Question

A worker's preferences over consumption (c) and leisure (l) can be represented by U(cl) = cl. The price of consumption is given by p = 1 and the wage by w=1 (a) Suppose we measure leisure in hours per day such that the maximum value I can take is 24. Let's represent hours worked by h; then we have h = 24-1. Write the Budget Constraint of this worker in terms of c and l. (b) Explain briefly why w/p can be defined as the opportunity cost of leisure. (c) Describe with words the income and substitution effects on leisure of a higher wage. (d) Find the optimal bundle (c*,1") for this worker. (e) Suppose now that a flat tax on wages given by t = 3/4 is introduced. This implies that for any hour worked the consumer earns w(1 - t) = w/4. Rewrite the new Budget Constraint and calculate the new optimal bundle (0,1). (f) Decompose the total effect of the tax on leisure TE=1-1* in Substitution Effect SE and Income Effect IE. (g) How did the introduction of the tax affect the supply of labor. Did it go down? Did it go up? Why? Explain using the concepts of substitution and income effect.

Answer 1

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