Indifference Curve Analysis

1 Explain Briefly How Indifference Curve Analysis can be used to Derive an Individual's Labour- Supply Schedule Economics defines a consumer as a rational individual who is keen to maximize his/her utility by making rational choices. More often choices come in when a consumer is exposed to two goods, where a given amount of one substitutes the use of another one. To understand the rationality of a consumer in such a situation, an indifference curve is used. For instance, the curve is used to explain how a consumer makes work and leisure related choices given differentials in the wage rate. More often, the analysis of an indifference curve brings together the combination of two vital concepts, the budget constraints largely referred to as budget lines and the indifference curves. This essay seeks to expound how this analysis can be used to come up with an individual labor supply schedule.

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Leisure Hours

A

6

B

3

2

5

Work Hours

2 An indifference curve can be defined as a line that pinpoints possible combinations between two goods (Edgmand et al. 2007). These combinations showcase points where a consumer is indifferent; that is, a consumer is able to derive the same level of satisfaction from any points in the curve. The figure below explains this scenario very well.

Diagram 1

Source: (Jackson et al. 2008, p. 233) The graph above is a pictorial representation of how workers are able to maximize their revenues by balancing working hours and leisure hours. From the graph, a worker is able to realize the same level of utility or satisfaction by either combining 6 leisure hours with 2 working hours, or relatively by opting for 3 leisure hours and 5 work hours’ combination. This implies that the worker is equally satisfied at point A as he is satisfied at point B. The aforementioned is possible despite the worker utilizing more leisure hours at point A or by opting for more working hours i.e. at point B. When a customer moves from point A to point B, it means that he/she is willing to forego 3 hours of leisure for 3 hours of work.

In the real economic world, rational individuals will spend their hard earned income on quite a number of goods and services in every stage of their life. During these developments,

3 they will be exposed to changes in interest rates as well as commodity prices. The interest rates are used to measure and ascertain the cost associated with commodities being consumed in relation to future expectations. Considering the negative externalities present in world markets, individuals are exposed to uncertainties whereby they may or may not realize their full utility and subsequent satisfaction. The aforementioned implies that advanced analysis of the indifference curve is relevant to ascertain how utility is derived. The analysis is based on two goods, income and leisure. However, it is prudent to expect that at the equilibrium of these two goods under analysis, the marginal rate of substitution equals the relative prices of the pair (Taylor & Moosa 2008).

To maximize utility in the commodity market, one needs to have access to good amounts of income. This income is often earned as a reward of labor, where a worker sells his/her labor power for a wage or salary. In indifference curve analysis, a worker derives his satisfaction by allocating them to work and leisure. Despite not being considered a good i.e. quite a number of people believe that work lowers satisfaction, an indifference curve helps in the determination of how people are willing to work. Workers often assert that leisure, which is an opposite of work, generates much utility. However, that might not necessarily be the case in reality as consumers require income to enhance their welfare (McTaggart et al. 2010).

A normal good can be defined as a commodity whose price is largely dependent on the income of the consumer. This implies that with an increase in the level of income, a customer will consume more of the good. On the other hand, a reduction in the level of income will largely hamper the demand of such a good. From the above, it is apparent that the nature of a good often changes depending on income range. Therefore, there is a high possibility that a good may be a normal good as well as an inferior good. On matters of income, an individual who has a low

4 income will often forego leisure for work. In this case, therefore, leisure may be a normal good; that is, the worker will consume an addition leisure hour for every increased penny in his income levels. However, considering the consumer income increases rapidly, then more leisure hours will be foregone in the process (Edgmand et al. 2007). The graph below explains the scenario where leisure becomes a normal good at some point. Therefore, the ultimate question that sought to be answered here is how much leisure hour a worker is willing to sacrifice for a unit increase in his wage. Put simply, each individual has a fixed number of hours, often 24 hours. Individuals have to divide these 24 hours to work and leisure. From the above, the question can now be paraphrased to capture the autonomous levels of leisure demanded at given wage units.

5

Time constraint U2

Income BL 2

U1

E2 BL 1

E1 E3

0 24

Substitution effect Income effect

24 Daily Leisure Hours 0 Daily Leisure hours

Diagram 2: Source: (Jackson et al., 2008, p. 237) BL1 and BL2 in the diagram above are budget lines 1 and 2 respectively. In the other hand, U1 and U2 represent the indifference curves. In addition, the X-axis showcases the leisure hours while the Y-axis showcases the Income earned.

Given there is a relative increase in a worker’s income, the cost of leisure rises; that is, it becomes expensive. Therefore, individuals are willing to increase their working hours and reduce their leisure hours. In other words, individuals are ready to substitute or else forego leisure for income. E1 to E3 in the graph above depicts this scenario well. On the other hand, increase in the wages advanced to workers leads to an increase in their income levels. This, therefore, leads to a

6 shift of the budget line together with the equilibrium to point E2 from E3. The points E3 and E2 above are the optimum levels of consumer satisfaction. The shift showcased in the diagram above resulted because leisure is considered a normal good, meaning the individual is willing to increase leisure consumption. When the aggregate effect of substitution and income is greater than zero i.e. SE+IE>0, consumers are engaging more of their time in work. This, therefore, implies that there is a rapid decrease in leisure consumption (Stonecash et al. 2009). The aforementioned case is only possible when wages rise.

From the above diagram, the income effect is responsible for the movement of income/leisure ratio to point E3, while substitution effect is depicted by the movement of income/leisure relationship from point E3 to E1 where the individual reduces the amount of leisure hours in favor of work hours. The aforementioned relationship is possible because the price associated with leisure has relatively been reduced by the increased price value of wages.

The state of leisure often fluctuates between being an inferior or a normal good. Leisure possesses the attributes of an inferior good given wages are low. However, it is considered a normal good when the wages are relatively high. Often, individuals often seek to increase their income levels when their wage bill is low. They do this to increase their ability to afford other consumer goods in the market. To these persons, they prefer more work to leisure when there is a remarkable increase in wages. However, when they have accrued more riches, leisure takes the state of a normal good (Taylor & Moosa 2008).

McTaggart et al. (2010) define unemployment benefits as monetary compensation extended to unemployed persons by either a state or an authorized body. Unemployed persons are individuals who are willing and able to work but are yet to secure a job. To be awarded a benefit, a person has to be in government registry. The benefits are expected to cushion these

7 persons from the ever rising cost of living. This implies that they not only gather for basic needs, but also act as a compensation for lost man hours in relation to a past payment. Given that a consumer invests all his hours in work, it means that he has no time for leisure and vice versa.

However, in the case of an unemployed individual, all the hours can be utilized for leisure.

Unemployment benefits deprive individuals urge to work. This is because a consumer is able to improve his utility by utilizing the amount offered well. It can as well be said that an increase in consumer benefits increases his ability to purchase a relatively high combination of market commodities. The diagram below will aid in the explanation of unemployment benefit.

Diagram 3: Unemployment Benefits

U1 Consumption

U2

A F

G D E

300

C

B Hours of leisure 20

50

60

8 From the diagram above, the budget line AB and the indifference curve U1 depicts a situation without employment benefits. At this point, an individual consumes 60 leisure hours but has zero earning i.e. earns nothing. However, the individual has the ability of choosing a maximum point where he/she can maximize utility i.e. at point E where the budget line and the indifference curve U1 intersect. At this point, the individual has 20 hours of leisure and 40 hours for working.

The introduction of an unemployment benefit shifts vertically the utility point i.e. from point B to C. This is because the individual is able to enjoy the similar amount of leisure time and access income, as well. For example, in the diagram above, the individual is able to consume 60 leisure hours and still earn 300 US dollars income in form of unemployment benefits. Often, unemployment benefits have an indirect relationship with income earned i.e. increasing income earned relatively decreases unemployment benefits. From the aforementioned, it is apparent that the net value of wages associated with unemployment benefits is low.

Despite the relief that comes with the benefits, consumers still face the wrath of living costs; that is, although the benefits aide in the acquisition of basic needs, they fail to guarantee a good future. This leaves consumers with an increasing urge to earn more with their own efforts.

Consumers are often in need of diversity; and given the fact that human wants are insatiable, workers will seek to sell their efforts at relatively cheaper prices in order to attract buyers.

Having started from zero wages, these workers will seek to harness more wealth by fully utilizing their labor power. In the long run, they will have more income to spend and further increase in wages might fail to trigger their urge towards additional incomes.

The labor supply schedule is a representation of how labor reward or wage relates with the quantity supplied of labor (Hatch 2010). The labor supply schedule guides in the derivation

9 of a labor supply curve, a graph that eases the monitoring of worker decisions. In the contemporary business market, supply curves are often associated with producers. However, with the labor market, the consumer is often the supplier. Labor market decisions are often done by individuals seeking to sell their services for wages. Therefore, a consumer economic theory is of utmost importance in the deriving process of a supply curve.

According to Jackson et al. (2008), the labor curve is often downward sloping because of the inverse relationship between the rate of inflation and that of unemployment. This implies that the levels of unemployment in the economy dictate the nominal wage rates. When the unemployment rates are equal to zero, the nominal wages are stable. However, at low unemployment rates i.e. at the point where most individuals are in a pay roll, labor will attract relatively high rates. On the other hand, when the unemployment rates are high i.e. when supply is relatively high, the nominal wages will be bid down. The labor supply curve is upward sloping when the economy is experiencing higher rates of inflation. This implies that already established firms are unable to absorb workers into their systems with some sending off workers to contain costs. In addition, during high inflation rates, the cost of living increases rapidly, this drives individuals to the labor market in search for employments. At this point, the wages in the market are relatively low.

In conclusion, it is apparent that indifference curve analysis plays a cardinal role in understanding the rationality of consumers. From the above discussion, it can be observed that consumers are often driven by the urge to gain most satisfaction from the combination of goods; that is, his utility is of utmost importance. In matters related to the labor market, there is a tradeoff between hours spent on work and those utilized for leisure services. More often, quite a number of people prefer work to leisure although the same is irrational. This is because the need

10 to acquire other goods in the market supersedes leisure satisfaction. Another notable thing in the above discussion is the variation of leisure state, i.e. being both a normal and an inferior good.

For example, a low wage will always push a consumer to work. This is because of the urge to increase ones income and be able to afford other commodities in the market. For these workers, they are keen to inject more hours into work, especially when the wages are in the rise. This implies that leisure hours are sacrificed. However, the same tends to change when these workers have accrued a lot of wealth and enjoying strong financial muscle. This is the time when leisure turns from being an inferior good to being a normal good. This is because they are keen to enjoy more leisure than work. Therefore, at this state, despite wage increases, labor supply is often mild.

11 Reference List Edgmand, MR, Moomaw, RL & Olsen, KW 2007, Economics and contemporary issues, 7th edn, Thomson, South-Western.

Hatch, JV 2010, Reading between the lines, Pearson, Frenchs Forest, NSW Jackson, J, McIver, R & McConnell, C 2008, Economic principles, 2nd edn, McGraw-Hill, Sydney McTaggart, D, Findlay, C & Parkin, M 2010, Economics, 6th edn, Pearson, Sydney Stonecash, R, Gans, J, King, S & Mankiw, NG 2009, Principles of economics, 4th edn, Thomson Taylor, JB & Moosa, I 2008, Economics, 4th edn, John Wiley, Brisbane