In the two-period model with investment, we are confident that the labor supply curve is upward sloping at any wage level because we are making which of the following assumptions:

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We start by restating the question to focus our analysis: In the two-period model with investment, we are confident that the labor supply curve is upward sloping at any wage level because we are making which of the following assumptions:

Option 1: 'The substitution effect of a change in wages is always larger than the income effect.' This aligns with the standard intuition in labor supply: when wages rise, workers substitute away from leisure toward work (substitution effect) and also experience higher income, potentially choosing to work less if they want more leisure (income effect). If the substitution effect dominates the income effect, the net response is more work for a higher wage, steepening or upward-sloping labor supply. In a two-period model with investment, assuming the substitution effect dominates ensures that higher wages incentivize more labor supply regardless of income adjustments, supporting an upward slope.

Option 2: 'The substitution effect of a change in wages always compensates the income effect.' This wording suggests that the substitution and income effects offset each other exactly, leading to a neutral total effect. If compensation occurs perfectly, the labor supply would be unit-elastic or even horizontal at certain ranges, not necessarily upward sloping at all wage levels. Therefore this option would not guarantee an upward-sloping supply curve across all wages.

Option 3: 'The substitution effect of a change in wages is always smaller than the income effect.' If the income effect dominates, higher wages could lead to reduced labor supply due to preferring leisure from increased income, potentially flattening or even bending the labor supply curve backward in some cases. This would not support a universally upward-sloping labor supply in a two-period model, contradicting the stated confidence.

Option 4: 'There is no substitution effect.' The absence of a substitution effect would eliminate the primary mechanism by which wages influence labor supply through the trade-off between leisure and work hours. Without substitution effects, changes in wages would affect labor supply only through income channels, which is not generally why we observe an upward slope. This option is inconsistent with the standard model-building assumption that substitution effects exist and play a key role.

Putting the pieces together, the most consistent assumption that yields an upward-sloping labor supply across wage levels in this two-period investment framework is that the substitution effect dominates the income effect, i.e., option 1. The other options either imply neutrality, downward pressure on labor supply, or eliminate the pivotal substitution mechanism, all of which would fail to guarantee an everywhere upward-sloping supply curve.

ECON 13310 1 Introduction to Macroeconomic Analysis: A Data Driven Approach Final Exam

In the two-period model with investment, we are confident that the labor supply curve is upward sloping at any wage level because we are making which of the following assumptions:

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