Question

If the wage elasticity of labor supply is negative, what can we say about the slope of the labor supply curve and the relative sizes of the income and substitution effects? Is leisure a normal or inferior good in this case? Will a fall in the tax rate on earnings increase or decrease tax revenues?

Answer 1

If the wage elasticity of labor supply is negative it indicates that the label supply curve is downward sloping. This is the case with backward bending supply curve, where an increase in the wage rate reduces the effort for work and increase the amount of leisure.

The substitution effect of a wage increase argues for more work and less leisure. in contrast the income effect of a wage increase for a backward bending supply curve suggest that more income can now be earned by working for less number of hours. Therefore income effect reduces the number of hours worked send increases leisure hours. This shows that income effect is greater than substitution effect and that leisure in is an inferior good.

If there is a reduction in the tax rate, it will discourage consumer to earn more income.therefore this will decrease tax revenue because income is not going to increase.