An employee of a firm has a job where the employee can easily adjust the number of hours they work for the employer per year. The employee is currently paid $40 per hour and will work 2000 hours in 2018. The employer had a good year in 2018 and is considering two changes in the employee’s compensation for 2019.

a) Suppose the employer decides to raise the employees wage to $45 per hour. Explain why it is unclear whether the wage change will cause the employee to choose more or less work in 2019. (Note: The ability of the firm to change wages means this firm is not in a competitive labor market, but this has no impact on the worker’s decision) (1 point)

b) The other alternative the firm is considering is paying the employee a $10,000 bonus, but not changing the wage. Explain how this will change your answer to (a) about how much the employee works in 2019. Explain how it is possible both options cost the employer the same amount of money

The answer to both a and b is in the explanation below

Explanation:

a) The increase in wage can either decrease or increase the hours worked. This is became an increase in wage has both substitution effect and income effect that work in different directions. Substitution effect An increase in wage increases the opportunity cost of leisure, thereby making the worker increase number of hours worked. Income effect The increase in wage also makers the worker richer, thereby making the worker decrease number of hours worked.

Since no information about worker's preferences is given, we do not Imow which effect will dominate the other effect and, therefore, we do not know what the net impact of the increase in wage will be.

b) The bonus will only have income effect. The bonus will make the workers richer, thereby making the worker decrease number of hours worked.

If in part a), the substitution effect and income effect are equal in magnitude, then there will be no change in the number of hours worked. The number of hours worked will remain the same at 2000 hours. Since the employer would be paying $5 extra on each hour worked, the cost to the employer of increase in wage would be $10,000 (=2000 x $5), which is the same as the bonus in part b).

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