Question

An employer offers his or her employee the option of shifting x units of income from next year to this year. That is, the option to reduce income next year by x units and increase income this year by x units.

a) Would the employee take this option (use a diagram)?

b) Determine, using a diagram, how this shift in income will affect consumption this year and next year and saving this year. Explain your results.

Answer 1

Initially the budget line is AB.

(a) When an employer offers his or her employee the option of shifting x units of income from next year to this yeat. Then ,this will reduce the initial endowment point for future income by x units and increase the current income point by x units. As a result, budget line tilt outward. New budget line is AC.

So, we can see at the new budget line, final equilibrium is E'. Since, the employee prefers more to less and the budget line moves out if he takes this option . Hence , the employee would take this option.

(b) The budget line makes a parallel shift upward , i.e because of the income effect , budget line A'B'. . At this the equilibrium point is E''. From E to E'' is the pure income effect. Consumption in both periods would increase. Savings in this year decreases.