Question

When consumption and leisure are both normal goods, after an increase in real wage rate with a constant real dividend income minus taxation, the rational consumer

A) increases consumption, and increases labor supply.
B) increases consumption, but the labor supply change is unclear.
C) reduces consumption and increases labor supply.
D) reduces consumption but the labor supply change is unclear.

Answer 1

When both consumption and leisure are normal goods, the effect of an increase in the real wage rate on consumption and labor supply is uncertain due to the combined influence of a substitution effect and an income effect.

Step-by-step explanation:

When both consumption and leisure are normal goods, an increase in the real wage rate has two effects: a substitution effect and an income effect. The substitution effect suggests that the consumer will increase consumption and increase labor supply, as leisure becomes relatively more expensive. However, the income effect indicates that the consumer will reduce consumption and increase labor supply, as the increase in real wage makes them richer.

Considering both effects, we cannot determine the exact change in labor supply when the real wage increases. It depends on the relative strength of the substitution and income effects. The labor supply curve may slope upward, indicating an increase in labor supply, or it may have a backward-bending shape, indicating a reduction in labor supply.