EXERCISE 10: Income and Substitution Effects
J. Wahl – Micro Principles
1. Suppose your hourly wage rate is $8, your daily non-labor income is $10, and the price of
a composite good that represents your consumption is $2 per unit.
a. Draw your budget constraint (NOTE: you should put leisure on the horizontal
axis and goods on the vertical) and superimpose indifference curves to represent your
optimal choices of leisure and goods.
b. Suppose your hourly wage rate jumps to $10. Draw the new budget constraint,
indicate how your choices might change, and isolate the substitution and income effects.
c. What does your answer to b. imply for the shape of your labor supply curve?
2. The US has an earned income tax credit, designed to let lower-earning families take
home more than the wages they earn. At the lowest levels of annual income (the phase-in
range), families receive extra money proportional to their earnings, up to a maximum. In
the plateau range of income, all families receive the same flat amount of extra money. In
the phase-out range, families effectively are taxed upon additional earnings until the
entire EITC is phased out. The ranges of income and benefits for a family with 2+ kids
in 2008, for example, will be
earnings range benefits
phase in 0-12060 40 cents received for each additional dollar of earnings
plateau 12060-15740 $4824
phase out 15740-38646 21.06 cents taken away for each additional dollar of
earnings above 15740.
How would you expect the EITC to affect labor supply? Explain your answer carefully,
in terms of income and substitution effects.
