Question

1. Janet's utility depends on consumption c and leisure l. She earns a wage equal to w per hour, has an investment income equal to M(greater than or equal to) 0 and needs to sleep at least 8 hours a night. Normalize the price of consumption goods at $1.

(i) Draw her indifference curves between hours of leisure and consumption, her budget line and her equilibrium choice of c and l. What is the slope of the budget line and what are the intercepts.

(ii) Redo the above in terms of L, labor supply

(iii) Distinguish between income effects and substitution effects of an increase in wage. How does this differ in comparison to the traditional analysis for a good that Janet buys in the market

(iv) Is the labor supply upward-sloping or backward bending? Explain in terms of income and substitution effects

2. Using a labor/leisure model to show and discuss the income and substitution effects of a rise in wage rate when substitution effect is greater than the income effect. Using this model to analyze implications of employee disability programs How would you address its work disincentive effect?

Answer 1

1) In the following figure you will be able to see that the equilibrium is achieved when the indifference curve is tangent to the budget line. The figure also shows the intercept as well as the slope of budget line. In the following figure same has been done in relation to labor and income/consumption. Substitution effect is the effect that is applied on the demand of a commodity due to change in the relative price of the commodity. Income effect is the effect that is on the quantity demanded for a good due to change in income.The substitution effect when the income or wages are increased means workers will give up leisure to do more hours of work because he is being paid more. The income effect when the income or wages are increased  means workers will reduce the amount of hours they work because there is scope of reaching the income target with fewer work.

It is usually seen that with increase in income and labor is already supplying enough labor then the further increase in the wages will rather reduce the income effect and substitution will be higher. This causes a backward bending supply curve of labor.

2) The disincentive effect leads to labor opting to change the particular company or firm or workplace. If there is a disability employee program it means that the company is planning to cut off their employee strength. This will not help the company or the employee