Indifference Curve Analysis

In Appendix 10A, we showed that consumer choice can be represented using the concept of indifference curves, which provide a “map” of consumer preferences. If you have covered the appendix, you may find it interesting to learn that indifference curves are also useful for addressing the issue of labour supply. In fact, this is one place where they are particularly helpful.

Figure19A-4Labour Supply Choice: The Indifference Curve Approach Point A, on BL1, is Clive’s initial optimal choice. After a wage rate increase, his income and utility level increase: his new time allocation budget line is BL2 and his new optimal choice is point C. This change can be decomposed into the substitution effect, the fall in the hours of leisure from point A to point S, and the income effect, the increase in the number of hours of leisure from point S to pointC. As shown here, the income effect dominates the substitution effect: the net result of an increase in the wage rate is an increase in the hours of leisure consumed and a decrease in the hours of labour supplied.

Using indifference curves, Figure 19A-4 shows how an increase in the wage rate can lead to a fall in the quantity of labour supplied. Point A is Clive’s initial optimal choice, given an hourly wage rate of $10. It is the same as point A in Figure 19A-2; this time, however, we include an indifference curve to show that it is a point at which the budget line is tangent to the highest possible indifference curve.

Now consider the effect of a rise in the wage rate to $20. Imagine, for a moment, that at the same time Clive was offered a higher wage, he was told that he had to start repaying his student loan and that the good-news/bad-news combination left his utility unchanged. Then he would find himself at point S: on the same indifference curve as at A, but tangent to a steeper budget line, the dashed line BLS in Figure 19A-4, which is parallel to BL2. The move from point A to pointS is the substitution effect of his wage increase: it leads him to consume less leisure and therefore supply more labour.

But now cancel the repayment on the student loan, and Clive is able to move to a higher indifference curve. His new optimum is at point C, which corresponds to C in panel (b) of Figure 19A-2. The move from point S to point C is the income effect of his wage increase. And we see that this income effect can outweigh the substitution effect: at C he consumes more leisure, and therefore supplies less labour, than he did at A.