Question

Explain and support graphically income and substitution effects in production on the quantity demanded of labor if the price of labor (wage) declines.

Answer 1

* As the method is not mentioned, so, I'm using Slutsky equation and not Hicksian equation.

Suppose initially the optimal quantity of labour and capital are (L,K) represented by point E on budget line AB and indifference curve IC1

Decrease in price of changes the budget line such that the old bundle, E is just affordable. Making the new budget line CD. This is called compensatory budget line where real cost is same as before but input price ratio changes. According to substitution effect, because in decrease in wage rate, the producter will substitute labour for capital. Thus, increasing demand for labour to L' and decreasing demand for capital. This is represented by point E' on budget line CD and indifference curve IC2

For income effect, keeping input price ratio constant and decreasing real cost of the firm, the new budget line is AB' as real cost has decreased, from income effect, demand for both labour and capital will increase represented by point E" on budget line AB' and indifference curve IC3. H Thus, labour demand will increase further to L". But net demand for capital will depend on whether substitution effect is greater than or less than income effect. In the former case demand for capital will decrease and in latter it will increase.

*Please don’t forget to hit the thumbs up button, if you find the answer helpful.