Unit 3

SCARCITY, WORK, AND CHOICE

 Decision-making under scarcity

• Scarcity: ‘Limitation’ on resources(money and time). We have a fixed amount of money and
time. This forces us to make a trade-off.

• This theory (or chapter) help us understand ‘Decision-making under scarcity’. It is a ubiquitous
problem because each and every action involves a trade off (either in terms if time, resources
or both).

• Essence of the theory: Given the feasible set (given that the resources are limited what all
combinations are available) and the preferences, this theory evaluates which of the available
option is the best.

• A model of decision making under scarcity can be applied to the question of how does a
consumer make a choice between two goods; how does a producer make a choice of how
much to produce and what to produce; and, how does an employee decide on how much time
to spend on working.
OUTLINE
A. Some key concepts – feasible set (affordable
options) and indifference curves (preferences)
B. Put concepts together to understand the
theory (Decision-making model)
C. Income and Substitution Effects
D. Applications
Some questions
• How do wages affect labour supply? Does increase in wage always
lead to increase in labour supply, or it can lead to decrease in labour
supply as well?

• Does higher wage for overtime always lead to increase in working

hours, or it can, sometimes, lead to decrease in working hours as
well?

• Can lottery/huge bequest affects a person’s labour supply?

Some questions
New technologies raise the productivity of labour.
• How would that affect living standards?
• How would that affect the free time and working hours
chosen by individuals?
Some questions
• How do interest rates affect household saving? Will increase in
interest rate always increase the savings, or it can lead to decrease in
savings as well?
Scarcity and choice: Key concepts
The Feasible Set
• Consider two items between which the trade off is involved. Lets take the
example from a student point of view. Suppose, we take the two items as ‘free
time’ and ‘score’.
• For extra hour spent on studies, the marks increase, but that one hour is reduced
from free time. So, there is a trade-off between ‘free time’ and ‘marks’.

• Let us consider the following specific example:

The Feasible Set
• Feasible set gives you the all possible combination of free time and
scores.

• Graphically, we take the two goods between which the trade-off is

involved on two axis. And the, plot all the possible combinations of x
and y available.
 The Feasible Set

The pink shaded region gives the

feasible set: collection of all points that
are feasible/available/attainable.
• Points outside the shaded region are
not attainable.
• The feasible frontier (boundary)
shows the maximum output that
can be achieved with a given
amount of input.
• Inside points are available, but
inefficient.
 The Feasible Set
Slope of the feasible frontier gives the marginal rate of transformation (MRT)-
• it represents what amount of good Y has to be given up to consume one more unit of
good X. (Here, how many marks you have to sacrifice to enjoy one more hour of free
time.)
• Opportunity cost of good X (opportunity cost of free time)
• Thus, it reflects the tradeoffs that an individual is constrained to make between X and Y.

The frontier is downward because of the trade-off involved. The increase in free time
reduces the hours of study and therefore, the marks.
The frontier is concave in nature.*It is because of diminishing marginal productivity.
 Preferences - Indifference Curves
Preferences are represented by
indifference curves.
Indifference curves show
all combinations of goods that give
the same utility (satisfaction) B

Slope of the IC gives the marginal rate of

substitution (MRS) :represents the tradeoffs
that an individual is willing to make (how much
C
amount of scores you are WILLING to give up to
enjoy one more hour of free time).
 Decision-making under
scarcity(Constrained choice
problem)
 Constrained choice problem

• MRS : the marks she is willing to give up for one hour of free time
• MRT : the marks she would actually give up for one hour of free
time
 Optimal Decision Making
The optimal utility is obtained when
MRS = MRT
The amount of one good the
individual is willing to trade off for
the other good (MRS)
equals the actual tradeoff between
the two goods (MRT)
Another example: production
 Another example: production
• Optimal choice will be :
At A, where MRS = MRT(
considering FF – feasible set)

To the left of A, MRS>MRT: to increase free time by

one hour, (s)he is willing to give up higher amount of
grains than constrained to give up, so, will increase
the free time.

To the right of A, MRS<MRT: the grains (s)he is

willing to give up is lesser than what (s)he is
constrained to give up, so, will decrease the free
time.

At A, MRS = MRT, amount of grains willing to give up

is equal to what (s)he has to give up for an extra
hour of free time, so, stays put there.
 Another Example: Labour decision
How many hours to work?
People spend some of their time enjoying
leisure and some of it working so they can
afford to buy consumption goods. The
essence of the time-allocation problem is
the trade-off between leisure and
consumption.

Here, the feasible set is called the Budget

set; and the feasible frontier is known as
Budget constraint as it tells about the
affordability.
Suppose, the wage per hour is 15. The
equation of the budget constrained will be
given as: C = 15(24-leisure time).
 Another Example: Labour
decision
• The Budget Constraint gives how much worth of consumption HAS TO BE
GIVEN UP to enjoy an extra hour of free time (MRT)

• The trade off involved between each hour of leisure and consumption (MRT)
is constant, that is 15, hence, the budget constraint is the straight line.

• The slope of IC gives how much worth of consumption the consumer is

WILLING TO GIVE UP to enjoy an extra hour of free time (MRT)

• The optimal is achieved at A, where MRS = MRT.

 What happens when the feasible frontier
changes?

With technological productivity (say

introduction of new software, new machines)
the feasible set can expand as shown in the
image for students and producers. (The
students can score more, or the producers can
produce more for each hour of working time.)
What happens when the
feasible frontier changes?
• With increased
productivity, wages also
increase which will
expand the feasible set for
labour in the same
manner.
What happens when the
feasible frontier changes?
• Now, with expanded feasible set, how does the
optimal choice change?
• The person can
• Continue with same amount of same amount of free
time and enjoy higher produce/earnings/ sores, or

• Might increase the amount of both free time as well

as produce/earnings/scores in an intermediate
amount (Point E in the dia), or

• Can reduce the free time and enjoy substantial

increase in produce/earnings/scores*

• They new choice can be to the left of A (initial

optimal), or to right of A, or straight up at A.
D. Income and Substitution Effects
 Two important effects

An expanded feasible set (either due to technological

productivity/ wage increase/price reduction) will have 2 effects:
• Income effect: the change in optimal choice when real
income/ purchasing power changes.

• Substitution effect: the change in optimal choice when the

trade off involved between the two goods changes.
 Income effect
Income effect = the change in optimal choice when income (purchasing
power) changes, keeping opportunity costs (the budget constraint slope)
fixed.

Income effect is always positive (for the goods you value). As purchasing
power increases, you prefer to increase the amount of all goods you value
(assuming more is better).

For instance, a raise in wage increases the purchasing power -> thus, the
income effect gives incentives to increase free time and consumption.
 Substitution effect
Substitution effect is the change in optimal choice due to change in
opportunity cost (or the trade off involved). It arises when one good becomes
expensive/cheaper than before.
Substitution says, “a person will always reduce the amount of good that is
becoming expensive, or will increase the amount of good that is becoming
cheaper.”

For instance, with increase in wages free time becomes expensive (giving up
higher wages for each hour of free time), so, by substitution effect the person
will have incentives to reduce free time (substitute free time with work) and
increase consumption.
 Overall effect on optimal choice
Overall effect = Income effect + Substitution effect

• With increase in wages:

Income effect is positive: increase free time (increase hours of free time)
and consumption
Substitution effect is negative for free time (decrease hours of free time)
and positive for consumption
• What will be the net impact? It will be determined by which effect
dominates for an individual, which in turn depends on the preferences
So, if SE>IE – decrease free time and increase consumption by a substantial amount
If IE>SE – increase free time along with the consumption
If IE = SE - keep free time at the same level and enjoy higher consumption
 Is this a good model?
• As student and a consumer, you make so many decisions every day. But, you
never decide by writing down budget constraints and indifference curves.

• No consumer goes through the explicit optimization envisioned in the

theory. Yet consumers are aware that their choices are constrained by their
financial resources and time. And given those constraints, they do the best
they can to achieve the highest level of satisfaction.

• The theory of consumer choice tries to describe this implicit, psychological

process in a way that permits explicit, economic analysis, which helps in
analysing preferences, framing better policies.
E. Applications
 How do wages affect labour
supply?
• The increase in wages create:
• SE – as free time becomes expensive. It gives incentives to reduce free
time and increase consumption.
• IE – as income increases. It gives incentives to increase free time and
consumption.

So, labour can increase as well as decrease the supply with increase in
wages(or technological productivity) depending upon the preferences.
 Increased overtime wage rate
• SE : gives you incentives to reduce the free time
• IE : no income effect

• Labour ss will be increased.

Effect of increase in lump sum
income
• Say, you won a lottery and therefore, your income increases.

• There is no substitution effect. The wage rate is same as before. Thus, you give
up the same amount of earnings for an extra hour of free time as before. Free
time has not become expensive.

• But your income has increased, so there is an income effect, which will give
you incentives to increase free time.

• Thus, the new optimal after winning lottery income will definitely lie to the
right of initial optimal (showing increase in free time).
Effect of increase in lump sum
income
• The feasible frontier will shift parallelly upward (not pivot)
 Could This Happen in the Real
World???
• The results from studies of lottery winners are striking. Of those
winners who win more than $50,000, almost 25 percent quit working
within a year, and another 9 percent reduce the number of hours they
work. Of those winners who win more than $1 million, almost 40
percent stop working. The income effect on labour supply of winning
such a large prize is substantial.
• Similar results were found in a 1993 study, published in the Quarterly
Journal of Economics, of how receiving a bequest affects a person’s
labour supply. The study found that a single person who inherits more
than $150,000 is four times as likely to stop working as a single person
who inherits less than $25,000.
 How do interest rates affect
household saving?
• An important decision that every person faces is how much income to
consume today and how much to save for the future.
• The two goods which involve trade –off will be consumption when
young and consumption when old.
• We can use the theory of choice to analyse how people make this
decision and how the savings depend on the interest rate.
How do interest rates affect
household saving?
How do interest rates affect
household saving?
Now, suppose the interest rate rises.
Substitution effect
• Current consumption becomes more expensive relative to future consumption.
• Gives incentives to reduce current consumption (so, increase savings) and
increase future consumption
Income effect
• Can afford more consumption in both the present and the future. So, its like you
are becoming richer. It gives incentives to increase both goods that you value.
• Give you incentives to increase current consumption (so, reduce savings) and
increase future consumption.
How do interest rates affect
household saving?
So, if
• SE > IE : reduce current consumption (so, increase savings) and increase
future consumption
• IE>SE: increase current consumption (so, reduce savings) and increase future
consumption.
• IE= SE: keep current consumption same (so, same savings) and enjoy higher
future consumption.

Thus, savings might go up or down as well. Future consumption goes up

in all cases.
How do interest rates affect
household saving?
• This ambiguous result is interesting from the standpoint of economic theory, but it is
disappointing from the standpoint of economic policy.

• It raises a concern pertaining to an important policy : if interest income should be taxed or not?

• Some economists have advocated reducing the taxation on interest and other capital income,
arguing that such a policy change would raise the after-tax interest rate that savers can earn
and would thereby encourage people to save more.

• Other economists have argued that because of offsetting income and substitution effects, such
a tax change might not increase savings and could even reduce it.

• Unfortunately, research has not led to a consensus about how interest rates affect savings.
 Summary
1. Decision-making model under scarcity
• Indifference curves represent preferences, the slope
gives MRS – the trade-off you are willing to make
between two goods
• Feasible frontier represents availability, the slope gives
MRT – the actual trade-off involved between the two
goods
• Utility-maximizing choice where MRS = MRT
 Summary
• As the feasible set expands, there are 2 affects that come into play and decide
the effect on the optimal choice:

• Income effect: arises from the change in purchasing power (gives incentives to
increase the amount of good that a person values)

• Substitution effect: arises from the change in trade off involved (gives incentives
to increase the amount of good that becomes cheaper, or gives incentives to
decrease the amount of good that becomes expensive )

• Overall impact : depends up on which effect dominates for the person.

 Another example : Consumer
• Consumer consumes various items of goods. Suppose, it’s a two good
economy. Given the fixed amount of income, the consumer choice is
to analyse how a person allocates income between two goods.

• So, now we have good X and good Y on both axis. The feasible set
gives the set of all affordable bundles – known as Budget set.

• The budget constraint gives the combination of goods when the

entire money is utilised.
The slope of Budget Constraint gives :
how many units of good Y has to be
Another example :
given up to increase good X by one
unit.*
Consumer
Quantity of
The slope of IC shows how many units chocolates
of good Y you are willing to give up to
increase good X by one unit.

Optimal occurs where, MRS = MRT.

To the left: MRS>MRT – willing to give
up more number of chocolates than
constrained to give up for another
packet of chip, so will inc the qty of
chips.
To the right: MRS<MRT – willing to give
up fewer number of chocolates than
constrained to give up for another
packet of chip, so will dec the qty of
chips.
Quantity of
chips
What happens when the
feasible frontier changes?
• For consumers, if
price of a good Y
falls, then it will also
expand the feasible
set in the similar
fashion.