C.

Decision-making under
scarcity
Decision Making and Scarcity
• Which combination of final grade and free time will be chosen?
• Constrained choice problem: decision maker pursues an objective subject to a
constraint
• Objective is here utility maximization
• Constraint is the feasible frontier
• Combine feasible frontier and indifference curves
• Optimal choice is the combination of free time and final that lies on an
indifference curve as far away from the origin as possible and is still feasible

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Optimal Decision Making
• The optimal (utility-maximizing)
choice is where the indifference
curve is tangent to the feasible
frontier
• In this point, 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

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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.

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Another example: Grain production

• Tradeoff between grain produced and free time

• Technological change shifts the production function
upwards, and expands the feasible frontier

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Optimal Decision Making
• 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.

34 Microeconomics - Scarcity and Choice

D. Income and Substitution
Effects
Hours of Work and Free Time
• Given a particular wage rate, how many hours would you want to work?
• To answer this question, apply similar framework as before
• Two desired goods: leisure time and consumption
• The feasible frontier is now a straight line and given by
• For every hour of free time you lose consumption equal to the wage rate
• This wage rate is also the opportunity cost of free time and the marginal rate of
transformation
• Feasible frontier is in this case also called the budget constraint: you can not spend more
than your income
• Indifference curves show combinations of consumption and leisure time that provide the same
utility
• Optimal choice again where , so where

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Example: Working hours

37 Microeconomics - Scarcity and Choice

What if your wage changes
• Wage changes affect the slope of the budget constraint (MRT)
• Consider a wage increase – it will have 2 effects:
• Your total earnings increase, holding working hours fixed (income effect)
• The opportunity cost of free time increases (substitution effect)

38 Microeconomics - Scarcity and Choice

Income effect
• Income effect = the change in optimal
choice when income changes, keeping
opportunity costs (the budget constraint
slope) fixed
• Suppose you get unexpectedly 50€
from your aunt  budget constraint
shifts up and both consumption and
free time increase
• Likewise, a wage increase gives more
income per hour worked -> incentive to
decrease working hours
• Increase both free time and consumption

39 Microeconomics - Scarcity and Choice

Substitution effect
• Substitution effect = the change in
optimal choice 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
when wage increases

40 Microeconomics - Scarcity and Choice

Overall effect on labour choice
• Overall effect = Income effect +
Substitution effect
• Income effect decreases working
hours when wage increases
• Substitution effect increases
working hours when wage
increases
• Which effect dominates depends on
individual preferences

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 E. Application to
Technological Change
Working hours: Differences over time
• In US in 1900 in point A
• Increase in wage leads to steeper
budget constraint
• Income effect: increase in both
free time and consumption (point
C)
• Substitution effect: decrease in
free time and increase in
consumption
• Income effect dominates so in the
end free time has increased

43 Microeconomics - Scarcity and Choice

Working hours: Cross-country differences
• Differences in working hours can be
explained by preferences that differ
across countries.
• Other explanations?
• Differences in culture (norms)
• Politics (legal limits on hours)
• Social preferences (e.g. ‘Keeping
up with the Joneses’)

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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
• Helps us understand real-world phenomena: preferences and
income/substitution effects can explain differences in working hours across
countries and over time

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Summary
• Simple model of decision-making under scarcity
• Indifference curves represent preferences
• Feasible frontier represents choice constraints
• Utility-maximising choice where MRS = MRT

• Used model to explain effect of technological change on labour choices

• Overall effect = Income effect + Substitution effect
• Limitations of model – omits important factors

46 Microeconomics - Scarcity and Choice

In the next unit
• Models of individual choice that include other important factors

• The role of social interactions in individual choice

• The effect of individual choice on social outcomes

47 Microeconomics - Scarcity and Choice