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Unformatted text preview: -Leisure Tradeoﬀ ◮ The optimal choice occurs where the tradeoﬀ between
consumption and leisure equals the real wage. ◮ That is, the value of the extra consumption to the person
from working a little more just has to be equal to value of the
lost leisure that it takes to generate the consumption. ◮ The real wage, w , is the amount of consumption that this
person can purchase if she gives up an hour of leisure. Real wages and labor supply
◮ At an intuitive level, it may not seem reasonable that an
increase in the wage rate would always lead to an increase in
the supply of labor. If my wage becomes very high I might
spend some of extra income consuming leisure. ◮ An increase in the real wage has oﬀsetting income and
◮ Substitution eﬀect: Higher real wage encourages work, since
reward for working is higher ◮ Income eﬀect: Higher real wage increases income for same
amount of work time, so person can aﬀord more leisure, so will
supply less labor The Substitution Eﬀect
◮ A pure substitution eﬀect: a one-day rise in the real wage
◮ A temporary real wage increase has just a pure substitution eﬀect, since
the eﬀect on wealth is negligible ◮ Higher real wage encourages work, since the reward for working is higher.
◮ Another way to think about this is that when the wage rate rises the leisure become more expensive, which by itself leads people to want less
◮ If leisure is a normal good, we would then predict that an increase in the wage rate would lead to a decrease in the demand for leisure – and thus
an increase in the supply of labor.
◮ A normal good must have a negatively sloped demand curve. If leisure is a normal good, then the supply curve of labor must be positively sloped.
◮ But our story is not over... The Income Eﬀect ◮ A pure income eﬀect: winning the lottery
◮ ◮ Winning the lottery does not have a substitution eﬀect,
because it does not aﬀect the reward for working But winning...
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