SCARCITY, WORK, AND

CHOICE

The Economy – Unit 3

 Scarcity and Choice
• Decision making under scarcity is a common problem we face
o Resources available to meet our objectives are usually limited
• Key elements for a decision maker are
o Objectives: what do we want to achieve
o Constraints: define which actions are feasible
o Decision process
§ How objectives and constraints are taken into account to produce an action (a
decision)
§ The decision process evaluates which decision is best given the objectives
 Scarcity and Choice

• Opportunity Cost:
o Describes the trade-offs we face in the presence of scarcity:
“Satisfying one objective more means satisfying other objectives less”

o Under scarcity, whenever we choose one alternative we are sacrificing

something.
 Scarcity and Choice
• In many countries there has been a huge increase in living standards since
1870.

• But in some places people have carried on working just as hard as before
but consumed more, while in other countries people now have much more
free time.

• Why has this happened?

 Hours worked vs. GDP per capita
• Disparities in free
time and income
between
countries

• Higher-income
countries seem to
have lower
working hours
and more free
time

• But there are

some differences
between them…
 Hours worked vs. GDP per capita
• Over time ...More income .... Less work... 🤔

US
France
Netherlands
 Why has this happened?

• We can use a model of decision making under scarcity: Choice between

work hours and free time
• Income = Wage x Hours of work
• If you get a high increase in the hourly wage what would you do?
o Work more? … Work less?.... Work the same?
• People’s choices over the economy show that decisions change across
different countries and also over time.
 Grades vs Free time
• As a student, you make a choice every day: how many hours to spend studying …
many factors influencing your choice …
• Example: simple model of a student’s choice between grades and free
time
o Assumptions:
§ The more time you spend working/studying the better the final grade will be
§ MPL is diminishing: an extra hour of study helps a lot if you are not studying
much, but if you are already studying a lot studying even more does not help
very much
§ APL is diminishing: your “average grade per hour of study” becomes smaller
the more you study
 Grades vs Free time: Limits to Choice
1. First element: what CAN be done?
o Production function:
output (grade) as
function of work
hours
• Recall:
• APL …
• MPL …
• What are the average
and marginal products
of 4 hours of study?
 Grades vs Free time: Limits to Choice
• Marginal and Average Products
 Grades vs Free time: Limits to Choice
• The Feasible Frontier à RED LINE
o All points defining the maximum feasible quantity of one good for a given
quantity of the other.
o In our case: maximum grade for a given amount of free time
This is the mirror
image of the
production function
 Grades vs Free time: Limits to Choice
• The Feasible Set à RED LINE + Orange Area
o All feasible (possible) combinations of the two goods (alternatives)
o In our case: possible combinations of free time and grades Points below the
Feasible Frontier are
feasible but inneficient: D
Points in the Feasible
Frontier are feasible and
efficient: A,E,C,F
Any point above the
Feasible Set is
impossible to attain: B
 Grades vs Free time: Limits to Choice
• The Opportunity Cost (OC)
o How much we sacrifice of one good to have more of the other
o Intrinsically related with scarcity

OC of Free Time = | Slope Feasible Frontier |

𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 ()*+,
OC of Free Time =
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 -),, ./0,
 Grades vs Free time: Limits to Choice
• The Opportunity Cost (OC) • The OC can vary along the Frontier
OC at point A:
84
81

57

OC at point C:

The OC is ….
 Grades vs Free time: Limits to Choice
• The Opportunity Cost (OC)… and the Marginal Rate of Transformation (MRT)

84
81
• MRT: how much grade points
(good Y) change given a
change in free time (good X)
57
o Slope of Feasible Frontier
• It measures the trade-off that
we are constrained to make by
the feasible frontier
 Grades vs Free time: Preferences
2. Second element: Preferences
• The amount of free time you’ll choose depends on your preferences
• The problem is to know how much you care about Free time vs Final grade
• We can start with a simple description (assumptions)
o A higher grade is better a lower grade
o More free time is better than less free time
o More of both free time and higher grade means you are happier
o It gets trickier when higher grades mean less free time or vice versa…
 Grades vs Free time: Preferences

• How to measure our satisfaction? à Utility Function

o Utility: A numerical indicator of the value that we place on an outcome à
depends on our preferences
o Higher valued outcomes will be chosen over lower valued ones when both are
feasible
o For any two outcomes A and B where A is preferred to B then U(A) > U(B)
o For any two outcomes C and D where we are indifferent between them (equally
satisfied with both) then U(C) = U(D)
 Grades vs Free time: Preferences
o Example: U ( F , G ) = F0,5 G0,5 where F is free time and G are Grades
§ Outcome 1 à (F,G) = (20, 50) Assuming U(F,G) represents our
preferences concerning grades
§ Outcome 2 à (F,G) = (14, 81)
and free time, WHICH OUTCOME DO
§ Outcome 3 à (F,G) = (19, 52.622) WE PREFER?

§ U(20,50) = 200,5 x 500,5 =31,62

§ U(14,81) = 140,5 x 810,5 = 33,67
§ U(19,52.622) = 190,5 x 52.6220,5 = 31,62
§ U(14,81) > U(20,50) à _________________________________________________
§ U(20; 50) = U(19,52.622) à _____________________________________________
 Grades vs Free time: Preferences
2. Second element: Preferences
• How to represent preferences? à Indifference Curves (IC)
o Indifference Curve: points which indicate the combinations of goods that provide
a given level of utility to the individual
o Any point in the same indifference curve gives us the same satisfaction, that is,
the same utility level
o Example: U ( F , G ) = F0,5 G0,5 what is the Indifference curve for U = 10?
G
!" 𝟏𝟎𝟎
U ( F , G ) = 10ó F0,5 G0,5 = 10 óG0,5 = óG= à
#1,3 𝑭
U=10

F
 Grades vs Free time: Preferences
• Properties of Indifference Curves
1. Higher indifference curves correspond to higher utility levels
↘ You like having more of both goods
2. Indifference curves slope downward
↘If you are indifferent between two combinations, the combination that has
more of one good must have less of the other good.

3. Indifference curves do not cross

↘Your order is transitive: if A better B and B better and C then A better than C
 Grades vs Free time: Preferences

• Properties of Indifference Curves

4. It is possible to have an indifference map (set of indifference curves)
↘You can order outcomes: A better than B, B better A, or A indifferent to B
5. Indifference curves are usually smooth
↘ Small changes in the amounts of goods don’t cause big jumps in utility
6. As you move to the right along an indifference curve, it becomes flatter
↘ We are willing to give up more of something abundant
 Grades vs Free time: Preferences
• Marginal Rate of Substitution (MRS)

• MRS: Trade-off a person is willing to

make between two goods, staying
indifferent.
o Slope of an indifference curve
• It measures the trade-off that we are
willing to make according to our
preferences
 Grades vs Free time: Preferences
• Marginal Rate of Substitution (MRS)
• The MRS varies along an IC
MRS at point A:

MRS at point H:

The MRS is …. Recall Property 6: As you move to

the right along an indifference
curve, it becomes flatter à We are
willing to give up more of
something abundant
 Grades vs Free time: Decision Making
• Constraints + Preferences à Choice
• Indifference curves represent preferences, and their slopes show the trade-
offs that we are willing to make
• The feasible frontier is the constraint on our choice, and its slope shows the
trade-off we are constrained to make
• Optimal Choice: we choose the outcome giving us the highest utility among
those that are feasible
o Indifference Curve tangent to the Feasible Frontier
o Marginal Rate of Transformation = Marginal Rate of Substitution
 Grades vs Free time: Decision Making
• MRT = how many marks I gain Optimal Choice
if I have one less hour of free
time (work more), or how many
marks I lose if I have one more
hour of free time (work less).

• MRS = how many extra marks

I require to have one less hour
of free time (work more), or
how many marks I am willing
to give up to have one more
hour of free time (work less).

• Optimal Choice: MRT = MRS

 Grades vs Free time: Decision Making
Optimal Choice

• Why not point D?

o MRS > MRT
o I am willing to give up more
marks than what I actually
lose for one more hour of free
time.
o I would be better off by
increasing my free time
 Grades vs Free time: Decision Making
Optimal Choice

• Why not point A?

o MRS < MRT
o I require less marks than
what I gain for one less
hour of free time
o I would be better off by
decreasing my free time
Back to Economic Growth and Hours of Work

• Consider a constrained choice model similar to the one we just saw

o A farmer producing grain with his own work
o The farmer values free time but has to produce enough grain not to starve
o Diminishing marginal product: as the farmer moves along the production
function the grain produced from an additional hour of work falls

• What happens with economic growth?

o To understand her choice, and how it is affected by technological change, we
need to model her production function, and her preferences
Back to Economic Growth and Hours of Work
• Production Function • Feasible Set
o With a technological improvement the o With a technological improvement the
production function expands Feasible Set expands

Recall this is the mirror

image of the production
function
Back to Economic Growth and Hours of Work
If preferences where
• With a technological different this could be
another point
improvement Point A is
no longer our optimal
choice...
• Why?
• New optimal choice:
Point E
o Hours worked
decrease and grain
increases: as we saw
in the real data
Back to Economic Growth and Hours of Work

• New optimal choice: Point E

o Hours worked decrease and grain increases: as we saw in the real data
• But is it always like that?
o We can draw ICs differently…
• We need a framework!
o Lets see how we can decompose effects driving choices
 Income and Substitution Effects on Hours of
Work and Free Time
• Income and Substitution Effects: allow to decompose 2 effects driving
choices
• Framework
o We value two goods/objectives: free time and consumption
o Your spending cannot exceed your earnings
o You have a limited amount of money (resources are scarce)
o Jobs differ according to the number of hours you have to work
o Together, the hourly wage and the hours of work will determine how much free
time you will have, and your total earnings.
 Income and Substitution Effects on Hours of
Work and Free Time

• Let w be the hourly wage, t the hours of free time per day, c your maximum
level of consumption. Then consumption = wage x hours worked

𝑐 = 𝑤(24 − 𝑡)
• This expression is our Budget Constraint (BC)
o Budget Constraint: all combinations of goods and services that we can buy that
exhaust our budget >> what we can afford to buy

• Example: w=$15 and hours of work between 0 and 16…

 Income and Substitution Effects on Hours of
Work and Free Time
• Example: w=$15 and hours of work between 0 and 16...
o Budget constraint is: c = 15(24 – t) à Orange Line
• Slope of the budget constraint = wage
360
o For each additional hour of free time,
consumption must decrease by $15
Consumption ($)

MRT = 15 (constant)
OCFreeTime = 15 (constant)
Feasible Set
• Area under the budget constraint is your
feasible set
Hours of Free time
24
 Income and Substitution Effects on Hours of
Work and Free Time
• What would be your ideal job?
o The combination on the feasible
frontier that is on the highest
possible indifference curve
o MRS = MRT
o Point A
 Income and Substitution Effects on Hours of
Work and Free Time
• The effect of income on consumption…
• Two types of income changes
o Transfer of income à Income Effect
§ Example 1: Consider someone gives you 50$ a day for life (a gift)
o Changes in the hourly wage à Substitution Effect
§ Example 2: Consider your hourly wage goes from 15$ to 25$

• Not all people react in the same way to increases in income…

Income Effect on Hours of Work and Free Time

• Example 1: Consider someone gives you 50$ a day for life (a gift)

360
Parallel shift of • New Budget Constraint à Blue Line
the BC
c = 15(24 – t) + 50
Consumption ($)

• The extra income of $50 does not

change your opportunity cost of time
- Each hour of free time still reduces
your consumption by $15 (the wage)

Hours of Free time

24
 Income Effect on Hours of Work and Free
Time
• What is your new optimal choice? It will depend on preferences…

Case 1 Case 2 This person chooses

This person increases to keep their free
consumption by less time the same, and
than $50, and takes consume $50 more
some extra free time
 Income Effect on Hours of Work and Free
Time
• Income effect: The effect that additional income (unearned) has if there are
no changes in the relative price or opportunity cost of goods
• In Case 1:
o The income effect is positive
o This means that extra income raises your choice of free time
• In Case 2:
o The income effect is zero
o This means that extra income does not change your choice of free time
Substitution Effect on Hours of Work and Free Time
• Example 2: Consider your hourly wage goes from 15$ to 25$
• New Budget Constraint à Blue Line
c = 25(24 – t)
BC has a different slope:
25 instead of 15 2 EFFECTS:
360
• Free Time becomes more “expensive”:
each hour of free time now reduces
Consumption ($)

your consumption by $25 rather than

$15
• More income for each level of free
time
Hours of Free time
24
 Substitution Effect on Hours of Work and
Free Time
• What would be your new optimal choice?

• Point D:
• We increase our consumption
and reduce our free time
• We reduce consumption of the
good that became relatively more
expensive à Free time
 Income and Substitution Effects: How to calculate
• We have 2 effects: income and substitution effects

o Substitution Effect: The effect that is only due to changes in the price or
opportunity cost, given the new level of utility.
• We need a bundle that allows us to decompose the two effects: Separating
Bundle

• Two possible alternatives to obtain this bundle

1. Bundle that assumes the initial prices or OC but the new utility level >> used
in the book
2. Bundle that assumes the new prices or OC but the initial utility level >> the
one we are going to use more often
Income and Substitution Effects on Hours of Work
and Free Time: Alternative 1 – Initial OC, New U
Point C:
o Point A: starting point BC after income transfer
assuming same OC
and
o Point C : our choice if we have New Utility Level
an income transfer but OC did
not change
Income Effect: A à C
o Point D: final choice
Substitution Effect: C à D
Point D:
o Overall Effect: A à D “Real” BC
and

o Overall Effect: final effect after New Utility Level

income and substitution effects

 Income and Substitution Effects: Why does this happen?

• Because there are two effects of

a wage increase:
1. More income for every hour
worked
• The effect that the additional
income would have if there were
no change in the opportunity cost
à Income Effect
2. The budget constraint is steeper
• the effect of the change in the
opportunity cost, given the new
level of utility à Substitution Effect
Explaining Our Working Hours: Changes over Time
• Recall the data: overall
less working hours over
time
• The slopes of the budget
constraints through
points A and D are the
real wage (goods per
hour) in 1900 and in
2013
• How does our model
explain how we got from
point A to point D?
Explaining Our Working Hours: Changes over Time
• Income Effect: workers
had a higher level of
consumption and valued
free time relatively more
so the income effect of a
wage rise was larger.
AàC
• Substitution Effect:
each hour of work brings
more rewards than
before in the form of
goods, increasing the
incentive to work longer
hours.
CàD
Explaining Our Working Hours: Changes over Time

• Income effect
dominates

• When the income

effect began to
outweigh the
substitution effect,
working time fell.
 Explaining Our Working Hours: Differences
Between Countries

• Recall the data:

countries choose
different combinations
of free time and
income
Income and Substitution Effects: Alternative 2
– New OC or Prices, Initial U
Point C: Separating
o Point A: initial optimal choice
Bundle

o Separating Bundle: keep initial New price Levels

and
utility constant, and find the new
Inicial Utility Level
decision of consumption given the
new prices à C
C
o C: What would be our choice if we
were able to achieve the initial D A
utility at the new prices or OC
o In the graph: Increase in Px

𝑁𝑒𝑤 𝑃!
𝑀𝑅𝑆 =
! 𝑃"
𝑈 𝑋, 𝑌 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑈 Increase in Px
Income and Substitution Effects: Alternative 2
– New OC or Prices, Initial U
Point C: Separating
Bundle
New price Levels
and
Inicial Utility Level

o Substitution Effect: A à C
C
Change in the consumption of X A
D
“pretending” that the only thing
changing are prices or OC

Increase in Px
 Income and Substitution Effects: Alternative
way of defining Point C: Separating
Bundle
New price Levels
and

o Point D: final choice Inicial Utility Level

o Income Effect: C à D
Change in the consumption of X C
“pretending” that the only thing Point D:

D A “Real” BC (new prices)

changing is the income level
and

o Overall Effect: A à D New Utility Level

Net effect of Substitution and

Income effects together

Increase in Px
• So far we assumed well behaved preferences...
• Simple and elegante model... Assumes rational
consumers

BUT

• Is this always an accurate description of choice

behaviour?

NO
 Behavioural Economics
• It uses some of the insights from psychology to develop predictions about
choices people will make and many of these predictions are at odds with
the conventional economic model of “rational” consumers.

• We will see three examples of potential biases in choice resulting from

factors not included in the standard model of choice

1. Framing Effects
2. Costs of too many choices
3. Loss Aversion
 Framing Effects

• So far choices were described in the abstract: coffee, hamburgers, tea…

• However, in real life, people are strongly affected by how choices are
presented to them or framed

o Example: A faded pair of jeans in a thrift shop may be perceived very

differently than the same jeans sold in an exclusive store

• Lets see some other exemples in more detail...

 Framing Effects
WHICH TREATMENT WOULD YOU CHOOSE?

• A serious disease threatens 600 people

• You are offered a choice between two treatments, A and B, which will
yield the following outcomes

o Treatment A: Saving 200 lives for certain

o Treatment B: 1/3 chance of saving 600 lives and 2/3 chance of
saving no one
 Framing Effects

WHICH TREATMENT WOULD YOU CHOOSE?

• A serious disease threatens 600 people

• Now consider the choices between these treatments.
o Treatment C: Having 400 people die for certain
o Treatment D: 2/3 chance of 600 people dying and a 1/3 chance of no
one dying
 Framing Effects

THE DISEASE DILEMMA: Positive vs Negative Framing

• Most people usually choose A over B in the positive framing (saving lives)
• Most people usually choose D over C in the negative framing (deaths)
• Both framings present the same alternatives, just described in a slightly
different way
 Costs of Too Many Choices
• Conventional theory argues that more choice is better, but this ignores
that there is a cost of making choices (Cognitive costs)
o This cost increases with the number of choices presented and increases more
than proportionally
• Researchers (Iyengar and Leppe (2000)) set up sampling booths for jam in
a supermarket
o One booth offered 24 flavors: attracted more consumers but only 3% of the
consumers bought a jam
o The other offered only 6: attracted less consumers but 30% of the consumers
bought a jam
o Suggests that more choice starting from very few options is good for the
consumer, but after some point too many choices become too costly to
process and consumers end up worse off (not buying)
 Loss Aversion
• Loss aversion means that people have a higher cost of losing something
than the benefit of gaining the same thing.
o Quantitatively equal situations are felt differently by people, according
to whether a loss or a gain is involved
• From Kahneman, Knetsch and Thaler (1986):
o 1A: A shortage has developed for a popular model of automobile, and
customers must now wait two months for delivery. A dealer has been
selling these cars at list price. Now, the dealer prices this model €200
above list prices. Do you consider this change to be: completely fair,
acceptable, somewhat unfair, very unfair? Increase
in Price
 Loss Aversion

• From Kahneman, Knetsch and Thaler (1986):

o 1B: A shortage has developed for a popular model of automobile, and
customers must now wait two months for delivery. A dealer has been
selling these cars at a discount of €200 below list price. Now, the dealer
sells this model only at list price. Do you consider this change to be:
completely fair, acceptable, somewhat unfair, very unfair? End of a discount
o The increase in price, which is likely to be seen as a loss, is considered
more unfair than ending a discount, which is seen as a reduction in a
gain. Both situations are objectively the same Loss of
200€