Question

1.If the substitution effect is larger than the income effect, what will be the labour-supply response to an increase in the income-tax rate? (Recall that income taxes are a percent of income, not a fixed sum.)

A.	Labor supply will remain unchanged.

B.	Labor supply will change ambiguously.

C.	Labor supply will increase.

D.	Labor supply will decrease.

2. Suppose your firm produces according to a function in which capital and labour are perfect compliments. The wage rate is currently $120 per day and the daily capital cost is $100. If the wage rate falls to $100, does the substitution effect dominate the scale effect and ensure that more capital is used?

A.	Yes. In the end, the use of both labour and capital increase.

B.	No. In the end, the use of labour increases but the use of capital decrease.

C.	No. There is no substitution effect, so the use of both labour and capital increase equally.

D.	None of the above.

Answer 1

1. Ans is D) Labor supply will decrease.

When substitution effect is larger than income effect so an increase in the marginal income tax rate lowers the price (opportunity cost) of leisure (the opportunity cost of leisure is the after tax wage) and so people will demand a greater quantity of leisure.

2 Ans is C) No. There is no substitution effect, so the use of both labour and capital increase equally.

Given that the two inputs are perfect compliments, there is no substitution effect in response to a change in factor prices. As such, any decrease in wage paid to labor will only induce an increase in the scale of production, thereby increasing both labour and capital equally.