Homework 2

1. Consider a situation in which lump-sum tax is higher than dividend income and the consumer
prefers an equal proportion of consumption and leisure.

a. Suppose that h=16, w=0.5, π=0.6, and T=4. Use a diagram to show the consumer’s
optimal choice of consumption and leisure.

Point B: C = I = (0.5 × 16 + 0.6 − 4)/(1 + 0.5) = 3.07. The intercept A is 4.6 and the
intercept D is 9.2. The slope of the budget constraint ABD is 0.5.

b. If the consumer likes a fixed proportion of 4 units of consumption and 1 unit of leisure,
how will your answer to part (a) change? Use the diagram from your answer to part (a)
to show the changes.

Point C: I = (0.5 × 16 + 0.6 − 6)/(4 + 0.6) = 1.02; C = 4(0.5 × 16 + 0.6 − 6)/(4 + 0.6) = 4.08.
c. Show the new optimal choice of consumption and leisure on the same diagram if w is
now doubled. Explain this change in terms of income and substitution effects.

A = 1, h = 16, w = 1, π = 0.6, and T = 4.

Point F: C = I = (1 × 16 + 0.6 − 4)/(1 + 1) = 6.3. The intercepts of E and H are 12.6 each.
The slope of the new budget constraint is 1.

If both goods are perfect complements, there will be no substitution effects. The move
from point B to point F is due to the income effect.
2. Suppose that a consumer can earn a higher wage rate for working overtime. That is for the first
q hours the consumer works, he or she receives a real wage rate of w1, and for hours worked
more than q he or she receives w2, where w2>w1. Suppose that the consumer pays no taxes
and receives no nonwage income, and he or she is free to choose hours of work.

a. Draw the consumer’s budget constraint, and show his or her optimal choice of
consumption and leisure.

The budget constraint is now EJG in the figure below. The budget constraint is steeper
for levels of leisure less than h - q, because of the higher overtime wage. The figure
depicts possible choices for two different consumers. Consumer #1 picks point A on her
indifference curve, I1. Consumer #2 picks point B on his indifference curve, I2. Consumer
#1 chooses to work overtime; consumer #2 does not.

b. Show that the consumer would never work q hours, or anything very close to q hours.
Explain the intuition behind this.

The geometry of the figure above makes it clear that it would be very difficult to have an
indifference curve tangent to EJG close to point J. In order for this to happen, an
indifference curve would need to be close to right angled as in the case of pure
complement. It is unlikely that consumers wish to consume goods and leisure in fixed
proportions, and so points like A and B are more typical. For any other allowable shape
for the indifference curve, it is impossible for point J to be chosen.
 c. Determine what happens if the overtime wage rate w2 increases. Explain your results in
terms of income and substitution effects. You must consider the case of a worker who
initially works overtime, and a worker who initially does not work overtime.

An increase in the overtime wage steepens segment EJ of the budget constraint, but has
no effect on the segment JG. For an individual like consumer #2, the increase in the
overtime wage has no effect up until the point at which the increase is large enough to
shift the individual to a point like point A. Consumer #2 receives no income effect
because the income effect arises out of a higher wage rate on inframarginal units of
work. An individual like consumer #1 has the traditional income and substitution effects
of a wage increase. Consumer #1 increases her consumption, but may either increase or
reduce hours of work according to whether the income effect outweighs the
substitution effect.

3. Suppose that the government imposes a proportional income tax on the representative
consumer’s wage income. That is, the consumer’s wage income is w(1-t)(h-l) where t is the tax
rate. What effect does the income tax have on consumption and labor supply? Explain your
results in terms of income and substitution effects.

When the government imposes a proportional tax on wage income, the consumer’s budget
constraint is now given by:

C = w(1-t)(h-l) + π – T
 where t is the tax rate on wage income. In the figure below, the budget constraint for t = 0 is
FGH. When t > 0, the budget constraint is EGH. The slope of the original budget line is –w, while
the slope of the new budget line is −(1 − t)w. Initially the consumer picks the point A on the
original budget line. After the tax has been imposed, the consumer picks point B. The
substitution effect of the imposition of the tax is to move the consumer from point A to point D
on the original indifference curve. The point D is at the tangent point of indifference curve, I1,
with a line segment that is parallel to EG. The pure substitution effect induces the consumer to
reduce consumption and increase leisure (work less).

The tax also makes the consumer worse off, in that he or she can no longer be on indifference
curve, I1, but must move to the less preferred indifference curve, I2. This pure income effect
moves the consumer to point B, which has less consumption and less leisure than point D,
because both consumption and leisure are normal goods. The net effect of the tax is to reduce
consumption, but the direction of the net effect on leisure is ambiguous. The figure shows the
case in which the substitution effect on leisure dominates the income effect. In this case, leisure
increases and hours worked fall. Although consumption must fall, hours worked may rise, fall, or
remain the same.

4. Suppose that the government announces a ban on hiring foreign domestic helpers. The
representative consumer now has to give up some of her leisure activities to spend more of her
time doing housework. Her preference toward the consumption bundle changes and she is now
willing to consume less for additional leisure time. Assuming that there has been no effect on real
wage (w), taxes (T), and dividend income, how does this new policy affect the consumer’s choice
of work and consumption? Draw a diagram to explain your answer.

Given the same budget constraint, Hira cannot achieve a higher indifference curve. As she prefers
to have less consumption and more leisure time in the consumption bundle, a new indifference
curve (l2) must be plotted. This new indifference curve crosses the indifference curve (I1) showing
that her utility level remains the same, but she prefers to give up more consumption for
additional leisure time. Preference changes. The new optimal consumption bundle is at point B
where leisure rises from l1* to l2*. As she works less, she earns less income at fixed wages,
thereby reducing her consumption level from C1* to C2*.
5. Suppose a two-person household. Person 1 has h1 units of time and takes l1 units of leisure time,
and person 2 has h2 units of time available and takes l2 units of leisure time. Collectively, the two
persons in the household care about their total consumption c, and their total leisure l=l1+l2, and
they have preferences over their total consumption and total leisure. But person 1 faces a market
wage w1, and person 2 faces a market wage w2, with w1>w2.

a. Draw the budget constraint faced by the two-person household. What will the household
do, that is, how much does each household member work?

We can write the household’s budget constraint as 𝐶𝐶=𝑤𝑤1(ℎ1−𝑙𝑙1)+𝑤𝑤2(ℎ2−𝑙𝑙2)

This makes the problem seem complicated, but because w1 > w2, and the household
cares collectively only about total consumption and total leisure time of the household, it
will be optimal for only person 1 to work so long as person 1 is not supplying all available
time as labor. Therefore, the budget constraint for the household looks like the following:
 The household’s budget constraint is ABDF. Only person 1 works if the household
chooses a point on DB, while both members of the household work if the household
chooses a point on FD, with person 1 supplying all of his or her available time as labor.

b. What happens if the market wage of person 2 rises?

If the wage of person 2 increases, ABD remains the same in the figure, but FD becomes
steeper. Therefore, if the household had previously chosen a point on DB, then the
household’s behavior would not change, except if the household had chosen point D and
person 2’s wage increased sufficiently. However, if person 2 were working initially (a
point on DF) was chosen, then our analysis would be exactly the same as for a consumer
facing a market wage that increases. There would be income and substitution effects
involved in the household’s labor supply decision, and person 2 might work more or less
as a result.

6. Suppose that the government imposes a lump-sum tax on goods produced by a firm. Determine
the effect of this tax on the firm’s demand for labor.
d d
Initially, without any tax, the profit for the firm is π = zF(K, N ) − wN , where the production
d d
function, or revenue function, is zF(K, N ) and the cost function is wN . To maximize profits, the
firm chooses a quantity of labor where the slope of the revenue function equals the slope of the
cost function. That is, MPN = w.

The firm’s demand for the labor curve is the marginal product of labor schedule (MPN)
as shown in the diagram.
d
After imposing a lump-sum tax, the firm’s profit function becomes π = zF(K, N ) − T −
d
wN , where T is the lump-sum tax on the output produced.
 The lump-sum tax reduces the firm’s revenue, leading to a downward parallel shift in its revenue
function by T. In other words, for each quantity of leisure, the marginal product of labor remains
the same. To maximize the profits, the firm choses the quantity of labor input where the slope of
the revenue function is equal to the slope of the cost function, MPN = w. Since the lump-sum tax
does not change the MPN, the labor demand remains unchanged. Given w, the labor demand
curve does not shift.

7. An emerging economy changes its policy, attracting more foreign direct investment, which leads
to the accumulation of a more productive capital stock. How does this policy affect the aggregate
output, consumption, employment, and real wage? Explain your results with a diagram and
illustrate the income and substitution effects.
Suppose that the initial equilibrium is at point A where I1 is tangent to PPF1. For each working
hour, the worker will be more productive with more advanced capital stock. The PPF shifts
upwards to PPF2, making its slope steeper than that of PPF1 for each quantity of leisure.

To capture the substitution effect, the PPF2 shifts downward to PPF3 by a constant amount, say
C0. I2 is tangent to PPF2, showing that given the initial income, as the wage increases, the leisure
becomes more expensive in relation to the consumption, so the consumer substitutes leisure
with consumption, as indicated by the movement from A to B. By substitution effect, leisure falls
and consumption increases.

As for the income effect, the constant amount C0 is added back, so PPF3 shifts back to PPF2, and
higher IC (I2) is achieved. Given the same number of hours worked, the income received
increases, and more C and l can be consumed.

Combining the substitution and income effects, consumption must increase, but leisure can
increase or decrease or remain the same, depending on whether the income effect is stronger or
weaker than, or equal to, the substitution effect.

In the diagram, we show that the income effect (from B to C) is stronger than the substitution
effect (A to B). Point C is the new equilibrium point where the consumption and leisure increase,
and the hours of work fall.