Question

Consider the following instructions: show how the optimal combination of work and consumption changes after a decline in the wage rate.  Draw two graphs, one where the income effect dominates the choice of leisure and the other where the substitution effect dominates the choice of leisure.

Answer 1

The equilibrium or optimal condition in the labor market occurs when the marginal revenue product equals the wage rate ie MPL/PL=MPK/PK
Whenever there is a decline in the wage rate the employers will hire more employees and the quantity demanded of labourers will increase.
To explain the individuals choice between the income and leisure the indifference curve analysis can be used.If the individuals prefer more income over the leisure workers will be willing to do more hours of work by sacrificing their leisure time.While comparing the leisure and income leisure provides more satisfaction to the individuals while the higher income of individuals implies higher purchasing power of the individuals.

The rise in the wage rates can lead to both income effect and the substitution effect. The magnitude of the income effect and substitution effect will determine the supply of labor. Leisure and income are positively related. Income effect has a positive impact on the increased wage rate. Whenever the income of the individuals or workers increases they prefer to have more leisure time.
On the other hand substitution effect have negative impact on the increased wage rates. The opportunity cost of leisure becomes expensive when there is an increase in wage rates. Thus individuals substitutes more hours of work for leisure. The supply of labor increases when the substitution effect dominates and there is less supply of labor when income effect dominates.
In the graph given below the first diagram depicts income effect more than substitution effect. When the wage rate increases there is decrease in the labor supply from L1 to L2.The substitution effect increases the labor supply L2 L1.In the first diagram income effect dominates the substitution effect and in the second diagram substitution effect dominates income effect where there is increase in the labor supply.