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Notes 4 Labor Markets and Unemployment I Labor Supply and Labor Demand A Labor Supply Background Recall from Topic 2 we discussed the difference between the income and substitution effect The income effect says that as people become richer they want to work less The substitution effect says that as the price of a good goes up today i e leisure then you want less of that good and more of other goods in this case less leisure and more consumption how do you get more consumption work more to earn more In micro you probably learned models with two goods I am going to go through a quick example of two goods and then we will take it to the macro level Suppose you only want to consume apples and bananas Suppose further that you like consuming these goods Think about your own consumption decision If the price of apples increases you are going to switch towards bananas Remember from micro we are going to consume until the marginal utility of apples price of apples marginal utility of bananas price of bananas Or MU apples P apples MU bananas P bananas If the price of apples increases you need the marginal utility of apples to increase in order for this equality hold How do you get the marginal utility of apples to increase You consume LESS apples this is the law of diminishing marginal utility the more you consume of a good the LESS extra utility you get think about it the 10 th hamburger is not as satisfying as the 1st This is the substitution effect As the price of apples increase you are going to substitute away from apples towards bananas But as the price of apples increase you spend more for the apples you buy That means in some sense you are relatively poorer You could not have bought the same bundle of apples and bananas as you did before the price changed at the same cost after the price change Given that you are poorer due to the price change you will buy less of everything you like apples and bananas This is the income effect As the price of apples increase you will



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