors, including the possibility that Dutch people may prefer less income but more leisure time for cultural or other reasons. That would be nice. However past performance does not necessarily mean that the trend will continue in the future.
High study time Low study time Good environment 3. The marginal product and average product are approximately the same for the initial hour. Terribly polluted water has no uses. Garbage is also not desirable. In fact, we pay others to take away our trash. Since we live in a world full of scarcity, we must make choices. How should you use your birthday money? Which after school job should you take? Which classes should you take to best utilize your scarce time?
Because of scarcity, economics as the study of choices is a critical subject. To an economist, there are several types of costs. The one with which we are most familiar is called explicit cost. Explicit costs are the money prices paid for goods and services. The more important type of cost to an economic thinker, though, is the implicit cost. Opportunity costs are what you give up when you use your resources.
It is not the money price. Rather, it is the opportunity cost of making a decision. Opportunity cost is the value of the next best option not selected. It is not the value of every option not selected, just the second best. Only by understanding and taking into consideration the opportunity cost can we make good, thoughtful decisions. When choices are made without thinking about all that is given up, the choices are too whimsical. For this reason, good economic choices involve a close examination of benefits and costs — all the costs.
Imagine that you go out for lunch and the restaurant has three items on the menu: a sandwich, a salad, and a pasta dish. You face scarcity of money, time, and space in your stomach, and must therefore make a choice of just one item on the menu.
The pasta is not calculated as part of the cost because you never would have ordered the pasta. If the restaurant sold out of sandwiches, you would have ordered the salad.
This is a very simple example. The opportunity cost of the house in Denver is an even larger house in the suburbs. Other choices have much bigger opportunity costs. If you decide to go to college, you will incur many costs. There will be explicit costs of tuition and books. The implicit costs are also important to consider when making your decision, though.
If instead of attending classes at the closest state university, you would have attended a college on the other side of the country, you miss the opportunity to experience the educational opportunities as well as trying out living in another state.
Another cost would be the money you may have earned if you got a job instead of going to college first. Governments should also consider the opportunity costs of decisions. If the federal government decides to subsidize a solar energy company, the money cannot then be used for whatever the second best choice would be. A person will make choices to maximize his own self-interest.
The alternative with the most advantageous combination of costs and benefits will be chosen. In order to make the best choice, a decision-making model can be used to fully help examine costs and benefits.
Next, list the criteria important to you. Some criteria might be more important than others and should therefore carry more weight in the decision-making process. You can rank the criteria, assigning a multiplier to each.
The study of incentive structures is central to the study of all economic activities both in terms of individual decision-making and in terms of cooperation and competition within a larger institutional structure. Perhaps the most notable incentive in economics is price. Price acts as a signal to suppliers to produce and to consumers to buy.
For example, a sale is nothing more than a store providing an incentive to potential customers to buy. The lowering of the price makes the purchase a better idea for some customers; the sale seeks to persuade individuals to change their actions namely, to buy the product. Sales are Incentives : Sales are incentives for consumers to buy, because firms know consumers generally respond to lower prices by purchasing more. Similarly, the increase in price acts as an incentive to suppliers to produce more of a good.
If suppliers think they can sell their products for more, they will be inclined to produce more. The price acts, therefore, as an incentive to customers to buy and suppliers to produce. Incentives come in many other forms, however. Broadly, most incentives can be grouped into one of four categories:. Economics is mainly concerned with remunerative incentives, though when discussing government regulations, coercive incentives often come into play.
By manipulating incentives, individuals as well as businesses and governments hope to encourage some behaviors and discourage others. Companies leverage incentives-based strategies to drive performance and optimize employee decision-making and behaviors through meaningful reward systems. While there are both advantages and drawbacks to this type of approach, remunerative financial incentives are highly attractive options for employers in a variety of industries and businesses.
Providing incentives such as variable income, where an individual can obtain more personal rewards for successfully creating a product or making a sale, often drives up production for highly motivated employees. An example of this would be a manufacturing facility making widgets. The floor manager shifts the wage system from an hourly wage perspective to a straight piece rate system.
The more widgets a worker creates, the higher his or her prospective income will be. Under this incentive system less productive workers may stay the same, but highly productive workers will respond by increasing their production.
Privacy Policy. Skip to main content. Principles of Economics. Search for:. Individual Decision Making. Scarcity Leads to Tradeoffs and Choice When scarce resources are used, actors are forced to make choices that have an opportunity cost. Learning Objectives Give examples of economic trade-offs.
Key Takeaways Key Points Scarce resources diminish as they are used and almost all resources are scarce. In order to use a scarce resource, you are inherently using the resource for one purpose and not an alternative.
The cost of using a resource is called the opportunity cost: the value of the next best alternative that you could be using the resource for instead. Key Terms Scarce : Insufficient to meet demand. Opportunity cost : The value of the best alternative forgone. Individuals Face Opportunity Costs Individuals face opportunity costs when they choose one course of action over another. Learning Objectives Distinguish between explicit costs and opportunity costs.
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