Megan took a pay cut from $10 an hour to $7 an hour. As a result of the wage decrease, Megan desires to work less hours and take more hours of leisure. For Megan
A) the substitution effect dominates the income effect.
B) the income effect dominates the substitution effect.
C) the substitution effect must equal the income effect.
D) the substitution effect must be zero.

Question

Quizplus · Accepted Answer

The substitution effect occurs when the decrease in wage encourages Megan to work fewer hours and enjoy more leisure time, as the wage decrease has reduced the marginal benefit from working. The income effect, however, is negative, as she now has less income at her disposal. In this case, the substitution effect dominates, as Megan's desire to work less is greater than her need for income, resulting in a net decrease in labor supply.

Megan Took a Pay Cut from $10 an Hour to $7