Answer to Question #226596 in Macroeconomics for Mariam

Question

Assume that a representative consumer has consumption good and leisure in the consumption bundle. Both consumption good and leisure are normal goods. If the consumer’s real wage increases, holding everything else constant, explain in your own words what would be the effects on consumption and labour supply. Provide your explanation in terms of income and substitution effects under a static equilibrium model. [

Answer 1

From the onset, the increase in real wages shifts the consumer budget constraint outwards. In other words, the budget constraint of the consumer broadens. The consumer chooses a consumption bundle of goods where the indifference curve is tangent to the new budget constraint. Since consumption goods and leisure are said to be normal goods, increasing wages will subsequently increase their consumption.

The impact of the increase in the consumer's wages is broken down into substitution effect and income effect. The substitution effect is exemplified by the consumer moving along the initial indifference curve in response to the increase in wages. The consumer is indifferent between increasing consumption goods or decreasing consumption of leisure. Still, since the items mentioned above are normal goods, consumption automatically increases in both consumption goods and leisure due to increased wages. The consumer can consume more leisure and consumption goods since a new budget constraint has shifted outwards. The income effect is shown when an increase in wages increases the demanded quantities for both consumption goods and leisure.

It is important to note that when goods are normal, the substitution and income effects work the same as the consumer has higher purchasing power due to increased wages. Hence, there is an increase in the overall consumption by the consumer under a static equilibrium model.