Question

1. Mikaela has a relatively low wage and no savings. Using the logic of labor supply theory to guide your answer, discuss the forces that influence Mikaela’s decision of how many hours she wants to work. If there are contradictory forces, make sure to mention that the ultimate effect is unclear. Your answer must use the logic of labor supply theory – answers just based on your own guesses will not receive credit.

Answer 1

The labor supply theory states that whether number of hours worked increases or decreases with increase in the wage rate depends on substitution effect and income effect of wage change. As the wage rate increases, the substitution effect induces the worker to work for more number of hours . However, if the income effect dominates, then worker will reduce the number of hours worked and start enjoying more leisure. In the above case since the person has low wage and no savings, substitution effect will play an important role in determination of the number of hours she wants to work, However, contradictory forces in the form of income effect will induce the worker to work less. The ultimate effect of wage change on the number of hours worked depends on whether income effect or substitution effect of the wage change dominates. Thus, ultimate effect is ambiguous. If substitution effect dominates income effect then labor supply will increase and if income effect dominates substitution effect, then labor supply will decrease.