Question:

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Expert answer:

Step: 1

(a)

A budget line illustrates the trade-off between two goods. In

this case, income for hours is trading of with childcare. It is
given that the wage is $10/hr. This means that spending all
200,000 available hours working would result in an income
of $2,000,000. Alternatively, each child requires 20,000 hours
of time. This means that spending all 200,000 available hours
raising kids would allow the couple to raise 10 kids. These
values become the endpoints of the budget constraint, which
is a straight line connecting them.

Indifference curves are convex to the origin. The optimal

choice is the one in which the couple's indifference curve is
tangent to the budget constraint. This is because, at this point
of tangency, the couple would be unable to increase utility by
trading more money for kids or more kids for money. They
couple is also incapable of earning more money while raising
the same number of kids or raising more kids while earning
the same amount of money.

The graph is drawn below:

Step: 2

Notice that ($*, K*), the optimal levels of income and

children are less than $2,000,000 and 10, respectively. This
characterizes what is referred to as an "interior solution."

Step: 3

(b)

When the wage rate increased to $12 per hour, the value of
the vertical intercept increased from 2,000,000 to 2,400,000
(200,000×12). As a result the budget constraint will rotate.

The new graph is as follows:

Notice that the new optimal bundle of kids and income

contains more kids and more income than previously, but that
income increases more than kids. This is because there is both
an income effect and a substitution effect.

The income effect is that the new budget curve is higher than
the old budget curve at all points. That is, the new budget
contains all of the bundles feasible under the old bundle, but
it also contains new bundles. The income effect increases the
efficient quantity of both income and kids.

The substitution effect is the change in the slope between the

old curve and the new curve, which increases the opportunity
cost of having kids. The substitution effect increases the
efficient level of income and decreases the efficient number
of kids.

Step: 4

(c)

Yes, that fact is consistent with this model. This model shows
an income effect and a substitution effect. Which is larger is
ultimately an empirical question. Since there is empirical data
to suggest that "as societies get richer and wages rise, people
typically have fewer children," it must be that the substitution
effect is larger than the income effect for those societies.