Question

Use the concepts of Income effects and substitution effects to explain effects on labour supply of
a) lump-sum transfers
b) income tax credit.

Answer 1

Lump sum transfers are basically like an increase in the income of the beneficiary. It results in a parallel upward shift of the budget line between leisure and income. Therefore, for each given amount of labour the consumer now enjoys higher income. Here, because the prices have not changed therefore there is no substitution effect. The entire effect is the income effect. Assuming leisure to be a normal good the income effect will be positive and therefore the labour hours and hence labour supply would fall. On the other hand if leisure had been an inferior good then income effect is negative and hence leisure would fall and labour supply increase. Here, it is also possible that income effect is zero which would mean no change in either labour supply or leisure. Although this is a rare case.

In the case of income tax credit the budget line shifts outward on the income axis (y axis) while the x intercept remains unchanged. So the slope of the budget line changes.

If the leisure is normal good then income effect is positive while substitution effect for leisure is negative here as the leisure has become costlier.

Depending on the relative strength of the two the effect on labour supply can be calculated. If IE>SE then leisure increases and labour hours fall while if IE<SE then leisure falls and labour supply increases. If the two effects are equal then there is no change in either labour or leisure.

Also, note that if in this case leisure was an inferior good then it has negative income effect as well as negative substitution effect which would mean that an income tax credit would necessarily reduce leisure and increase labour supply.