Figure 3.13b - Decomposing the Income and Substitution Effects of a Wage Rise

The Condition for Isolating the Income Effect (Constant Opportunity Cost)

Mathematical Solution of the Constrained Choice Problem Using Calculus

Numerical Decomposition of Income and Substitution Effects

Figure E3.4 - Decomposition of Income and Substitution Effects with a Different Utility Function

Activity: Four-Step Method for Decomposing the Effect of a Wage Rise

An individual experiences a significant increase in their hourly wage. After this wage change, they are observed to be working fewer hours per week than before. Based on this outcome, what can be concluded about the income and substitution effects on their demand for leisure?

An economist is graphically decomposing the total effect of a wage increase on an individual's choice between leisure and consumption. The analysis involves an initial optimal point (A), a final optimal point (D), and a hypothetical intermediate point (C). Arrange the following steps into the correct logical sequence for performing this decomposition using the Hicksian method.

Analyzing a Worker's Response to a Wage Increase

An individual's optimal choice of leisure and consumption changes in response to a wage increase. The graphical analysis of this change involves an initial optimal point (A), a final optimal point (D), and a hypothetical intermediate point (C). Point C lies on the original indifference curve but is tangent to a hypothetical budget line that has the same slope as the new, final budget line. Match each economic effect to the corresponding movement between these points.

In the graphical analysis of a wage increase, a hypothetical point 'C' is used to separate the total change in an individual's choice into two components. To correctly isolate the pure income effect as the first step of the decomposition, this point 'C' must represent a combination of goods and leisure that lies on the individual's original indifference curve.

Explaining the Decomposition of a Wage Change

In the analysis of a worker's response to a wage change, the portion of the total change in hours worked that is attributable to the change in the relative price of leisure, while keeping the worker's level of satisfaction or utility constant, is called the ________ effect.

Explaining the Substitution Effect

An analyst is graphically decomposing the total effect of a wage increase on a worker's choice between consumption and leisure. The analysis moves from an initial optimal point (A) to a final optimal point (D). To do this, a hypothetical intermediate point (C) is constructed. If the goal is to define the substitution effect as the movement from point C to point D (a movement along the final indifference curve), which of the following correctly describes the necessary properties of point C and its associated hypothetical budget line?

Analyzing the Labor-Leisure Choice from a Graph