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PROFESSOR: All right.

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So today we are going to start
by reviewing income and

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substitution effects.

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Because that's a pretty hard
concept and pretty central to

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a lot of what we'll do for
the rest of the semester.

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And then we're going to dive
in and talk about an

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application, a more interesting
application, of

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income and substitution effects
which is the effects

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of wages on labor supply.

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So let's review.

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If you take the handout, grab
the handout and look at the

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first figure, it's the same
as the last figure of the

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previous lecture.

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To review, remember, whenever
the price changes, a price

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change can be decomposed into
two effects, the substitution

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effect and the income effect.

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The substitution effect is the
change in the quantity

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demanded when the
price changes,

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holding utility constant.

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And as we proved last
time, that is always

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negative, 0 or negative.

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It is always non-positive.

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It's always true that when
a price goes up, the

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substitution effect
is negative.

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We proved that both
mathematically and graphically

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last time showing that if you're
going to hold utility

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constant, and the price of a
good is going to go up, you're

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going to shift away
from that good.

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OK.

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That's the substitution
effect.

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In our example, we showed
graphically how you measure a

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substitution effect.

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You draw a new imaginary budget
constraint, BC3, which

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is parallel to the new budget
constraint, BC2.

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So it's got the new price ratio
but tangent to the old

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indifference curve.

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So the key thing to understand
is the imaginary budget

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constraint, BC3, where
it comes from.

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It's parallel to the new
budget constraint.

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That is it's got the new
marginal rate of

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transformation, the new slope,
but it's tangent to the old

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indifference curve.

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That gets you to point B. And so
the movement from A to B is

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the substitution effect.

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Then we have an income effect
which is, in fact, utility

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isn't held constant when
prices change.

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In fact, utility falls, because

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you're effectively poorer.

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You're effectively poorer.

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Utility is falling.

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And since you're effectively
poorer, that further reduces

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demand if the good is normal.

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So if it's a normal good, if
it's a good where lower income

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causes less consumption of
it, the fact that you're

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effectively poorer further
lowers the consumption from

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point B to point C.

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So the total price effect is the
one we demonstrated at the

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beginning of the last lecture.

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We raised the price of movies
from $8 to $12.

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And we saw the number
of movies consumed

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fell from 6 to 4.

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But what we can see now to
understand what's underneath

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that is two things, an effect of
the fact that prices change

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holding utility constant,
and the fact that you're

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effectively poorer.

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And that's the key thing.

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No, your income hasn't
actually gone down.

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But that $96 your parents gave
you can buy you less.

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Your opportunity set has
been restricted.

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And that makes you effectively
poorer.

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And so you buy less
for that reason.

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And so you get the total
movement from A to C.

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Now, as we emphasized last time,
this will be the case if

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it's a normal good.

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So substitution effects
are done.

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Substitute effects are
always negative,

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nothing fun about that.

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Income effects are a little
more interesting, because

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goods can be not normal
but inferior.

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We have inferior goods which
are ones such that they're

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crummy stuff that as your
income goes up, you

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want less of it.

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And that can change
the analysis.

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So if we look at Figure 7-2,
now we're talking about the

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price change with an
inferior good.

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And now imagine someone
choosing

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between steak and potatoes.

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So now the choice is between
steak and potatoes.

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And steak costs $5 a pound,
initially, and potatoes cost

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$1 a pound.

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Initially, you have
an income of $25.

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So someone has an income
of y equals $25.

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The price of steak is $5, and
the price of potatoes is $1.

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So your budget constraint, your
original BC1, runs from

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you can either have 5 steak, or
25 potatoes, or something

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in between.

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And so individuals choose
point A where they're

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consuming 8.3 potatoes.

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They choose point A.

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I don't know what the
number of steaks is.

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We probably also ought to label
that, the number of

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steaks that comes from that.

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But whatever.

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It comes out of the
utility function.

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So then we say, now let's
imagine that the price of

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potatoes rises to $3 a pound.

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There's a blight on the potatoes
like there was in

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Ireland in the 1800s.

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There's a potato blight, and
that shifts in the supply

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curve for potatoes raising the
price of potatoes from $1 a

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pound to $3 a pound.

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Now, what we know is that that
will move consumers, given the

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utility function that we've
chosen here, that will move

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consumers from point A to point
C. Once again, that's

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not labeled, but some lower
amount of potatoes.

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That will move them from point
A to point C. So, ultimately,

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they'll choose fewer potatoes
and fewer steaks.

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But, in fact, what we can see is
that's the composition of a

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substitution effect which is
negative, and an income effect

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which is positive.

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So if we do our standard
decomposition, we draw a new

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monetary budget constraint
BC3.

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It's parallel to the new budget
constraint, BC2, so the

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same price ratio.

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It's parallel.

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But it's tangent to the old
indifference curve at point B

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which is actually to the left
of the ultimate choice at

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point C.

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So the substitution effect
takes us from A to B. The

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income effect actually takes us
back from B to C. That is

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as that budget constraint shifts
from BC3 to BC2, as you

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get poorer, you choose
more potatoes.

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So the substitution effect would
say that from the price

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change of potatoes alone, we go
all the way to point B. We

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massively reduce our consumption
of potatoes.

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But because we're poorer,
effectively, we now consume

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more potatoes.

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Because we're effectively
poorer, we now

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consume more potatoes.

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And so, on net, you get
a reduction in potato

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consumption.

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But it offsets the substitution
effect.

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So that's when income effects
can be a little more

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interesting.

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It's going to be a little more
interesting exercise.

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When you think about substitute
effects in the same

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way, it's not that
interesting.

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It's just look, quantity fell.

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It doesn't really matter why.

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You don't see, in
the real world,

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substitution income effects.

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What's interesting is when
they're opposed to each other.

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That's when it gets
more interesting.

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And so you see this small
reduction you get from the

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substitution effect alone.

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By the way, there's
two handouts.

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Right?

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Jessica, is there
two handouts?

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There should be.

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There's tables as well.

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I didn't actually get it.

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Jessica, grab me one of those.

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There's tables as
well as graphs.

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So make sure you have
both handouts.

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Anyone else need tables?

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Am I the only one who
didn't get it?

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OK, good.

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So, in principle, the income
effect could be so large it

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could offset the substitution
effect.

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There's no reason,
theoretically,

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that couldn't happen.

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That is, in principle, you could
derive preferences such

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that the income effect is
so large it offsets the

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substitution effect--
thank you--

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and the price increase actually
leads to more

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potatoes being consumed.

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That is what we'd call
a Giffen good as I

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talked about last time.

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So if you look at the table,
the top table, this sort of

00:08:25.730 --> 00:08:29.110
lays out our possibilities.

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So look at the top table.

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It sort of maps out the possible
sets of things that

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can happen.

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So if we have a normal good,
and the price of that good

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rises, then we know that the

00:08:39.789 --> 00:08:42.270
substitution effect is negative.

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The income effect is negative.

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So the total effect
is negative.

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Quantity falls.

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That's the law of demand.

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We talked about that
last time, downward

00:08:48.750 --> 00:08:50.430
sloping demand curves.

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Likewise, if the price
falls, the

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substitution effect is positive.

00:08:53.910 --> 00:08:55.090
The income effect is positive.

00:08:55.090 --> 00:08:58.050
You're now richer because the
price of the good fell.

00:08:58.050 --> 00:09:00.200
And so, therefore,
demand goes up.

00:09:00.200 --> 00:09:02.300
Quantity consumed goes up, once
again, downward sloping

00:09:02.300 --> 00:09:03.230
demand curve.

00:09:03.230 --> 00:09:04.870
Price rises, you consume
less of it.

00:09:04.870 --> 00:09:06.060
Price falls, you consume
more of it.

00:09:06.060 --> 00:09:08.460
That's what we learned about
in the first lecture.

00:09:08.460 --> 00:09:12.730
However, once goods are
inferior, all bets are off.

00:09:12.730 --> 00:09:14.910
Because now the income effect
is the opposite sign of the

00:09:14.910 --> 00:09:15.720
substitution effect.

00:09:15.720 --> 00:09:18.360
It's possible it could
be larger.

00:09:18.360 --> 00:09:20.770
So the total effect
is ambiguous.

00:09:20.770 --> 00:09:24.810
You could actually get an upward
sloping demand curve.

00:09:24.810 --> 00:09:27.610
You could actually get that a
price rise leads to more of a

00:09:27.610 --> 00:09:30.290
good, and a fall leads
to less of a good.

00:09:30.290 --> 00:09:31.390
Now will you?

00:09:31.390 --> 00:09:32.720
Only if it's a Giffen good.

00:09:32.720 --> 00:09:34.610
And, in fact, there's a lot of
controversy in economics about

00:09:34.610 --> 00:09:36.500
whether any good in the world
has ever been a Giffen good.

00:09:36.500 --> 00:09:39.600
At most, there's maybe one or
two examples people can find.

00:09:39.600 --> 00:09:42.760
Even then, it's controversial.

00:09:42.760 --> 00:09:45.890
So I think it's fine in life to
assume that demand curves

00:09:45.890 --> 00:09:46.850
slope down.

00:09:46.850 --> 00:09:49.000
I think, in fact, I don't see
convincing evidence that any

00:09:49.000 --> 00:09:51.250
subset or set of goods
are Giffen goods.

00:09:51.250 --> 00:09:53.480
I think it's just generally fine
it life to assume demand

00:09:53.480 --> 00:09:55.450
curves slope down.

00:09:55.450 --> 00:09:57.420
Nonetheless, it's important to
understand this theoretical

00:09:57.420 --> 00:10:00.000
possibility even if it's
just theoretical.

00:10:00.000 --> 00:10:01.570
Because it's important to
understand income and

00:10:01.570 --> 00:10:03.690
substitution effects.

00:10:03.690 --> 00:10:04.440
OK.

00:10:04.440 --> 00:10:08.710
Questions about that, either
on substitution effect or

00:10:08.710 --> 00:10:10.860
price changes?

00:10:10.860 --> 00:10:11.450
OK.

00:10:11.450 --> 00:10:15.330
So now, armed with that, let's
go onto the more interesting

00:10:15.330 --> 00:10:17.095
case which is labor supply.

00:10:17.095 --> 00:10:19.710
It's more interesting, because
as I'll come to in a few

00:10:19.710 --> 00:10:24.510
minutes, we talk about labor
supply, labor is typically

00:10:24.510 --> 00:10:26.090
going to be an inferior good.

00:10:26.090 --> 00:10:27.890
So things are going to get a
little more interesting.

00:10:27.890 --> 00:10:29.600
So let's talk about that.

00:10:29.600 --> 00:10:32.940
So the question you want to ask
here is how hard do folks

00:10:32.940 --> 00:10:33.690
decide to work?

00:10:33.690 --> 00:10:38.430
How many hours of labor do
folks decide to provide?

00:10:38.430 --> 00:10:40.970
As we talked about when we
talked about minimum wage,

00:10:40.970 --> 00:10:44.360
just as we all have to decide
between consuming pizza and

00:10:44.360 --> 00:10:47.670
consuming movies, or consuming
steak and consuming potatoes,

00:10:47.670 --> 00:10:50.380
we also have to decide between
how much labor we're going to

00:10:50.380 --> 00:10:52.690
provide and how much we're
going to consume.

00:10:52.690 --> 00:10:55.210
The more labor you provide to
the market, the more you

00:10:55.210 --> 00:10:58.170
consume, but the less
fun you get to have.

00:10:58.170 --> 00:11:00.040
Fun, we call leisure.

00:11:00.040 --> 00:11:02.840
The less labor you provide to
the market, the more fun you

00:11:02.840 --> 00:11:04.630
get to have, the more leisure
you get, but the less you get

00:11:04.630 --> 00:11:06.470
to consume, because you
have less income.

00:11:06.470 --> 00:11:08.200
And that's the trade-off we
talked about when we talked

00:11:08.200 --> 00:11:10.230
about the effect of
minimum wage.

00:11:10.230 --> 00:11:12.430
Now let's come back and
get underneath that

00:11:12.430 --> 00:11:13.840
labor supply curve.

00:11:13.840 --> 00:11:14.770
So we talked about
the minimum wage.

00:11:14.770 --> 00:11:18.600
We talked about the labor supply
curve which was how the

00:11:18.600 --> 00:11:21.750
hours you provide respond to
the wage and a labor demand

00:11:21.750 --> 00:11:24.030
curve, which was how the
hours that firms want

00:11:24.030 --> 00:11:25.140
respond to the wage.

00:11:25.140 --> 00:11:28.330
Now let's get underneath
the supply curve.

00:11:28.330 --> 00:11:30.240
A minute ago, we were talking
about the demand curves and

00:11:30.240 --> 00:11:31.900
getting underneath the demand
curve for consumers.

00:11:31.900 --> 00:11:35.940
Well, now let's get underneath
the supply curve for labor.

00:11:35.940 --> 00:11:42.410
Now, the key thing is that when
we talk about labor, it's

00:11:42.410 --> 00:11:44.480
not a good, it's a bad.

00:11:44.480 --> 00:11:46.480
The typical person doesn't
want to work.

00:11:46.480 --> 00:11:48.280
The typical person is
not in this room.

00:11:48.280 --> 00:11:49.770
You guys like to work.

00:11:49.770 --> 00:11:51.770
The typically person actually
doesn't like to work.

00:11:54.610 --> 00:11:59.750
Leisure is a normal good.

00:12:02.360 --> 00:12:05.250
For the typical person, leisure
is a normal good.

00:12:05.250 --> 00:12:06.600
They like time off.

00:12:13.160 --> 00:12:17.430
Leisure is a good, which
means labor is a bad.

00:12:17.430 --> 00:12:19.870
They don't like to work.

00:12:19.870 --> 00:12:21.000
The problem is we don't
know how to

00:12:21.000 --> 00:12:24.450
model bads in economics.

00:12:24.450 --> 00:12:26.020
It's just we're used to
trading off between

00:12:26.020 --> 00:12:26.900
two things you want.

00:12:26.900 --> 00:12:28.980
When I used to trade-off, we
know how to model something

00:12:28.980 --> 00:12:30.630
you want to get something
you don't want.

00:12:30.630 --> 00:12:32.600
Indifference curves wouldn't
work, because

00:12:32.600 --> 00:12:34.020
more wouldn't be better.

00:12:34.020 --> 00:12:36.130
If you drew an indifference
curve for labor, it would

00:12:36.130 --> 00:12:37.960
violate the more is
better assumption.

00:12:37.960 --> 00:12:38.730
Because you wouldn't
want more.

00:12:38.730 --> 00:12:40.480
You'd want less.

00:12:40.480 --> 00:12:43.320
So the modeling trick we're
going to use whenever we're

00:12:43.320 --> 00:12:48.880
modeling bads, is to model the
complementary good and then,

00:12:48.880 --> 00:12:51.930
in the end, solve for the bad.

00:12:51.930 --> 00:12:53.020
We're not going to
model labor.

00:12:53.020 --> 00:12:55.100
We're going to model leisure.

00:12:55.100 --> 00:12:58.790
And given the total amount of
hours you have to supply, the

00:12:58.790 --> 00:13:00.680
total hours minus the
amount of leisure is

00:13:00.680 --> 00:13:02.320
the amount of labor.

00:13:02.320 --> 00:13:03.880
So we're going to
model leisure.

00:13:03.880 --> 00:13:05.660
We're going to model the
good and then solve for

00:13:05.660 --> 00:13:08.080
labor at the end.

00:13:08.080 --> 00:13:10.210
So, in other words, if you have
24 hours a day you can

00:13:10.210 --> 00:13:16.230
work, then your amount of hours
of work is 24 minus the

00:13:16.230 --> 00:13:20.880
amount of leisure N. Call it N
or call it L. We'll call it N

00:13:20.880 --> 00:13:24.320
because L, typically, we
think of as labor.

00:13:24.320 --> 00:13:26.750
Let's call leisure N for
reasons I don't quite

00:13:26.750 --> 00:13:27.220
understand.

00:13:27.220 --> 00:13:29.430
Let's just use that.

00:13:29.430 --> 00:13:31.370
Basically the amount
of hours you can

00:13:31.370 --> 00:13:33.120
work is 24 minus leisure.

00:13:33.120 --> 00:13:37.440
So if we solve for the optimal
amount of leisure you want, we

00:13:37.440 --> 00:13:41.300
can obviously get the amount
of labor you supply.

00:13:41.300 --> 00:13:44.160
So the trick when modeling a bad
is not to model the bad.

00:13:44.160 --> 00:13:46.840
It's to model the complementary
good.

00:13:46.840 --> 00:13:49.720
In this case, the complementary
good is leisure.

00:13:49.720 --> 00:13:53.670
So we're going to model the
trade-off between leisure and

00:13:53.670 --> 00:13:59.030
consumption and use the result
of that to solve for the

00:13:59.030 --> 00:14:01.640
amount of labor you supply.

00:14:01.640 --> 00:14:04.190
So it's the general modeling
trick you need to understand,

00:14:04.190 --> 00:14:05.980
which is turn a bad
into a good.

00:14:05.980 --> 00:14:07.240
That's the modeling trick.

00:14:07.240 --> 00:14:08.230
Because we know how
to model the

00:14:08.230 --> 00:14:09.330
trade-off between two goods.

00:14:09.330 --> 00:14:12.110
We don't know how to model
the trade-off with a bad.

00:14:12.110 --> 00:14:16.710
So to think about that, let's
go to Figure 7-3, and let's

00:14:16.710 --> 00:14:20.740
talk about what's underneath
a labor supply curve.

00:14:20.740 --> 00:14:25.860
What's underneath a labor supply
curve is the trade-off

00:14:25.860 --> 00:14:30.130
between how much leisure you
want and how much consumption

00:14:30.130 --> 00:14:33.690
you can have. So you see here,
here's a trade-off.

00:14:33.690 --> 00:14:37.080
On the y-axis is the amount
of goods you can have. You

00:14:37.080 --> 00:14:38.680
earn a wage, w.

00:14:38.680 --> 00:14:40.610
The y-axis is the amount of
goods you can have from a

00:14:40.610 --> 00:14:43.080
day's work.

00:14:43.080 --> 00:14:44.820
So you earn w per hour.

00:14:44.820 --> 00:14:46.650
That means the most goods
you can have from a

00:14:46.650 --> 00:14:47.540
day's work is 24w.

00:14:47.540 --> 00:14:50.310
If you worked all 24 hours
at that wage, you

00:14:50.310 --> 00:14:53.170
can have 24w goods.

00:14:53.170 --> 00:14:56.760
On the other hand, if you work
not at all, then you take 24

00:14:56.760 --> 00:15:01.820
hours in leisure and have no
consumption from that day.

00:15:01.820 --> 00:15:04.030
So we see as you move
to the right on the

00:15:04.030 --> 00:15:05.730
x-axis, that's leisure.

00:15:05.730 --> 00:15:06.840
That's the good.

00:15:06.840 --> 00:15:08.290
As you move to the left,
that's labor.

00:15:08.290 --> 00:15:09.540
That's the bad.

00:15:09.540 --> 00:15:10.220
OK?

00:15:10.220 --> 00:15:10.930
That's just illustrating.

00:15:10.930 --> 00:15:12.090
But we're going to
model the good.

00:15:12.090 --> 00:15:13.340
We're going to model leisure.

00:15:16.330 --> 00:15:18.740
Your trade-off is between how
much you want to consume and

00:15:18.740 --> 00:15:20.810
how much leisure you
want to take.

00:15:20.810 --> 00:15:22.060
Now, here's what's
interesting.

00:15:25.940 --> 00:15:27.920
In general, what determines
the slope of a budget

00:15:27.920 --> 00:15:29.170
constraint?

00:15:31.010 --> 00:15:32.930
What determines the slope
of a budget constraint?

00:15:32.930 --> 00:15:34.640
AUDIENCE: Marginal rate
of transformation.

00:15:34.640 --> 00:15:35.556
PROFESSOR: Which is what?

00:15:35.556 --> 00:15:37.300
AUDIENCE: Ratio between
prices.

00:15:37.300 --> 00:15:38.190
PROFESSOR: Ratio
between prices.

00:15:38.190 --> 00:15:40.180
Prices determine the slope
of the budget constraint.

00:15:40.180 --> 00:15:41.260
But here's what's tricky.

00:15:41.260 --> 00:15:44.830
What's the price of leisure?

00:15:44.830 --> 00:15:45.700
AUDIENCE: Wage.

00:15:45.700 --> 00:15:46.180
PROFESSOR: The wage.

00:15:46.180 --> 00:15:46.985
Why?

00:15:46.985 --> 00:15:51.645
AUDIENCE: Because for every hour
you take having leisure,

00:15:51.645 --> 00:15:54.452
you are effectively using
money that you

00:15:54.452 --> 00:15:55.330
could gain at work.

00:15:55.330 --> 00:15:56.090
PROFESSOR: Exactly.

00:15:56.090 --> 00:16:03.390
The key is the economic concept
of opportunity cost,

00:16:03.390 --> 00:16:06.040
which we've talked about and
will continue to talk about

00:16:06.040 --> 00:16:10.780
this semester, opportunity cost.
By not working, you are

00:16:10.780 --> 00:16:13.120
forgoing earning a wage.

00:16:13.120 --> 00:16:15.500
So that is the price
of leisure.

00:16:15.500 --> 00:16:17.290
You may not think of it this
way, but, once again, that's

00:16:17.290 --> 00:16:19.530
why we're the dismal science.

00:16:19.530 --> 00:16:21.650
When you go home today, and you
sit on the couch, and you

00:16:21.650 --> 00:16:25.990
watch TV for an hour, you
have just paid a price.

00:16:25.990 --> 00:16:27.710
And that price is what you
could have earned by

00:16:27.710 --> 00:16:29.760
working that hour.

00:16:29.760 --> 00:16:31.510
Every action has a price.

00:16:31.510 --> 00:16:38.040
And the price of leisure is the
wage you forgo, The wage

00:16:38.040 --> 00:16:42.850
you forgo by sitting around
is the price of leisure.

00:16:50.010 --> 00:16:54.760
Let's assume here that the price
of goods is $1, that the

00:16:54.760 --> 00:16:57.200
goods you're going
to buy cost $1.

00:16:57.200 --> 00:16:58.560
Whatever your consumption,
it costs $1.

00:16:58.560 --> 00:16:59.730
That's the trick we always
use with modeling.

00:16:59.730 --> 00:17:01.600
Make as many things
$1 as you can.

00:17:01.600 --> 00:17:02.870
That makes the model easy.

00:17:02.870 --> 00:17:04.609
So let's assume that the price
of the goods you're going to

00:17:04.609 --> 00:17:05.990
buy are $1.

00:17:05.990 --> 00:17:09.760
So the slope of the budget
constraint is minus w over 1.

00:17:09.760 --> 00:17:11.569
The slope of the budget
constraint is just the price

00:17:11.569 --> 00:17:13.990
of leisure which is minus w .

00:17:13.990 --> 00:17:17.440
So the trade-off with the price
of goods of $1, the

00:17:17.440 --> 00:17:21.800
trade-off between taking leisure
and consuming is that

00:17:21.800 --> 00:17:25.410
if you take leisure,
an hour of leisure,

00:17:25.410 --> 00:17:26.789
you get w fewer goods.

00:17:29.470 --> 00:17:32.500
And if you work an hour, you get
w more goods, but you lose

00:17:32.500 --> 00:17:34.780
an hour of leisure.

00:17:34.780 --> 00:17:39.150
And that gives you the trade-off
between how much you

00:17:39.150 --> 00:17:41.190
consume and how much leisure you
take which determines how

00:17:41.190 --> 00:17:42.660
much you work.

00:17:42.660 --> 00:17:42.960
OK.

00:17:42.960 --> 00:17:45.530
Questions about that?

00:17:45.530 --> 00:17:49.290
Now let's take this framework
and ask, what happens when the

00:17:49.290 --> 00:17:51.810
wage changes, Figure 7-4.

00:17:54.630 --> 00:17:57.780
So we have an original
outcome with the

00:17:57.780 --> 00:17:59.030
budget constraint BC1.

00:18:06.780 --> 00:18:10.320
We have an original budget
constraint, BC1.

00:18:10.320 --> 00:18:15.700
Now imagine the wage goes
up, so we move to BC2.

00:18:15.700 --> 00:18:18.770
BC2 is a budget constraint
with a higher wage.

00:18:18.770 --> 00:18:20.290
The wage goes up.

00:18:20.290 --> 00:18:23.020
So what we're going to see is
you're going to move from

00:18:23.020 --> 00:18:27.720
point A where you work N1 hours
to point C where you

00:18:27.720 --> 00:18:30.030
work N3 hours.

00:18:30.030 --> 00:18:32.250
That's where your indifference
curves are tangent with the

00:18:32.250 --> 00:18:33.500
new budget constraint.

00:18:35.920 --> 00:18:36.730
Not work, take leisure.

00:18:36.730 --> 00:18:37.300
I'm sorry.

00:18:37.300 --> 00:18:40.470
We take leisure of N1 hours
to leisure of N3 hours.

00:18:40.470 --> 00:18:42.920
The wage going up
has reduced your

00:18:42.920 --> 00:18:45.790
leisure which makes sense.

00:18:45.790 --> 00:18:47.580
If the wage goes up,
you work harder.

00:18:47.580 --> 00:18:48.270
Right?

00:18:48.270 --> 00:18:50.750
So your wage going up, we always
first take if there's a

00:18:50.750 --> 00:18:52.850
leisure and then convert
to labor.

00:18:52.850 --> 00:18:59.010
Wage goes up, leisure falls
from N1 to N3, which means

00:18:59.010 --> 00:19:00.720
labor goes up.

00:19:00.720 --> 00:19:03.360
But actually two things are
happening here, the

00:19:03.360 --> 00:19:05.740
substitution and
income effect.

00:19:05.740 --> 00:19:09.830
The substitution effect, which
we see by drawing the

00:19:09.830 --> 00:19:15.040
imaginary budget constraint BC*
which is parallel to BC2

00:19:15.040 --> 00:19:18.100
but tangent to the original
difference curve, the

00:19:18.100 --> 00:19:22.240
substitution effect is a very
large reduction in leisure.

00:19:22.240 --> 00:19:25.895
It moves all the way
from N1 to N2.

00:19:25.895 --> 00:19:27.590
The substitution effect
is a very large

00:19:27.590 --> 00:19:28.930
reduction in leisure.

00:19:28.930 --> 00:19:33.760
The income effect is that
leisure is a normal good.

00:19:33.760 --> 00:19:36.830
I'm now richer, because
my wage has gone up.

00:19:36.830 --> 00:19:39.570
So I want to buy more of it.

00:19:39.570 --> 00:19:41.430
So I buy more leisure.

00:19:41.430 --> 00:19:45.620
And that moves me
from N2 to N3.

00:19:45.620 --> 00:19:50.700
So, basically, now the income
effect offsets the

00:19:50.700 --> 00:19:54.690
substitution effect even with
a normal good, or with a

00:19:54.690 --> 00:19:55.860
normal good.

00:19:55.860 --> 00:19:57.800
With a normal good, the income
effect offsets that

00:19:57.800 --> 00:19:59.950
substitution effect.

00:19:59.950 --> 00:20:03.220
And that's because the money
you're getting, you're using

00:20:03.220 --> 00:20:06.210
to buy leisure.

00:20:06.210 --> 00:20:10.940
So, in fact, if you flip to 7-5,
you can see a case where

00:20:10.940 --> 00:20:12.190
the income effect dominates.

00:20:19.460 --> 00:20:22.410
And you actually get that a
wage increase leads you to

00:20:22.410 --> 00:20:24.600
work less hard.

00:20:24.600 --> 00:20:25.160
Now, think about that.

00:20:25.160 --> 00:20:25.970
If I'd said to you--

00:20:25.970 --> 00:20:27.200
I probably should have
started with this--

00:20:27.200 --> 00:20:29.540
if you increase the wage, will
people work more or less hard?

00:20:29.540 --> 00:20:31.110
Your initial instinct would
have been more hard.

00:20:31.110 --> 00:20:32.730
You would have thought, well,
if your wage goes

00:20:32.730 --> 00:20:33.580
up, you work harder.

00:20:33.580 --> 00:20:34.990
But that's because your instinct
was focused on the

00:20:34.990 --> 00:20:36.660
substitution effect.

00:20:36.660 --> 00:20:37.920
You're thinking about
the income effect.

00:20:37.920 --> 00:20:41.200
Here's a case where
I started at N1.

00:20:41.200 --> 00:20:43.610
The substitution effect
leads me to N2.

00:20:43.610 --> 00:20:47.410
But I feel so much richer from
that higher wage that I

00:20:47.410 --> 00:20:48.870
actually move all
the way to N3.

00:20:48.870 --> 00:20:53.690
My leisure goes up, and
I work less hard.

00:20:53.690 --> 00:20:59.280
Now, unlike a Giffen good, this
is totally plausible.

00:20:59.280 --> 00:21:00.750
Why is it plausible?

00:21:00.750 --> 00:21:02.980
Well, let me do give you
a simple intuition

00:21:02.980 --> 00:21:04.470
for why it's plausible.

00:21:04.470 --> 00:21:08.280
Let's say that you're someone
who has a certain amount of

00:21:08.280 --> 00:21:09.980
things you want to
buy every week.

00:21:09.980 --> 00:21:12.250
You don't save. You have a
certain amount of things you

00:21:12.250 --> 00:21:13.320
want to buy every week.

00:21:13.320 --> 00:21:15.210
You have to pay your rent, you
have to buy your food, you

00:21:15.210 --> 00:21:17.740
have to buy your other goodies,
a certain budget.

00:21:17.740 --> 00:21:19.440
A lot of people live
on a budget.

00:21:19.440 --> 00:21:20.710
You have a certain budget.

00:21:20.710 --> 00:21:23.220
And the truth is you're happy
with that budget.

00:21:23.220 --> 00:21:25.420
That's kind of what
you want to do.

00:21:25.420 --> 00:21:28.070
Now let's say I doubled
your wage.

00:21:28.070 --> 00:21:31.550
Well, now to meet the budget you
can work half as hard and

00:21:31.550 --> 00:21:33.620
still meet the same budget.

00:21:33.620 --> 00:21:36.780
So you'll work less hard.

00:21:36.780 --> 00:21:39.370
You could say, look, I can get
more leisure and consume the

00:21:39.370 --> 00:21:42.070
same amount of goods
as I did before.

00:21:42.070 --> 00:21:44.410
So I'll work less hard.

00:21:44.410 --> 00:21:45.640
That's a totally
plausible case.

00:21:45.640 --> 00:21:48.340
That's a case of what we
call target income.

00:21:48.340 --> 00:21:51.370
If someone has a target income,
and their wage goes

00:21:51.370 --> 00:21:53.790
up, they'll work less.

00:21:53.790 --> 00:21:56.120
Now, that's not necessarily
the truth.

00:21:56.120 --> 00:21:59.240
But it's, at least to me, sort
of a plausible case of how

00:21:59.240 --> 00:22:01.380
people might behave. And that's
a case where income

00:22:01.380 --> 00:22:03.630
effects can dominate.

00:22:03.630 --> 00:22:12.480
So if we, once again, go to the
second chart on that page,

00:22:12.480 --> 00:22:13.500
now we see the income
and substitution

00:22:13.500 --> 00:22:14.750
effects for labor supply.

00:22:19.700 --> 00:22:21.380
Once again, we're assuming
leisure is a normal good.

00:22:21.380 --> 00:22:22.610
We're always going to assume
leisure is a normal good.

00:22:22.610 --> 00:22:25.050
We're never going to assume
people don't like leisure.

00:22:25.050 --> 00:22:29.530
Assuming leisure is a normal
good, then as the wage rises,

00:22:29.530 --> 00:22:33.260
the substitution effect is
you take less leisure.

00:22:33.260 --> 00:22:34.720
This table is a bit different
than the other table.

00:22:34.720 --> 00:22:36.370
Instead of the first panel being
normal and the second

00:22:36.370 --> 00:22:38.670
panel being inferior,
the first panel is

00:22:38.670 --> 00:22:39.930
what happens to leisure.

00:22:39.930 --> 00:22:42.750
The second panel converts it
to what happens to labor.

00:22:42.750 --> 00:22:45.530
So for instance, in the first
cell, when the wage rises, the

00:22:45.530 --> 00:22:48.300
substitution effect on leisure
is unambiguously negative.

00:22:48.300 --> 00:22:50.810
You clearly take less leisure
when the wage rises.

00:22:50.810 --> 00:22:53.100
So, likewise, you
have more labor.

00:22:53.100 --> 00:22:55.530
So on the bottom panel, labor
is clearly greater than or

00:22:55.530 --> 00:22:56.710
less than 0.

00:22:56.710 --> 00:23:00.240
But the income effect is
positive for leisure.

00:23:00.240 --> 00:23:01.450
You're rich, you take
more leisure.

00:23:01.450 --> 00:23:04.110
Or, likewise, negative for
labor, you're richer, so your

00:23:04.110 --> 00:23:05.480
work less hard.

00:23:05.480 --> 00:23:09.550
And, therefore, the
net is ambiguous.

00:23:09.550 --> 00:23:15.240
So with goods consumption, we
needed goods to be inferior

00:23:15.240 --> 00:23:17.630
for there to be a Giffen
good type phenomena.

00:23:17.630 --> 00:23:23.500
Here, even with leisure being
normal, you can have a Giffen

00:23:23.500 --> 00:23:24.530
good type phenomena.

00:23:24.530 --> 00:23:26.250
It's much less random.

00:23:26.250 --> 00:23:28.430
And, in some sense, this
is why we learn income

00:23:28.430 --> 00:23:29.540
substitution effects.

00:23:29.540 --> 00:23:31.750
To be honest, they're just
not that interesting for

00:23:31.750 --> 00:23:32.970
consumption.

00:23:32.970 --> 00:23:34.800
The book makes a big deal out
of them and talks about

00:23:34.800 --> 00:23:36.420
consumer price indices
and all that.

00:23:36.420 --> 00:23:38.920
It's just not that important
for consumption.

00:23:38.920 --> 00:23:40.240
Because we know in consumption
if prices goes

00:23:40.240 --> 00:23:41.670
up, you consume less.

00:23:41.670 --> 00:23:43.010
It's just not that
interesting.

00:23:43.010 --> 00:23:45.570
It's much more interesting for
things like labor supply.

00:23:45.570 --> 00:23:47.420
And we talk about savings
in a number of lectures.

00:23:47.420 --> 00:23:48.700
It's the same thing.

00:23:48.700 --> 00:23:49.550
There, it's more interesting.

00:23:49.550 --> 00:23:51.560
Because now they can often
offset each other in

00:23:51.560 --> 00:23:53.100
meaningful ways.

00:23:53.100 --> 00:23:55.210
And so now this is why the
tools of income and

00:23:55.210 --> 00:23:58.220
substitution effects become
much more important.

00:23:58.220 --> 00:23:59.890
OK?

00:23:59.890 --> 00:24:09.230
So if we put this together, if
we go to Figure 7-6, we can

00:24:09.230 --> 00:24:13.640
now think about deriving where
labor supply comes from.

00:24:13.640 --> 00:24:15.770
Where does labor supply
come from?

00:24:15.770 --> 00:24:17.960
Well, first, you've got the
consumer's decision of how

00:24:17.960 --> 00:24:18.600
hard to work.

00:24:18.600 --> 00:24:19.270
So here's a case.

00:24:19.270 --> 00:24:23.440
It's sort of small, but
you can take a look.

00:24:23.440 --> 00:24:26.920
Here's a case where you've got
someone initially working,

00:24:26.920 --> 00:24:30.110
taking 16 hours of leisure and,
therefore, working eight

00:24:30.110 --> 00:24:32.750
hours, at a wage of W1.

00:24:38.780 --> 00:24:41.250
Now their wage goes up to W2.

00:24:41.250 --> 00:24:44.100
They choose to take 12 hours
of leisure and, therefore,

00:24:44.100 --> 00:24:48.890
work 12 hours.

00:24:48.890 --> 00:24:50.920
This is someone who works harder
when the wage goes up.

00:24:50.920 --> 00:24:52.600
That is, the income effect
does not offset the

00:24:52.600 --> 00:24:55.600
substitution effect.

00:24:55.600 --> 00:24:59.670
Now, we can take that to draw
a demand for leisure curve

00:24:59.670 --> 00:25:02.050
just like we drew any
other demand curve.

00:25:02.050 --> 00:25:04.080
It's the same technique
as last time.

00:25:04.080 --> 00:25:07.700
Just bring those point and say,
look, at a wage of W1,

00:25:07.700 --> 00:25:08.780
leisure is 16.

00:25:08.780 --> 00:25:10.250
At a wage of W2,
leisure is 12.

00:25:10.250 --> 00:25:13.500
We have a downward sloping
demand for leisure, standard

00:25:13.500 --> 00:25:15.180
downward sloping demand
for leisure.

00:25:15.180 --> 00:25:19.063
But we can convert that to a
supply of labor, which is what

00:25:19.063 --> 00:25:19.340
we care about.

00:25:19.340 --> 00:25:21.300
Nobody cares about the demand
for leisure curve.

00:25:21.300 --> 00:25:24.270
We care about the supply
of labor curve.

00:25:24.270 --> 00:25:26.210
You just subtract
these from 24.

00:25:26.210 --> 00:25:29.880
You use the supply of labor
curve which is upward sloping.

00:25:29.880 --> 00:25:32.780
So as long as substitution
effects dominate income

00:25:32.780 --> 00:25:37.610
effects, we'll get an upward
sloping labor supply curve.

00:25:37.610 --> 00:25:42.900
But it's certainly possible
that if income effects

00:25:42.900 --> 00:25:45.900
dominates substitution effects,
you could get a

00:25:45.900 --> 00:25:50.180
downward sloping supply curve,
if you will, what we call in

00:25:50.180 --> 00:25:53.720
labor economics, a
backward-bending supply curve,

00:25:53.720 --> 00:25:55.260
a supply curve that goes
the wrong way.

00:25:55.260 --> 00:25:57.600
Instead of sloping up like
supply curves are supposed to,

00:25:57.600 --> 00:26:00.280
it goes the wrong way
and slopes down.

00:26:00.280 --> 00:26:01.890
And we can see that's
plausible.

00:26:01.890 --> 00:26:03.900
The target income case I
just described to you

00:26:03.900 --> 00:26:05.500
would deliver that.

00:26:05.500 --> 00:26:07.660
The target income case I just
described to you would deliver

00:26:07.660 --> 00:26:09.450
a downward sloping
supply of labor.

00:26:09.450 --> 00:26:11.740
As the wage rose, people would
work less and less.

00:26:14.620 --> 00:26:17.240
That's a totally
plausible case.

00:26:17.240 --> 00:26:18.770
And that's why income and
substitution effects are

00:26:18.770 --> 00:26:19.370
interesting.

00:26:19.370 --> 00:26:21.540
Because they can deliver
this weird result.

00:26:21.540 --> 00:26:25.050
They can get the wrong
signed supply curve.

00:26:25.050 --> 00:26:27.790
Questions about income
and substitution

00:26:27.790 --> 00:26:31.620
effects or labor supply?

00:26:31.620 --> 00:26:34.330
So what I want to spend the
rest of the lecture on is

00:26:34.330 --> 00:26:38.570
talking about well,
what is the case?

00:26:38.570 --> 00:26:40.750
Do labor supply curves
slope up or down?

00:26:40.750 --> 00:26:41.970
And what do we know
about that?

00:26:41.970 --> 00:26:46.600
Well, this is probably the major
focus of a field we call

00:26:46.600 --> 00:26:47.850
labor economics.

00:26:49.990 --> 00:26:52.570
And there's an excellent course
on labor economics,

00:26:52.570 --> 00:26:56.045
14.64 taught by Josh Angrist,
which goes into much detail in

00:26:56.045 --> 00:26:56.730
the entire field.

00:26:56.730 --> 00:26:59.810
But one of the main focuses of
the field is understanding the

00:26:59.810 --> 00:27:02.560
elasticity of labor supply,
and is it positive or

00:27:02.560 --> 00:27:04.270
negative, and how big is it.

00:27:04.270 --> 00:27:06.250
So, basically, measuring the
slope of the labor supply

00:27:06.250 --> 00:27:08.320
curve is the focus of this
literature, the elasticity of

00:27:08.320 --> 00:27:09.940
the labor supply.

00:27:09.940 --> 00:27:12.730
Now, what I want to do is start
with a historical fact,

00:27:12.730 --> 00:27:13.960
and then I'll come to
the modern age.

00:27:13.960 --> 00:27:16.110
Let's think about
30 years ago.

00:27:16.110 --> 00:27:20.250
30 years ago, all men
worked and less than

00:27:20.250 --> 00:27:21.550
half of women worked.

00:27:21.550 --> 00:27:24.610
It was more normal for women
not to work than to work,

00:27:24.610 --> 00:27:25.250
married women.

00:27:25.250 --> 00:27:25.590
I'm sorry.

00:27:25.590 --> 00:27:27.060
Less than half of married
women worked.

00:27:30.790 --> 00:27:32.630
Now, married women could work.

00:27:32.630 --> 00:27:36.230
I'm not talking 60 years ago
or 80 years ago when there

00:27:36.230 --> 00:27:37.340
were marriage bars.

00:27:37.340 --> 00:27:39.730
Literally, firms wouldn't hire
you if you were married.

00:27:39.730 --> 00:27:40.420
It's true.

00:27:40.420 --> 00:27:41.500
If you're interested in
that, you can actually

00:27:41.500 --> 00:27:42.700
read Claudia Goldin.

00:27:42.700 --> 00:27:45.530
She's a labor historian who's
written about the early 20th

00:27:45.530 --> 00:27:46.760
century when, literally,
women could be

00:27:46.760 --> 00:27:48.670
fired for being married.

00:27:48.670 --> 00:27:49.790
We're not talking
about that era.

00:27:49.790 --> 00:27:51.710
I'm talking about 30 years ago
when you could work if you

00:27:51.710 --> 00:27:52.090
were married.

00:27:52.090 --> 00:27:53.030
It's no problem.

00:27:53.030 --> 00:27:59.400
But most women chose not to,
maybe 40 years ago now.

00:27:59.400 --> 00:28:03.750
So, in that case, let's think
about two groups.

00:28:03.750 --> 00:28:10.260
Let's think about married
men, and let's think

00:28:10.260 --> 00:28:12.520
about married women.

00:28:12.520 --> 00:28:17.730
And let's just posit,
hypothetically, how big we

00:28:17.730 --> 00:28:21.190
think their substitution and
income effects would be.

00:28:26.600 --> 00:28:28.560
Let's start with substitution
effect.

00:28:28.560 --> 00:28:33.050
Do we think the substitution
effect would be bigger?

00:28:33.050 --> 00:28:36.740
This is the change in the wage
holding utility constant.

00:28:36.740 --> 00:28:39.180
Do we think that would have a
bigger effect on leisure and,

00:28:39.180 --> 00:28:42.280
therefore, labor for men
or for women and why?

00:28:42.280 --> 00:28:42.900
Don't yell it out.

00:28:42.900 --> 00:28:44.570
Somebody, raise their
hand and tell me.

00:28:44.570 --> 00:28:46.726
Do we think that the
substitution effect would be

00:28:46.726 --> 00:28:51.080
bigger for men or
women and why?

00:28:51.080 --> 00:28:51.830
Remember the name.

00:28:51.830 --> 00:28:52.950
It's the substitution effect.

00:28:52.950 --> 00:28:54.200
That's the key to the answer.

00:28:58.520 --> 00:28:58.785
Yeah.

00:28:58.785 --> 00:29:02.000
AUDIENCE: I think it would be
the same, because they each

00:29:02.000 --> 00:29:05.444
have equal use for the goods.

00:29:05.444 --> 00:29:08.396
Maybe their income effect
would be different.

00:29:08.396 --> 00:29:08.888
PROFESSOR: OK.

00:29:08.888 --> 00:29:10.190
[UNINTELLIGIBLE PHRASE].

00:29:10.190 --> 00:29:11.565
They each have equal
use for the goods.

00:29:11.565 --> 00:29:12.840
Well let's deal with where
the substitution

00:29:12.840 --> 00:29:13.410
effect comes from.

00:29:13.410 --> 00:29:16.600
Let's break it down.

00:29:16.600 --> 00:29:19.460
So you're someone
who's deciding.

00:29:19.460 --> 00:29:23.720
You've got you and your wife,
and you're each deciding how

00:29:23.720 --> 00:29:27.050
to respond to a change
in the wage.

00:29:27.050 --> 00:29:30.100
Now, you both value the
goods the same.

00:29:30.100 --> 00:29:32.490
But it's goods versus leisure.

00:29:32.490 --> 00:29:34.085
What's the other feature
that you're going

00:29:34.085 --> 00:29:35.280
to be thinking about?

00:29:35.280 --> 00:29:37.780
Think about a married man
40 years ago, and

00:29:37.780 --> 00:29:39.783
the wage goes down.

00:29:39.783 --> 00:29:41.900
AUDIENCE: They have
to work more.

00:29:41.900 --> 00:29:42.660
PROFESSOR: No.

00:29:42.660 --> 00:29:43.880
We're just doing substitution
effects.

00:29:43.880 --> 00:29:44.240
That's unambiguous.

00:29:44.240 --> 00:29:45.980
If the goes down,
they work less.

00:29:45.980 --> 00:29:47.120
We're just doing substitution
effects.

00:29:47.120 --> 00:29:48.220
That's ambiguous.

00:29:48.220 --> 00:29:52.540
The question is, if they work
less, what do they do?

00:29:52.540 --> 00:29:55.360
Whereas think about a married
women 40 years ago.

00:29:55.360 --> 00:29:56.680
If she works less,
what does she do?

00:29:56.680 --> 00:29:58.670
What does a married man do?

00:29:58.670 --> 00:29:59.340
Nothing.

00:29:59.340 --> 00:30:00.060
There's nothing to do.

00:30:00.060 --> 00:30:01.050
Your friends are all at work.

00:30:01.050 --> 00:30:03.250
You can't go play golf.

00:30:03.250 --> 00:30:04.360
You can't do anything.

00:30:04.360 --> 00:30:06.370
You don't take care of kids,
because men didn't take care

00:30:06.370 --> 00:30:08.910
of kids 40 years ago.

00:30:08.910 --> 00:30:09.670
What do you do?

00:30:09.670 --> 00:30:11.100
There's nothing to do.

00:30:11.100 --> 00:30:13.860
Whereas a woman, married woman,
if the wage goes down

00:30:13.860 --> 00:30:16.730
40 years ago, you can take
care of kids instead.

00:30:16.730 --> 00:30:18.840
You can hang out with other
women who aren't working.

00:30:18.840 --> 00:30:20.670
There's plenty to do.

00:30:20.670 --> 00:30:22.030
Based on that, now change
your answer.

00:30:22.030 --> 00:30:22.840
Where do you think
the substitution

00:30:22.840 --> 00:30:24.082
effect would be bigger?

00:30:24.082 --> 00:30:26.830
AUDIENCE: [INAUDIBLE PHRASE].

00:30:26.830 --> 00:30:28.160
PROFESSOR: In women,
it would be bigger.

00:30:28.160 --> 00:30:30.860
Because men, there's less of
a substitution effect.

00:30:30.860 --> 00:30:33.940
Because it's all about
substitutability of options.

00:30:33.940 --> 00:30:35.760
There's no good alternative
option to work for

00:30:35.760 --> 00:30:37.480
men 40 years ago.

00:30:37.480 --> 00:30:39.130
It's either work or nothing.

00:30:39.130 --> 00:30:41.870
Basically, everybody worked.

00:30:41.870 --> 00:30:44.620
So, basically, there's
no good substitution

00:30:44.620 --> 00:30:45.960
effect option for men.

00:30:45.960 --> 00:30:50.030
For women, there's lots
of outside options.

00:30:50.030 --> 00:30:54.300
There's sociability, there's
child rearing, et cetera.

00:30:54.300 --> 00:30:57.590
The substitution effect will
be larger the more things

00:30:57.590 --> 00:31:00.680
there are you can
substitute to.

00:31:00.680 --> 00:31:03.180
Men don't have anything to
substitute to from work.

00:31:03.180 --> 00:31:07.300
Women have options to substitute
to from work.

00:31:07.300 --> 00:31:09.870
For men, this is going
to be very small.

00:31:09.870 --> 00:31:13.750
For women, this will be big.

00:31:13.750 --> 00:31:15.820
We know the sign.

00:31:15.820 --> 00:31:18.090
The smallest this can be is 0.

00:31:18.090 --> 00:31:20.020
We know the sign.

00:31:20.020 --> 00:31:21.530
But it's going to be a very
small substitution effect,

00:31:21.530 --> 00:31:23.930
because I don't have
a lot else to do if

00:31:23.930 --> 00:31:24.560
my wage goes down.

00:31:24.560 --> 00:31:27.060
Women, if it's a low
wage, why work?

00:31:27.060 --> 00:31:29.060
You can be much more effective
taking care of the kids or

00:31:29.060 --> 00:31:30.010
hanging out with your friends.

00:31:30.010 --> 00:31:31.150
Why work for a low wage?

00:31:31.150 --> 00:31:34.100
Men, there's nothing
else to do.

00:31:34.100 --> 00:31:38.410
So that's the relative size to
the substitution effects.

00:31:38.410 --> 00:31:42.770
Now, the income effect, I think,
is a little bit harder.

00:31:42.770 --> 00:31:45.200
And let's come back and
think about what

00:31:45.200 --> 00:31:46.925
drives an income effect.

00:31:54.320 --> 00:31:57.810
We talked about the income
effect as being delta q over

00:31:57.810 --> 00:31:59.870
delta y, how much a
quantity changes

00:31:59.870 --> 00:32:01.750
when your income changes.

00:32:01.750 --> 00:32:03.670
But, in reality, what's going
to matter for your income

00:32:03.670 --> 00:32:08.660
effect given when you start
today, is going to be not only

00:32:08.660 --> 00:32:13.140
delta q over delta y, how your
taste for work changed or

00:32:13.140 --> 00:32:19.010
income changes, but also how
hard you worked to start.

00:32:19.010 --> 00:32:21.090
Think of it this way.

00:32:21.090 --> 00:32:25.550
The income effect is how much
richer you feel if your wage

00:32:25.550 --> 00:32:27.370
goes up, or how much
poorer you feel if

00:32:27.370 --> 00:32:28.900
your wage goes down.

00:32:28.900 --> 00:32:35.270
If you are working 0 hours,
the income effect is 0.

00:32:35.270 --> 00:32:37.110
You don't feel any richer if the
wage goes up, because you

00:32:37.110 --> 00:32:40.390
don't earn any money.

00:32:40.390 --> 00:32:43.800
The more hours you work the
bigger the income effect is,

00:32:43.800 --> 00:32:46.490
because the bigger that
shock is to you.

00:32:46.490 --> 00:32:48.620
So we can think of the income
effect, a shorthand for the

00:32:48.620 --> 00:32:56.140
income effect, is going to be
h times dh/dy, the hours you

00:32:56.140 --> 00:33:00.820
work times how your hours
change with your income.

00:33:00.820 --> 00:33:03.600
OK?

00:33:03.600 --> 00:33:06.450
Now, to prove this it involves
using complicated algebra.

00:33:06.450 --> 00:33:07.710
We're not going to get into
it in this course.

00:33:07.710 --> 00:33:09.960
I worked hard last night to
see if I could make the

00:33:09.960 --> 00:33:11.710
algebra less complicated,
and I can't.

00:33:11.710 --> 00:33:16.000
I just have to try to work
intuitively on this.

00:33:16.000 --> 00:33:19.050
The notion of the income effect
is bigger the more

00:33:19.050 --> 00:33:20.080
you're in the market.

00:33:20.080 --> 00:33:23.220
You can think about
it for goods too.

00:33:23.220 --> 00:33:28.260
Think about the income effect
of a change in the price of

00:33:28.260 --> 00:33:30.760
something you buy a lot
of for something you

00:33:30.760 --> 00:33:33.090
buy very little of.

00:33:33.090 --> 00:33:37.210
So let's say you're someone
who's buying two Starbucks a

00:33:37.210 --> 00:33:43.830
day, and you very rarely
go see a movie.

00:33:43.830 --> 00:33:47.570
Well, if the price of a movie
goes up 10%, or the price of

00:33:47.570 --> 00:33:49.500
Starbucks goes up 10%,
which is going to

00:33:49.500 --> 00:33:51.400
make you feel poorer?

00:33:51.400 --> 00:33:52.940
The price of Starbucks
going up, because you

00:33:52.940 --> 00:33:54.540
buy a lot of Starbucks.

00:33:54.540 --> 00:33:57.710
So how much poorer you'll feel,
or the income effect,

00:33:57.710 --> 00:34:01.840
will depend on your
starting point.

00:34:01.840 --> 00:34:04.160
The more you're in a market,
the more you'll feel the

00:34:04.160 --> 00:34:05.330
income effect.

00:34:05.330 --> 00:34:07.250
Now, based on that, who's going
to have a bigger income

00:34:07.250 --> 00:34:09.050
effect, men or women?

00:34:09.050 --> 00:34:10.800
Same person, what
do you think?

00:34:10.800 --> 00:34:13.100
The income effect is going to be
stronger the more you're in

00:34:13.100 --> 00:34:13.920
the market.

00:34:13.920 --> 00:34:15.062
So who's going to have a
bigger income effect?

00:34:15.062 --> 00:34:15.909
AUDIENCE: Married men would have
a bigger income effect.

00:34:15.909 --> 00:34:16.403
PROFESSOR: Exactly.

00:34:16.403 --> 00:34:18.920
Married men would have a bigger
income effect, because

00:34:18.920 --> 00:34:19.650
they're in the market.

00:34:19.650 --> 00:34:21.360
Married women, most of
them don't work.

00:34:21.360 --> 00:34:23.480
So there's no income effect.

00:34:23.480 --> 00:34:30.800
So this is going to be big for
men and small for women.

00:34:30.800 --> 00:34:32.650
There's another issue,
which is does dh/dy

00:34:32.650 --> 00:34:33.440
differ for men and women?

00:34:33.440 --> 00:34:35.000
I'll leave that alone.

00:34:35.000 --> 00:34:37.489
Let's assume they both have
the same underlying income

00:34:37.489 --> 00:34:39.230
elasticity.

00:34:39.230 --> 00:34:41.380
But, certainly, the initial
hours are much bigger from men

00:34:41.380 --> 00:34:42.630
than for women.

00:34:44.560 --> 00:34:49.020
So what does this mean in terms
of the labor supply

00:34:49.020 --> 00:34:52.239
curves you would see for married
men and married women

00:34:52.239 --> 00:34:55.460
40 years ago?

00:34:55.460 --> 00:34:57.830
Based on these facts, what
would you think?

00:34:57.830 --> 00:34:58.680
Yeah?

00:34:58.680 --> 00:34:59.770
AUDIENCE: They would have
opposite slopes.

00:34:59.770 --> 00:35:00.100
PROFESSOR: Yeah.

00:35:00.100 --> 00:35:02.590
So, in particular, the female
labor supply curve

00:35:02.590 --> 00:35:03.450
would look like what?

00:35:03.450 --> 00:35:04.848
It would slope up or down?

00:35:04.848 --> 00:35:06.720
AUDIENCE: It would slope up.

00:35:06.720 --> 00:35:07.880
PROFESSOR: It would slope up.

00:35:07.880 --> 00:35:12.500
You'd have an upward sloping
curve, because you'd have

00:35:12.500 --> 00:35:14.820
these big substitution effects
and small income effects.

00:35:14.820 --> 00:35:17.530
So it would look much more
like Figure 7-4.

00:35:21.680 --> 00:35:23.220
You'd have the big substitution
effect when the

00:35:23.220 --> 00:35:25.650
wage goes up and a small
offsetting income effect.

00:35:25.650 --> 00:35:27.750
Think about the woman who
is not working at all.

00:35:27.750 --> 00:35:29.340
She's now working at
all at $8 an hour.

00:35:29.340 --> 00:35:31.530
You raise her wage
to $12 an hour.

00:35:31.530 --> 00:35:32.650
She's like, hey, I wasn't
working at all.

00:35:32.650 --> 00:35:33.650
So there's no income effect.

00:35:33.650 --> 00:35:36.390
But now I'm going to go to
work and make some money.

00:35:36.390 --> 00:35:37.200
So it's upward sloping.

00:35:37.200 --> 00:35:40.690
But for men, it's going to look
more potentially like

00:35:40.690 --> 00:35:42.330
Figure 7-5.

00:35:42.330 --> 00:35:45.050
There's a small substitution
effect but a potentially big

00:35:45.050 --> 00:35:49.050
income effect or bigger
than women.

00:35:49.050 --> 00:35:51.160
Now, how big it is,
that's not clear.

00:35:51.160 --> 00:35:52.460
Because, once again, men
have nothing to do

00:35:52.460 --> 00:35:54.010
if they don't work.

00:35:54.010 --> 00:35:59.660
So it could be this ends up
being bigger and smaller.

00:35:59.660 --> 00:36:03.230
It's not clear how big
this ends up being.

00:36:03.230 --> 00:36:06.540
But it's at least possible that
you could have men having

00:36:06.540 --> 00:36:11.020
a backward-bending or downward
sloping labor supply curve.

00:36:11.020 --> 00:36:12.910
Because the income effect could
even more than offset

00:36:12.910 --> 00:36:14.950
the substitution effect.

00:36:14.950 --> 00:36:17.410
But, in reality, given the way
I set up the example, you'd

00:36:17.410 --> 00:36:18.660
think men would basically
have a pretty

00:36:18.660 --> 00:36:20.650
inelastic labor supply.

00:36:20.650 --> 00:36:23.090
You'd think, 40 years ago, these
things would basically

00:36:23.090 --> 00:36:25.950
both be 0, both offset.

00:36:25.950 --> 00:36:28.735
And, basically, you'd have a
situation where the change in

00:36:28.735 --> 00:36:30.000
the wages didn't matter
much for men.

00:36:32.940 --> 00:36:36.540
And, in fact, that's
what people found.

00:36:36.540 --> 00:36:38.570
This is a wonderful case of the
convergence of truth with

00:36:38.570 --> 00:36:41.020
theory and a wonderful chance
to see the power of some

00:36:41.020 --> 00:36:43.620
pretty simplistic theory.

00:36:43.620 --> 00:36:46.110
The intuition is exactly borne
out in the data, which is

00:36:46.110 --> 00:36:47.860
males, 40 years ago,
would have a very

00:36:47.860 --> 00:36:49.070
inelastic labor supply.

00:36:49.070 --> 00:36:51.660
Their labor supply curves were
virtually vertical and maybe

00:36:51.660 --> 00:36:52.410
backward-bending.

00:36:52.410 --> 00:36:54.920
There's some controversy
on that.

00:36:54.920 --> 00:36:56.190
Some estimates got
backward-bending.

00:36:56.190 --> 00:36:56.900
Some didn't.

00:36:56.900 --> 00:37:00.300
But there were certainly
not upward sloping.

00:37:00.300 --> 00:37:02.060
It was basically vertical.

00:37:02.060 --> 00:37:04.460
Women had a very few elastic
labor supply.

00:37:04.460 --> 00:37:07.380
The elasticity is estimated
to be around 1.

00:37:07.380 --> 00:37:10.490
That is every 1% change
in the wage lead to

00:37:10.490 --> 00:37:12.360
1% more labor supply.

00:37:12.360 --> 00:37:15.550
So that's a fairly elastic
labor supply for women.

00:37:15.550 --> 00:37:19.990
Where, for men, the estimate
was basically 0.

00:37:19.990 --> 00:37:21.920
And that's kind of neat, because
we're actually getting

00:37:21.920 --> 00:37:23.230
confirmation in the data
of what the theory

00:37:23.230 --> 00:37:25.960
would have told us.

00:37:25.960 --> 00:37:30.480
Now, someone else tell me what
do you think has happened over

00:37:30.480 --> 00:37:36.190
the last 40 years relative to
these elasticities of married

00:37:36.190 --> 00:37:39.305
men and married women.

00:37:39.305 --> 00:37:40.736
Yeah.

00:37:40.736 --> 00:37:43.836
AUDIENCE: The elasticity of
married women has gone down in

00:37:43.836 --> 00:37:45.510
the last 40 years--

00:37:45.510 --> 00:37:45.915
PROFESSOR: Why?

00:37:45.915 --> 00:37:47.390
Speak up so the class
can hear you.

00:37:47.390 --> 00:37:48.868
Why is that?

00:37:48.868 --> 00:37:51.832
AUDIENCE: Because women
work more often now

00:37:51.832 --> 00:37:52.326
than they did before.

00:37:52.326 --> 00:37:54.230
PROFESSOR: Women work
more often now.

00:37:54.230 --> 00:37:58.450
So the income effect is going to
be getting bigger for them.

00:37:58.450 --> 00:38:00.700
So the income effect is going
up, because their

00:38:00.700 --> 00:38:03.100
initial h is bigger.

00:38:03.100 --> 00:38:06.900
Plus there's actually now,
in some sense, less good

00:38:06.900 --> 00:38:08.420
opportunities if you're
not working.

00:38:08.420 --> 00:38:10.420
So when we had our first kid,
and we lived in Brookline,

00:38:10.420 --> 00:38:12.660
which is sort of an urban city,
and my wife decided to

00:38:12.660 --> 00:38:15.660
stay at home, she didn't have
moms to hang out with.

00:38:15.660 --> 00:38:17.680
It was just nannies
at the park.

00:38:17.680 --> 00:38:19.670
And it wasn't that much fun.

00:38:19.670 --> 00:38:23.130
And so, basically, the
substitution effect is

00:38:23.130 --> 00:38:25.550
shrinking, because the outside
options aren't quite as good

00:38:25.550 --> 00:38:29.760
as they were, as the norms
shift towards work.

00:38:29.760 --> 00:38:33.580
Whereas for men, actually it's
becoming more normal for men

00:38:33.580 --> 00:38:36.110
to be engaged in child care.

00:38:36.110 --> 00:38:38.840
My best friend is a
stay-at-home dad.

00:38:38.840 --> 00:38:42.770
It's becoming more normal
for that to happen.

00:38:42.770 --> 00:38:45.360
And so the substitution
effect is rising.

00:38:45.360 --> 00:38:47.720
It's not implausible that if
you cut a man's wage down,

00:38:47.720 --> 00:38:48.440
he'll just say forget it.

00:38:48.440 --> 00:38:49.050
My wife's going to work.

00:38:49.050 --> 00:38:50.340
I'm taking care of the kids.

00:38:50.340 --> 00:38:53.880
That would be socially
ostracizing 40 years ago.

00:38:53.880 --> 00:38:56.180
But it's not that odd now.

00:38:56.180 --> 00:38:58.850
And, likewise, as men are less
engaged in the labor force and

00:38:58.850 --> 00:39:00.930
spending more time at home,
their income effects are

00:39:00.930 --> 00:39:04.280
falling, because their
initial h is smaller.

00:39:04.280 --> 00:39:06.950
So you're getting a convergence
in these labor

00:39:06.950 --> 00:39:09.270
supply elasticities.

00:39:09.270 --> 00:39:11.050
What really seems to be
happening is mostly

00:39:11.050 --> 00:39:13.530
convergence down for women,
not much up for men.

00:39:13.530 --> 00:39:15.800
So men are maybe going
from 0 to 0.1.

00:39:15.800 --> 00:39:18.980
Women are coming from
like 1 to 1/2.

00:39:18.980 --> 00:39:21.880
So what you're seeing is that
men aren't actually working

00:39:21.880 --> 00:39:23.310
that much less.

00:39:23.310 --> 00:39:24.510
There's a few stay-at-home
dads.

00:39:24.510 --> 00:39:25.830
But they're still not
the majority.

00:39:25.830 --> 00:39:28.550
Women are working a lot
more, and kids are in

00:39:28.550 --> 00:39:30.520
child care a lot more.

00:39:30.520 --> 00:39:34.020
So what you're seeing over
time is you're seeing men

00:39:34.020 --> 00:39:35.860
being a little more responsive,
but not that much

00:39:35.860 --> 00:39:36.140
more responsive.

00:39:36.140 --> 00:39:39.380
They're still, basically,
working all the time.

00:39:39.380 --> 00:39:41.230
Women are working a lot
more and being more

00:39:41.230 --> 00:39:43.530
responsive to wages.

00:39:43.530 --> 00:39:49.690
And there's a reduction coming
in both women's leisure and

00:39:49.690 --> 00:39:52.840
production of child
care at home.

00:39:52.840 --> 00:39:57.790
Now, that raises a very
interesting question of is

00:39:57.790 --> 00:39:59.740
this is a good thing?

00:39:59.740 --> 00:40:01.430
Now this is a very deep
and hard topic.

00:40:01.430 --> 00:40:03.340
In economics, we think if people
do something it's good,

00:40:03.340 --> 00:40:06.200
or they wouldn't have done it.

00:40:06.200 --> 00:40:08.770
It is true that if you look
at data on self-reported

00:40:08.770 --> 00:40:14.020
well-being or happiness data,
married women report a general

00:40:14.020 --> 00:40:16.680
decline in happiness, over the
last 40 years, as they've

00:40:16.680 --> 00:40:20.100
entered the labor force
more and more.

00:40:20.100 --> 00:40:24.700
And the issue is, is this
something which is a good way

00:40:24.700 --> 00:40:27.560
for society to spend
its resources, to

00:40:27.560 --> 00:40:29.535
have everyone working?

00:40:29.535 --> 00:40:30.720
We're consuming more.

00:40:30.720 --> 00:40:32.370
Consumption has gone up.

00:40:32.370 --> 00:40:34.180
We're consuming more, but
we're getting less

00:40:34.180 --> 00:40:35.830
leisure as a family.

00:40:35.830 --> 00:40:37.370
Because the men aren't working
that much less.

00:40:37.370 --> 00:40:38.940
The women are working
a lot more.

00:40:38.940 --> 00:40:41.910
So we're getting less
leisure as a family.

00:40:41.910 --> 00:40:42.720
How do we feel about
that outcome.

00:40:42.720 --> 00:40:43.730
That's an interesting
question.

00:40:43.730 --> 00:40:47.000
And we'll talk about that some
more later on in the semester.

00:40:47.000 --> 00:40:48.040
OK.

00:40:48.040 --> 00:40:49.190
Questions about this?

00:40:49.190 --> 00:40:50.189
Yeah.

00:40:50.189 --> 00:40:51.439
AUDIENCE: [INAUDIBLE PHRASE].

00:41:08.540 --> 00:41:10.960
PROFESSOR: That's a really
good question.

00:41:10.960 --> 00:41:13.530
And let me talk about that
for a couple of minutes.

00:41:13.530 --> 00:41:23.320
The definition of unemployment
is those employed

00:41:23.320 --> 00:41:25.490
over looking for work.

00:41:29.480 --> 00:41:32.610
If the number of people employed
does not change, and

00:41:32.610 --> 00:41:35.770
women suddenly want to work, and
they report to surveyors

00:41:35.770 --> 00:41:38.680
that they're looking
for work--

00:41:38.680 --> 00:41:39.750
that's the employment rate.

00:41:39.750 --> 00:41:40.390
I'm sorry.

00:41:40.390 --> 00:41:41.660
The unemployment rate--

00:41:41.660 --> 00:41:42.370
I'm sorry--

00:41:42.370 --> 00:41:46.660
is going to be those looking
over employed.

00:41:46.660 --> 00:41:48.310
My bad.

00:41:48.310 --> 00:41:50.010
The unemployment rate
is going to be those

00:41:50.010 --> 00:41:52.060
looking over those employed.

00:41:52.060 --> 00:41:53.310
So the unemployment rate is how
many people are looking

00:41:53.310 --> 00:41:54.490
for work over how many
are employed.

00:41:54.490 --> 00:42:00.000
If women start suddenly looking
for work, and there's

00:42:00.000 --> 00:42:02.920
no jobs to be had, that will
raise the unemployment rate.

00:42:02.920 --> 00:42:06.670
So one thing that's been a focus
of a lot of research has

00:42:06.670 --> 00:42:09.700
been do increases in the
supply of labor lead to

00:42:09.700 --> 00:42:12.160
increases in unemployment?

00:42:12.160 --> 00:42:14.310
What you've expressed is what's
often called the lump

00:42:14.310 --> 00:42:15.820
of labour view.

00:42:15.820 --> 00:42:18.700
The lump of labour view is
basically the view that

00:42:18.700 --> 00:42:21.870
there's a fixed box of
production in the economy.

00:42:21.870 --> 00:42:24.450
And as more workers come in to
fill that box, there will be

00:42:24.450 --> 00:42:26.100
more unemployment.

00:42:26.100 --> 00:42:28.940
The alternative view is that
the economy is dynamic.

00:42:28.940 --> 00:42:31.940
And as more women are working,
and earning income, and buying

00:42:31.940 --> 00:42:34.490
stuff, that makes more jobs.

00:42:34.490 --> 00:42:37.100
So our standard of consumption
is way higher

00:42:37.100 --> 00:42:38.990
than 40 years ago.

00:42:38.990 --> 00:42:41.430
We all have much cooler stuff
than 40 years ago.

00:42:41.430 --> 00:42:46.170
You have no idea how bad life
sucked 40 years ago.

00:42:46.170 --> 00:42:48.200
We have way better stuff.

00:42:48.200 --> 00:42:50.680
We have that stuff, because
women are working and making

00:42:50.680 --> 00:42:52.810
the income to buy it, which
means people have to make it

00:42:52.810 --> 00:42:54.580
which makes jobs.

00:42:54.580 --> 00:42:56.910
So, in fact, the existing
evidence is labor supply

00:42:56.910 --> 00:43:00.390
shocks do not cause unemployment
increases.

00:43:00.390 --> 00:43:02.010
This is something I've
worked a lot on.

00:43:02.010 --> 00:43:07.210
What you see, a very interesting
case is in Europe.

00:43:07.210 --> 00:43:10.190
In the US and all over the
world, we have assistance of

00:43:10.190 --> 00:43:14.460
what we call Social Security,
a term you've

00:43:14.460 --> 00:43:15.780
all heard, I'm sure.

00:43:15.780 --> 00:43:21.400
The Social Security program is
a program which provides

00:43:21.400 --> 00:43:25.230
income when you're retired.

00:43:25.230 --> 00:43:28.280
So it provides income when
you're retired to help you

00:43:28.280 --> 00:43:29.760
deal with the fact that you
don't have a source of labor

00:43:29.760 --> 00:43:30.100
income anymore.

00:43:30.100 --> 00:43:33.060
And that's a program that
virtually every country, and

00:43:33.060 --> 00:43:34.570
all developed countries
have a very generous

00:43:34.570 --> 00:43:35.990
social security program.

00:43:35.990 --> 00:43:39.180
But they're different in the
US than in other countries.

00:43:39.180 --> 00:43:42.950
In the US, the way the social
security program works is when

00:43:42.950 --> 00:43:45.990
you hit 62, you get a choice.

00:43:45.990 --> 00:43:49.570
You can stop working and get
your benefits from Social

00:43:49.570 --> 00:43:53.350
Security, and then you get them
every year until you die.

00:43:53.350 --> 00:43:57.880
Or you can keep working, delay
getting your benefits, but

00:43:57.880 --> 00:44:00.700
they'll increase what you
get to offset the delay.

00:44:00.700 --> 00:44:03.800
So, in other words, if I retire
at 63 rather than 62,

00:44:03.800 --> 00:44:06.380
given that I'm going to die at
the same date, I'm going to

00:44:06.380 --> 00:44:08.600
get one fewer year of
benefits in my life.

00:44:08.600 --> 00:44:12.390
But they raise them by 6.7%
to compensate for that.

00:44:12.390 --> 00:44:14.430
So I get one fewer year of
benefits, but every year it's

00:44:14.430 --> 00:44:15.570
6.7% higher.

00:44:15.570 --> 00:44:17.570
And it turns out, given life
expectancy, that works out to

00:44:17.570 --> 00:44:19.440
be a roughly fair deal.

00:44:19.440 --> 00:44:22.080
So, basically, at 62, your
choice is I can get one more

00:44:22.080 --> 00:44:24.240
year of benefits or I
get higher benefits

00:44:24.240 --> 00:44:25.580
for one fewer years.

00:44:25.580 --> 00:44:27.940
And that's a choice that's
a roughly fair deal.

00:44:27.940 --> 00:44:28.180
OK.

00:44:28.180 --> 00:44:29.030
Questions about that?

00:44:29.030 --> 00:44:31.490
Am I making sense of that?

00:44:31.490 --> 00:44:34.310
In Europe, it's not
a fair deal.

00:44:34.310 --> 00:44:37.605
In Europe the way it works is
they say, you can get one more

00:44:37.605 --> 00:44:38.390
year of benefits.

00:44:38.390 --> 00:44:40.810
But if you decide to work this
year, we're not given you any

00:44:40.810 --> 00:44:44.050
more in the future.

00:44:44.050 --> 00:44:46.690
So let me describe how it works
in the Netherlands.

00:44:46.690 --> 00:44:50.430
At age 55, the Netherlands says,
if you decide to retire

00:44:50.430 --> 00:44:55.130
this year, we will replace 90%
of your wages in social

00:44:55.130 --> 00:44:56.800
security payments to make sure
your income doesn't suffer

00:44:56.800 --> 00:44:58.600
when you retire.

00:44:58.600 --> 00:45:02.160
If you don't retire and work,
you're going to give up

00:45:02.160 --> 00:45:04.240
sitting at home earning
90% of your wage.

00:45:04.240 --> 00:45:07.650
That is the opportunity
cost of working.

00:45:07.650 --> 00:45:10.140
It's that you have forgone the
ability to sit at home and get

00:45:10.140 --> 00:45:11.920
90% of your wage.

00:45:11.920 --> 00:45:15.280
So what is your net
wage if you work?

00:45:15.280 --> 00:45:17.200
10% of what you would
have earned.

00:45:17.200 --> 00:45:20.150
So if you're earning $20 an
hour, then your choice is you

00:45:20.150 --> 00:45:24.110
can sit at home for $18 or
work for $20 an hour.

00:45:24.110 --> 00:45:27.470
So your net wage for working
is $2 an hour.

00:45:27.470 --> 00:45:34.380
The return to work, the
opportunity cost of leisure is

00:45:34.380 --> 00:45:35.830
only $2 an hour.

00:45:35.830 --> 00:45:38.030
You're only forgoing $2 an
hour by sitting at home.

00:45:38.030 --> 00:45:41.390
But wait, there's more.

00:45:41.390 --> 00:45:44.340
If you sit at home, you don't
have to pay the payroll taxes

00:45:44.340 --> 00:45:48.370
of financing the system
that are almost 50%.

00:45:48.370 --> 00:45:52.060
If you work, you have to
pay the payroll taxes.

00:45:52.060 --> 00:45:55.910
Which means that if you
work, you lose money.

00:45:55.910 --> 00:45:58.600
Because if you work, you forgo
getting to sit at home at 90%

00:45:58.600 --> 00:46:00.480
of your wage, and you
pay a tax that's

00:46:00.480 --> 00:46:02.400
about 40% of your wages.

00:46:02.400 --> 00:46:06.080
So, actually, you will lose 30%
of your salary by working

00:46:06.080 --> 00:46:08.080
relative to sitting at home.

00:46:08.080 --> 00:46:11.140
Guess what people do in
the Netherlands at 55?

00:46:11.140 --> 00:46:12.050
They sit at home.

00:46:12.050 --> 00:46:15.440
No one works after 55 in the
Netherlands on the books.

00:46:15.440 --> 00:46:16.810
They work off the books
painting houses

00:46:16.810 --> 00:46:18.160
and doing odd jobs.

00:46:18.160 --> 00:46:20.280
No one works on the
books after 55.

00:46:20.280 --> 00:46:21.610
Economics works, guys.

00:46:21.610 --> 00:46:23.540
If you pay your guys to stay
at home, they stay at home.

00:46:26.160 --> 00:46:30.040
Now, if you ask European
politicians, why do you have

00:46:30.040 --> 00:46:31.200
this screwed up system?

00:46:31.200 --> 00:46:32.780
They'll say, well, it's easy.

00:46:32.780 --> 00:46:34.820
We want to get those old
guys out to make jobs

00:46:34.820 --> 00:46:36.470
for the young guys.

00:46:36.470 --> 00:46:38.980
We need to pay those old guys
to stay at home to make jobs

00:46:38.980 --> 00:46:40.490
for the young guys.

00:46:40.490 --> 00:46:42.330
And then you point out, have
you noticed that Europe has

00:46:42.330 --> 00:46:45.060
higher unemployment than
American, even though we don't

00:46:45.060 --> 00:46:46.150
do that and you do?

00:46:46.150 --> 00:46:48.140
And that's because
you're wrong.

00:46:48.140 --> 00:46:49.450
It doesn't work that way.

00:46:49.450 --> 00:46:52.880
Because by paying the old guys
to sit at home, you have to

00:46:52.880 --> 00:46:56.540
have such high taxes that no
one makes new businesses.

00:46:56.540 --> 00:46:59.470
And so there's not jobs for
the young guys to have.

00:46:59.470 --> 00:47:00.510
So it's true.

00:47:00.510 --> 00:47:02.500
In theory, you've made jobs for
the young guys by leaving

00:47:02.500 --> 00:47:03.690
the old guys at home.

00:47:03.690 --> 00:47:07.480
But by imposing the 40% tax rate
that you've had to impose

00:47:07.480 --> 00:47:10.380
to make it possible to pay the
old guys to sit at home,

00:47:10.380 --> 00:47:12.410
you've killed job creation
in your country.

00:47:12.410 --> 00:47:14.250
And, as a result, there's
not the jobs for

00:47:14.250 --> 00:47:17.180
young guys to get.

00:47:17.180 --> 00:47:20.250
That's a very long-winded way
of answering your question

00:47:20.250 --> 00:47:26.300
that supply, in substance,
creates its own demand.

00:47:26.300 --> 00:47:28.060
So more labor supply will not
necessarily cause more

00:47:28.060 --> 00:47:29.710
unemployment.

00:47:29.710 --> 00:47:33.700
And we're going to talk about
one more thing before we stop.

00:47:33.700 --> 00:47:35.920
I've just talked about a vast
empirical literature in how

00:47:35.920 --> 00:47:39.570
people understand the effects
of wages on labor supply.

00:47:39.570 --> 00:47:41.680
Well, how do they do it?

00:47:41.680 --> 00:47:45.180
Well, you could say, look, we
can just look at how you earn

00:47:45.180 --> 00:47:47.180
a higher wage than you do.

00:47:47.180 --> 00:47:50.290
And we'll ask, do you work
harder than you?

00:47:50.290 --> 00:47:53.280
And we'll say, the guys who earn
higher wages work harder.

00:47:53.280 --> 00:47:55.310
If guys who earn higher wages
work harder, that means labor

00:47:55.310 --> 00:47:56.600
supply slopes up.

00:47:56.600 --> 00:47:58.420
If guys who earn higher wages
don't work harder, that means

00:47:58.420 --> 00:47:59.880
labor supply slopes down.

00:47:59.880 --> 00:48:01.540
What's wrong with that?

00:48:01.540 --> 00:48:01.970
Yeah.

00:48:01.970 --> 00:48:04.434
AUDIENCE: Those who are getting
paid more probably are

00:48:04.434 --> 00:48:06.130
getting paid because they
want to work harder.

00:48:06.130 --> 00:48:07.260
PROFESSOR: Yeah.

00:48:07.260 --> 00:48:08.940
Maybe you guys are different.

00:48:08.940 --> 00:48:11.270
Maybe you're talented,
and you're not.

00:48:11.270 --> 00:48:13.740
And maybe because you're
talented, maybe you're driven,

00:48:13.740 --> 00:48:15.580
and you're not.

00:48:15.580 --> 00:48:18.520
And because you're driven, you
work harder and get paid a

00:48:18.520 --> 00:48:20.150
higher wage.

00:48:20.150 --> 00:48:24.190
So I'm not learning anything
about the causal effect of the

00:48:24.190 --> 00:48:25.400
wage on your labor supply.

00:48:25.400 --> 00:48:30.030
I've just documented a
correlation between wage and

00:48:30.030 --> 00:48:31.410
labor supply.

00:48:31.410 --> 00:48:34.600
How can we get the causal effect
of your wage on your

00:48:34.600 --> 00:48:35.270
labor supply?

00:48:35.270 --> 00:48:38.090
Well, once again, ideally
we'd run an experiment.

00:48:38.090 --> 00:48:40.940
We'd assign you a higher wage.

00:48:40.940 --> 00:48:42.260
We'd find someone
just like you.

00:48:42.260 --> 00:48:43.590
Not you, you're not driven.

00:48:43.590 --> 00:48:45.470
We find someone just like you.

00:48:45.470 --> 00:48:45.560
No offense.

00:48:45.560 --> 00:48:47.170
You know I'm joking.

00:48:47.170 --> 00:48:50.560
We'd find someone just like you
and, randomly, by a flip

00:48:50.560 --> 00:48:52.260
of a coin, assign them
a lower wage.

00:48:52.260 --> 00:48:56.070
And we'd see how your labor
supply differed.

00:48:56.070 --> 00:48:57.560
Now, it seems like you
couldn't do that.

00:48:57.560 --> 00:48:59.330
But, in fact, the US did that.

00:48:59.330 --> 00:49:01.770
In the 1970s, we ran what was
called the negative income tax

00:49:01.770 --> 00:49:04.740
experiment where we literally
assigned people different wage

00:49:04.740 --> 00:49:08.250
rates through taxing them
by different amounts.

00:49:08.250 --> 00:49:10.990
And that was part of what gave
us this very convincing

00:49:10.990 --> 00:49:14.000
evidence from 40 years ago
of these responses.

00:49:14.000 --> 00:49:15.990
So where we get this is from
a real experiment we

00:49:15.990 --> 00:49:17.780
ran 40 years ago.

00:49:17.780 --> 00:49:20.460
The problem is that's a pretty
hard experiment to run.

00:49:20.460 --> 00:49:23.850
It's pretty expensive, and
there's some ethical issues.

00:49:23.850 --> 00:49:26.560
So what do you do today
to estimate that?

00:49:26.560 --> 00:49:28.996
What you can do today is say,
well, we can't run the

00:49:28.996 --> 00:49:29.042
experiment.

00:49:29.042 --> 00:49:31.780
But the government runs
it for us every time

00:49:31.780 --> 00:49:34.060
they change tax rates.

00:49:34.060 --> 00:49:36.490
Because if you take two people
that are identical--

00:49:36.490 --> 00:49:39.630
so let's say you and you
were identical--

00:49:39.630 --> 00:49:41.880
and I change your tax rate
because you live in

00:49:41.880 --> 00:49:43.000
Massachusetts.

00:49:43.000 --> 00:49:45.180
I don't change your tax rate
because you live in New York.

00:49:45.180 --> 00:49:47.760
I can see what happens to
you relative to you.

00:49:47.760 --> 00:49:51.060
Because I've now essentially
run this experiment by the

00:49:51.060 --> 00:49:51.990
government changing
someone's tax rate

00:49:51.990 --> 00:49:54.500
and not someone else's.

00:49:54.500 --> 00:49:57.290
That's the way we do it if we
can't run a true, randomized

00:49:57.290 --> 00:49:57.740
experiment.

00:49:57.740 --> 00:50:00.690
And that gives very, very
similar answers.

00:50:00.690 --> 00:50:02.470
Let me stop there.

00:50:02.470 --> 00:50:04.880
And we will come back.

00:50:04.880 --> 00:50:10.670
Next lecture we'll talk about
applying this model.

00:50:10.670 --> 00:50:12.950
So I guess in section
on Friday, we

00:50:12.950 --> 00:50:14.330
review for the exam.

00:50:14.330 --> 00:50:16.030
In section on Friday, we
review for the exam.

00:50:16.030 --> 00:50:17.040
So show up to that.

00:50:17.040 --> 00:50:18.650
And the exam is next week.

00:50:18.650 --> 00:50:24.560
The exam will cover through
my next lecture.