HW 1 Solutions - Homework Solutions#1#2 Indicate in each of the following instances whether the specified circumstances will cause a worker to want

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Homework Solutions #1 #2. Indicate in each of the following instances whether the specified circumstances will cause a worker to want to work more or fewer hours: a.) The wage rate increases and the substitution effect is greater than the income effect. b.) The wage rate decreases and the income effect is greater than the substitution effect. c.) The wage rate decreases and the substitution effect is greater than the income effect. d.) The wage rate increases and the income effect is greater than the substitution effect. a.) A wage rate increase will cause an income and substitution effect. The income effect states that since an individual is wealthier, he/she will consume more goods-including leisure. This implies a reduction in work hours. The substitution effect states that because of the wage increase, the price of leisure has become more expensive, and a rational worker will respond by substituting away from expensive goods. Consequently, he/she will consume less leisure and work more. When the substitution effect is greater than the income effect, the net effect is for the worker to work more. b.) A wage rate decrease will cause an income and substitution effect. The income effect states that since an individual is less wealthy, he/she will consume fewer goods-including leisure. This implies a reduction in leisure and an increase in work hours. The substitution effect states that because of the wage decrease, the price of leisure has become cheaper, and a rational worker will respond by consuming more of the cheaper good. Consequently, he/she will consume more leisure. When the income effect is greater than the substitution effect, the net effect is for the worker to work more. c.) Net effect: work less. d.) Net effect: work less. #3. Employ a diagram similar to Figure 2.7 (illustrates income and substitution effects of a wage increase) to show an individual’s leisure-
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income choices before and after a wage rate decrease. Isolate the income and substitution effects, indicate whether each increases or decreases hours of work, and use the two effects to explain the overall impact of the wage decline on hours of work. Is your worker on the forward-rising or backward- bending portion of the labor supply curve? The diagrams below illustrates a scenario where a worker initially has a wage rate represented by budget constraint W_old. The worker maximizes utility by consuming L_1 units of leisure at point U_1. Then the worker’s wage drops so that the new wage produces budget constraint W_new. The new utility maximizing point is L_3 units of leisure, at point U_3. This movement from U_1 to U_3 can be decomposed into two steps: The income effect is illustrated by the movement from U_1 to U_2 (and corresponding
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This note was uploaded on 02/20/2010 for the course ECON 4960 taught by Professor Bhatt during the Fall '10 term at Georgia State University, Atlanta.

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HW 1 Solutions - Homework Solutions#1#2 Indicate in each of the following instances whether the specified circumstances will cause a worker to want

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