A consumer would ot choose point J as it is sub optimal due to there being

A consumer would ot choose point j as it is sub

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cuts the budget constraint, also cannot be optimal. A consumer would ot choose point J as it is sub optimal due to there being underutilised resources. The consumer would not choose any points along BD because more consumption goods are preferred to less consumption goods. Marginal rate of substitution of leisure for consumption equals the relative price of leisure in terms of consumption goods. The Representative Consumer Chooses Not to Work The consumer’s optimal consumption bundle is at the kink in the budget constraint, at B, so that the consumer does not work or I=h. This is a situation that cannot happen, taking into account consistency between the actions of the consumer and of firms. This can be seen as a corner solution in which the consumer does not work at all. Changing Real Dividends or Taxes for the Consumer We assume that consumption and leisure are both normal goods. This means that as income increases you use more of that good. An increase in ? ? for the consumer We first look at a change in ? ?, which is the component of real disposable income that does not depend on the real wage and this we hold w constant. A change in ? ? could be caused by a change in disposable income or a change in tax, or both. For example, an increase in disposable income could be caused by an increase in productivity of
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firms, which in turn results in an increase in the dividends that are paid to the consumer. Similarly, if taxes decrease, this represents a tax cut for the consumer, and disposable income increases. In any case, we think of an increase in ? ? as producing a pure income effect. This is because prices remain the same ( w is constant) while disposable income increases. The graph shows that the consumer initially chooses H, and when ? ? rises, this shifts the budget constraint upwards in a parallel fashion (the real wage, which determines the slope of the budget constraint, remains constant.) Consumption and leisure both increase as they are both normal goods. An increase in the market real wage rate The effects of an increase in the real wage on the consumer’s optimal choice of consumption and leisure can be broken down into an income and substitution effect. Firstly, given the higher real wage rate, suppose we take away dividend income from the consumer or increase taxes until he chooses consumption bundle O that is on the initial indifference curve I 1 . Thus, given the increase in real wage, we have taken real disposable income away from the consumer so that he is indifferent between the consumption bundle chosen (point O) and the initial consumption bundle (point F). It is as if the consumer now faces a budget constraint JKD. The movement from F to O is a pure substitution effect . It captures the movement along the indifference curve in response to the increase in the real wage. The real wage increases so that leisure has become more expensive relative to consumption goods, and the consumer substitutes away from the good
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that becomes more expensive (leisure) to the one that has become relatively cheaper (consumption). Therefore, the substitution effect of the real wage increase is for consumption
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