If a worker’s real wage rate falls, explain the consequent substitution effect.

Question

If a worker’s real wage rate falls, explain the consequent substitution effect. What is the
relevance of the substitution effect to the slope of the labour supply curve? (5 marks)
(b) What is meant by the Value of the Marginal Product of labour (VMPL), and by the
Marginal Revenue Product of labour (MRPL)? Illustrate this numerically, for a case
where the employment of an extra worker changes a firm’s weekly output of tables from
60 to 72, and the firm finds that it must sell its tables at the new price of £30 each
(whereas the old price was £31).

Use a diagram to illustrate the social cost of monopoly (relative to perfect competition),
being careful to label the areas indicating the consequent changes in consumer surplus
and producer surplus, as well as the area representing deadweight loss

Explanation / Answer

(a) If the real wage rate falls, the opportunity cost of leisure will fall. Therefore, because of the substitution effect, the person would like to work fewer hours and spend more leisure hours.

If the substitution effect is positive, the slope of labor supply curve is positive. On the other hand, if the substitution effect is negative, the slope of the labor supply curve is negative.

(b) Marginal Revenue Product of Labor (MRPL) refers to the change in revenue because of employing one more worker. Here, old revenue was 60 * £31 = £1860 and new revenue is 72 * £30 = £2160

So, MRPL = £2160 - £1860 = £300

Value of the Marginal Product of labor (VMPL) is the market value of the marginal product of labor. So, VMPL = market price * marginal product of labor.

Here, market price is  £30 and marginal product of labor = 72 - 60 = 12

So, VMPL = 12 *  £30 =  £360.

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