Answer to Question #253521 in Macroeconomics for Thanusha

Question

1. Show the effect of a wage decrease on an individual’s income-leisure choices. Isolate the income and substitution effects. Is the worker on the forward-rising or backward bending portion of the labor supply curve?

2. Indicate in each of the following instances whether specified events would cause a worker to want to work more or fewer hours:

(a) The wage rates rises and the substitution effect is   greater than the income effect.

(b) The wage rate falls and the income effect is greater       than the substitution effect.

Answer 1

Solution:

1.). The individual labor supply curve denotes the number of hours people are willing and able to work at various wage rates. The individual labor supply curve is designed to demonstrate the trade-off between labor and leisure at any given wage rate. Individuals typically choose between work and leisure, and they have the option of allocating their time between the two.

According to the income effect, when wages fall, the worker becomes poorer, so he purchases fewer goods, including leisure, and his working hours increase.

According to the substitution effect, when wages fall, leisure becomes less expensive, so workers will buy more leisure and work less.

The effect of a wage decrease on an individual’s income-leisure choices is depicted by the below graph:

Between Point B and C, the worker has high wages and the income effect is stronger and the worker chooses to have more leisure time and give up some working hours.

From A to B the substitution effect is stronger than the income effect since the worker’s wages have decreased. The worker substitutes leisure time with work time to earn more income.

The worker is on the backward bending portion of the labor supply curve.

2. a.). When the wage rates rise and the substitution effect is greater than the income effect, a worker will tend to work for more hours. The substitution effect of higher wages means a worker will give up leisure to do more hours of work since work has now a higher reward.

b.). When the wage rate falls and the income effect is greater than the substitution effect, the worker will tend to work for more hours. This is because the income effect of lower wages means that the worker is poorer and, therefore, will purchase less leisure and thus hours of work will increase.