Production Shocks on the Island

Now that we have a simple guide to Robinson's decision making, we are ready to shock his production process and look at the changes that occur after these shocks. Notice that, since our economy only has one inhabitant, the GDP of the island is the total number of goods that Robinson produces.

In the real world, most changes in the production process combine a change in level (for any hours worked, the total production changes by a constant amount) and a change in marginal productivity (adding an hour's work adds more or less goods than it would have before the shock). It is convenient to decompose any shock into these two effects, called wealth effect and substitution effects. Notice that there are cases where only the wealth effect appears: for instance, for an individual, winning at the lottery, and for an economy, if there is a big tempest that greatly increases the quantities of fish that can be harvested. For Robinson: imagine that a crate full of goods washes onto the shore. For any effort choice he possibly has, the total production in that moment has increased by the number of goods in the crate.

A pure substitution effect is more difficult to see in the real world, as there are always wealth effects . But it is very useful to see what happens in the hypothetical case in which there is a pure substitution effect: In the wealth effect, changes in GDP are accompanied with changes in consumption and labor in a certain direction (increase in wealth), lead to more consumption and less labor. If there are changes in productivity, then there are different changes due to the substitution effect.

So, what is the pure wealth effect? Robinson has all those extra goods. At his current labor choice, he can therefore consume more. However, leisure is relatively more attractive to him, so he decides to work a little less. There is then an increase in consumption and a decrease in labor. What is the pure substitution effect? Now, working a bit more increases his production by more than before… So Robinson has extra incentives to work. The pure substitution effect is thus an increase in labor, and an increase in consumption (Robinson can use all the extra goods he produces, like a sturdier shelter, in addition to the ones he had!).

Now, let's imagine a shock that combines both effects: for some reasons, there are a lot more fish in the sea, more coconuts on the trees, but Robinson also has refined his technique to prepare his shelter. Hence GDP on the island will go up. Since both effects allow Robinson to consume more, consumption goes up (it is procyclical). But the total effect on labor is unclear: since food is easy to get, Robinson can decrease the number of hours he puts in getting it. But since he is more productive at preparing a nice shelter, he also wants to work more on the shelter. In total, we don't know which effect dominates. In economics, we can go to the later data and see, based on the end result, which factor is more important by noting whether it increased or decreased. A labor increase would dictate that the substitution effect is stronger, for example.

Cyclicality