Question

Answer the following questions:

1.         What is a Reservation Wage?

2.         Distinguish between an Income Effect and a Substitution Effect of an increase in the wage rate.

3.         Distinguish between Welfare Programs and Work Incentives.

4.         Distinguish between the Added Worker Effect and the Discouraged Worker Effect.

Answer 1

1. The reservation wage is the lowest wage at which a worker is willing to do a particular type of job.

2. Substitution effect will always induced a worker to work more at higher wage. This is because wage rate is opportunity cost of leisure, so at higher wage leisure becomes relatively expensive. So, worker will substitute work in place of leisure.

On the other hand, Ordinary income effect and Endowment income effect induces worker to work less at higher wage. This is because with increase in wage there will be increase in income, which increases leisure (considering leisure to be normal good). Increase in leisure implies less work. Therefore, combined effect depends on magnitude of Substitution effect and sum of income effects. Initially, Substitution effect dominates so work increases but after a particular level, income effect dominates so work decreases.