Question 1

In a given week, Steve receives $50 (renting out a spare room in his house). Initially, he faces a wage rate of $10 for each hour that he works, and he chooses to work 55 hours (out of 100 total hours in the week). After receiving a promotion to $15/hour, he works 45 hours.

a) Draw Steve's initial budget constraint, and show his equilibrium choice of leisure and consumption. Make sure everything is labelled.

b) In the same picture, draw the budget constraint after the promotion-based wage change, and show the new equilibrium.

c) Graphically, decompose the change in hours worked into an income effect and a substitution effect.