Endogenous Labour Supply

Leisure time is introduced in the variety expansion model in Chap. 2 to endogenize the labour supply. While pollution is emitted through physical capital input, pollution is reduced through the input of pollution abatement goods. To internalise this negative externality, the government introduces emissions trading. A reduction in the emissions allowance brings about economic growth and improves welfare through the substitution effect. Due to the demand for pollution abatement goods, final goods firms increase the production of final goods by investing in intermediate goods. The rise in the price of intermediate goods encourages the development of new varieties, as it increases monopoly profits. The demand for labour in the R&D sector increases the wage rate, increasing the opportunity cost of leisure and substituting leisure for labour. As a result, the economy grows due to the development of varieties. When the preference parameter for pollution is high, welfare improvement due to increased consumption, economic growth and reduced pollution dominates welfare deterioration due to reduced leisure time, hence, welfare improves. In case there is no leisure time, the growth-enhancing effect of emission allowances disappears, therefore, this growth effect depends on the preference for leisure time.