Question

(Problem 1d). Leandro has 16 hours per day that he can allocate to work or leisure. His job pays a wage rate of $20. Leandro decides to consume 8 hours of leisure. His indifference curves have the usual shape: they slope downward, they do not cross, and they have the characteristic convex shape. Draw Leandro's time allocation budget line for a typical day, with income on the vertical axis and hours of leisure on the horizontal axis. Leandro's decision to work less as the wage rate falls is the result of a substitution effect and an income effect. In your diagram, show the income effect and the substitution effect from this reduced wage rate. Which effect is stronger?

The substitution effect is stronger than the income effect. We cannot tell which effect is stronger. The income effect is stronger than the substitution effect. The two effects are equally strong.

Answer 1

The substitution effect is Leandro's change in leisure consumption from point A to Point S In the diagram: we constructed it by holding Leandro's utility constant—by Keeping him on the same indifference curve he was on originally, I2—but allow the opportunity cost of leisure to change from 20 to 10. This is illustrated by the dashed budget line labeled BLS. The opportunity cost has fallen, pushing Leandro towards consuming more by the substitution effect. The income effect is Leandro's change in leisure consumption from point STo point B: the reduced wage rate has made Leandro poorer, so he should consume less leisure since it is a normal good.Since his overall leisure consumption has increased (from 8 hours to 12 hours).

The substitution effect is stronger than the income effect.