Question

Draw a neat and clear diagram and show the decomposition of total effect into substitution and income effects for a fall in wages when leisure is an inferior good (with leisure on the horizontal axis and consumption on the vertical axis).

Answer 1

Vertical axis : Consumption goods ( units)

Horizontal axis : Work hour ( hour )

Initial wage is OM which decreases to OM' .OM rotates to OM' showing change in wage.

Initially equilibrium is at E where OP hours of leisure is consumed , after a fall in wage new equilibrium settles at E' , leisure consumption increases to OP_{​​​​​s}. Since leisure is inferior good , hours of leisure Consumed increase as income falls. And substitution effect is as usual ,i.e., fall in wage which is also the opportunity cost of leisure or price of leisure makes leisure cheaper and one start substituting leisure for consumption. Here we seez substitution and income effect reinforces each other and overall leisure consumption increases after fall in wage.

PP_​I : income effect

P_{​​​​​I} P_{​​​​​s} : Substitution effect