Labor Supply

Question 0

In the V(N-Nbar)=w*U’(a+w*N) equation, what represents the income/wealth effect? How does the substitution effect change labor supply?

Answer 0

The w inside the consumption utility function carries the income/ wealth effect. The higher the wage the higher is wealth so the less you work, (a+w*N) is decreasing in N

Question 1

In the V(N-Nbar)=w*U’(a+w*N) equation, what represents the substitution effect? How does the substitution effect change labor supply?

Answer 1

The w that multiplies the consumption utility function a + w*n carries the substitution effect. If w increases, you work more to consume more.

Question 2

If you plot N vs. w for big a and small a, how does the labor supply curve change from small to big a? Which curve is more back bending?

Answer 2

The small a is to the right of the big a curve (as a increases, u provide less labor at a given w). The big a has less of a back bend than the small a because the income effect is not as strong (eg the desire to work less b/c of a wealth increase thru higher w). Conversely, the wealth effect is stronger for little a so at higher levels of w, people work less and curve bends back

Question 3

What does lambda represent?

Answer 3

Lambda is the marginal utility of wealth