Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary

Principles of Economics1 3. Scarcity, work, and choice

Giuseppe Vittucci Marzetti2

SCOR Department of Sociology and Social Research University of Milano-Bicocca

A.Y. 2018-19

1These slides are based on the material made available under Creative Commons BY-NC-ND © 4.0 by the CORE Project , https://www.core-econ.org/. 2Department of Sociology and Social Research, University of Milano-Bicocca, Via Bicocca degli Arcimboldi 8, 20126, Milan, E-mail: [email protected] Giuseppe Vittucci Marzetti Principles of Economics 1/26 Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary Layout

1 Income and working hours across time and countries

2 Scarcity and choice: key concepts Production function, average productivity and marginal productivity Preferences and indifference curves Opportunity cost Feasible frontier

3 Decision-making under scarcity Constrained choices and optimal decision making Labor choice Income effect and substitution effect Effect of technological change on labor choices

4 Concluding remarks and summary Concluding remarks Summary

Giuseppe Vittucci Marzetti Principles of Economics 2/26 Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary Income and free time across countries

Figure: Annual hours of free time per worker and income (2013)

Giuseppe Vittucci Marzetti Principles of Economics 3/26 Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary Income and working hours across time and countries

Figure: Annual hours of work and income (18702000)

Living standards have greatly increased since 1870. There are disparities in free time and income across countries.

Giuseppe Vittucci Marzetti Principles of Economics 4/26 Income and working hours across time and countries Scarcity and choice: key concepts Decision-making under scarcity Concluding remarks and summary Labor productivity, income and free time

Labor is an input in the production of goods and services. New technologies raise labor productivity. How would that affect living standards? How would that affect the free time and working hours chosen by individuals? Modeling individual choices to explain the differences in work hours across countries and over time.

Giuseppe Vittucci Marzetti Principles of Economics 5/26 Income and working hours across time and countries Production function, average productivity and marginal productivity Scarcity and choice: key concepts Preferences and indifference curves Decision-making under scarcity Opportunity cost Concluding remarks and summary Feasible frontier A simple production function Production functions show how inputs (e.g. labor) translate into outputs (e.g. goods and services), holding other factors constant. Example: a production function of a student shows how study hours produce the final grade.

Giuseppe Vittucci Marzetti Principles of Economics 6/26 Income and working hours across time and countries Production function, average productivity and marginal productivity Scarcity and choice: key concepts Preferences and indifference curves Decision-making under scarcity Opportunity cost Concluding remarks and summary Feasible frontier Average and marginal productivity

Marginal product (or productivity): change in output per unit change in input (evaluated at a given point, holding other inputs constant). Average product (or productivity): average output per unit of input.

Giuseppe Vittucci Marzetti Principles of Economics 7/26 Income and working hours across time and countries Production function, average productivity and marginal productivity Scarcity and choice: key concepts Preferences and indifference curves Decision-making under scarcity Opportunity cost Concluding remarks and summary Feasible frontier Diminishing marginal productivity: the law of diminishing marginal returns

Giuseppe Vittucci Marzetti Principles of Economics 8/26 Income and working hours across time and countries Production function, average productivity and marginal productivity Scarcity and choice: key concepts Preferences and indifference curves Decision-making under scarcity Opportunity cost Concluding remarks and summary Feasible frontier Choices, preferences and indifference curves

Choices depend on preferences. Indifference curves: combinations of goods that give the same utility. The Marginal Rate of Substitution (MRS): is the slope of the indifference curve; represents the trade-offs that an individual faces.

Giuseppe Vittucci Marzetti Principles of Economics 9/26 Income and working hours across time and countries Production function, average productivity and marginal productivity Scarcity and choice: key concepts Preferences and indifference curves Decision-making under scarcity Opportunity cost Concluding remarks and summary Feasible frontier Preferences and indifference curves

The curves we have drawn capture our typical assumptions about people’s preferences between two goods. Indifference curves slope downward due to trade-offs: if you are indifferent between two combinations, the combination that has more of one good must have less of the other good. Higher indifference curves correspond to higher utility levels: as we move up and to the right in the diagram, further away from the origin, we move to combinations with more of both goods. Indifference curves are usually smooth: small changes in the amounts of goods don’t cause big jumps in utility. Indifference curves do not cross. As you move to the right along an indifference curve, it becomes flatter: it is reasonable to assume that the more free time and the lower the grade the student has, the less willing she is to sacrifice further percentage points in return for free time, so her MRS is lower.

Giuseppe Vittucci Marzetti Principles of Economics 10/26 Income and working hours across time and countries Production function, average productivity and marginal productivity Scarcity and choice: key concepts Preferences and indifference curves Decision-making under scarcity Opportunity cost Concluding remarks and summary Feasible frontier Opportunity cost

Opportunity cost The opportunity cost of an action is the net benefit of the next best alternative action.

Opportunity costs are relevant whenever choices are limited by constraints and involve trade-offs, i.e. alternative and mutually exclusive courses of action (e.g. higher grades vs. more free time). Compare actions based on economic cost: Economic cost = Direct (monetary and non-monetary) costs + Opportunity costs If the benefit from an action exceeds the economic costs, you receive an economic rent from choosing it.

Giuseppe Vittucci Marzetti Principles of Economics 11/26 Income and working hours across time and countries Production function, average productivity and marginal productivity Scarcity and choice: key concepts Preferences and indifference curves Decision-making under scarcity Opportunity cost Concluding remarks and summary Feasible frontier Opportunity cost: example

Giuseppe Vittucci Marzetti Principles of Economics 12/26 Income and working hours across time and countries Production function, average productivity and marginal productivity Scarcity and choice: key concepts Preferences and indifference curves Decision-making under scarcity Opportunity cost Concluding remarks and summary Feasible frontier The feasible frontier The feasible frontier shows the maximum output that can be achieved with a given amount of input The Marginal Rate of Transformation (MRT): is the slope of the feasible frontier; represents the tradeoffs that an individual faces.

Giuseppe Vittucci Marzetti Principles of Economics 13/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Constrained choice problem

Model of how individuals choose, given their preferences and the constraints they face, when the things they value are scarce. Studying example: Free time and exam score are scarce because they are both goods, each with an opportunity cost.

Giuseppe Vittucci Marzetti Principles of Economics 14/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Optimal decision making

The utility-maximizing choice is where 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) MRS = MRT

Giuseppe Vittucci Marzetti Principles of Economics 15/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Another example: grain production

(a) Production function (b) Feasible frontier

Tradeoff between grain produced and free time. Technological change shifts the production function upwards, and expands the feasible frontier.

Giuseppe Vittucci Marzetti Principles of Economics 16/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Effect of the technological change on individual choices

Technological progress makes it feasible to both consume more and have more free time. Choice of free time/consumption depends on relative preferences and willingness to substitute one good for another.

Giuseppe Vittucci Marzetti Principles of Economics 17/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Choice between income and free time Budget constraints are the feasible frontiers for consumption choices. The optimal choice is where the slope of the indifference curve (MRS) equals the wage (MRT).

Giuseppe Vittucci Marzetti Principles of Economics 18/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Income effect and substitution effect

Wage changes affect the slope of the budget constraint (MRT). A wage increase has two effects: income effect: total earnings increase, holding working hours fixed; substitution effect: the opportunity cost of free time increases.

Giuseppe Vittucci Marzetti Principles of Economics 19/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Income effect

The optimal choice changes when income changes, keeping opportunity costs (the budget constraint slope) fixed. A wage increase gives more income per hour worked ⇒ incentive to decrease working hours.

Giuseppe Vittucci Marzetti Principles of Economics 20/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Substitution effect

The optimal choice changes when the opportunity cost changes, at the new level of utility. A wage increase raises the opportunity cost of free time ⇒ incentive to increase hours worked.

Giuseppe Vittucci Marzetti Principles of Economics 21/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Overall effect on labor choice

Income effect is negative. Substitution effect is positive. Which effect dominates depends on individual preferences. Overall effect = Income effect + Substitution effect

Giuseppe Vittucci Marzetti Principles of Economics 22/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Working hours: differences over time

Income and substitution effects can explain trends in working hours. E.g. In the US, the income effect dominated the substitution effect, so consumption and free time both increased.

Giuseppe Vittucci Marzetti Principles of Economics 23/26 Income and working hours across time and countries Constrained choices and optimal decision making Scarcity and choice: key concepts Labor choice Decision-making under scarcity Income effect and substitution effect Concluding remarks and summary Effect of technological change on labor choices Working hours: cross-country differences

Differences in working hours can be explained by preferences that differ across countries. There are other possible explanations.

Giuseppe Vittucci Marzetti Principles of Economics 24/26 Income and working hours across time and countries Scarcity and choice: key concepts Concluding remarks Decision-making under scarcity Summary Concluding remarks and summary Is this a good model?

Not realistic: People don’t actually do MRS/MRT calculations. Most people cannot choose their working hours. But still a good approximation: Over time, people learn what combination of working hours and free time suits them best. Working hours can change due to culture and politics (indirect choice). People can choose which jobs to apply for. It helps us understand real-world phenomena: Preferences and income/substitution effects can explain differences in working hours across countries and over time.

Giuseppe Vittucci Marzetti Principles of Economics 25/26 Income and working hours across time and countries Scarcity and choice: key concepts Concluding remarks Decision-making under scarcity Summary Concluding remarks and summary Summary

Economics is the science that studies human behaviour as a re- lationship between given ends and scarce means which have al- ternative uses. (Robbins, 1932)

Simple model of decision-making under scarcity Indifference curves represent preferences; Feasible frontier represents choice constraints; Utility-maximizing choice where MRS = MRT. Used model to explain effect of technological change on labor choices Overall effect = Income effect + Substitution effect Limitations of model: it omits important factors

Giuseppe Vittucci Marzetti Principles of Economics 26/26