Question

Draw the indifference curve for someone deciding how to allocate time between work and leisure. Suppose the wage increases. Is it possible that the person’s consumption would fall? Is this plausible? Discuss

Answer 1

In the graph wage rate rises from $20/hr to $30/hr

The effect of wage increase can be decomposed into income and substitution effects respectively

Income effect

When wage increases demand for leisure also increases reducing the number of working hours

substitution effect

Price for leisure rises since the higher wage rate makes every sacrificed labor hour more expensive.Therefore the number of working hours increases.

The aggregate effect depends on the price elasticity of labor supply.If it is negative like in the above case the the substitution effect will be higher than the income effect and therefore the number of working hours will decrease with an increase in wage rate.