Question

Consumers have preferences regarding income and leisure, just as they had among other goods in Chapter 2. As before, Ed would like more income and more leisure so the indifference curve map is Income Equilibrium ------- Slope = Wage rate - Tw+TB (365 – TH-T). Leisure time FIGURE 7-2 Labor-Leisure Trade-Off

Answer 1

Before the increase in Ed's wage, the optimal choice for Ed is at the point E where the slope of income-leisure curve is equal to the wage rate i.e, the slope of the income-leisure constraint. He enjoys OA amount of leisure and OY₁ amount of income.

If the new job pays him a higher wage rate, then the income-leisure constraint rotates to TM. A change in wage rate results in two effect taking place- income effect and substitution effect. Income effect says that if wage increases, then the leisure time increases as well because leisure happens to be a normal commodity.

According to substitution effect, a rise in wage rate increases the opportunity cost of an extra hour of leisure. So increase in wage rate results in leisure hours being reduced.

So the net effect depends on the magnitude of both the effects. If income effect dominates substitution effect, then leisure time increases, that means the optimal choice for the Ed would be somewhere at the right of point B on the income-leisure constraint TM.

If substitution effect dominates income effect, then the net effect is that leisure hours reduces and Ed works more. In this case, the optimal choice for the Ed would be somewhere at the left of point B on the income-leisure constraint TM.

Now since wage rate has increased and income-leisure constraint tilted upwards, that definitely means his optimal choice will now lie along a higher income-leisure curve. So Ed's utility increases.

y (Income) & leisure 345 -TH - T.