Draw a graph showing the trade-off between salary and benefits. Show an employee's indifference and a firm's isocost curve. Label the equilibrium salary/benefits combination. Discuss what would happen as individual taxes fall or as firm payroll taxes rise.

Question

What will be an ideal response?

Answer 1

The indifference curve "U" shows all salary/benefits combinations that meet the employee's reservation level of utility. The three isocost lines show three different levels of total compensation that the firm could offer. The cost-minimizing offer is (S*, F*). As individual taxes fall, the indifference curve would become flatter since the employee would be willing to trade off a lesser amount of salary for a dollar of benefits. In this case, the equilibrium point would involve more salary and fewer benefits. If payroll taxes rise, the firm incurs a higher cost of salary per dollar paid to the employee. The isocost curves will become flatter, and the equilibrium point will involve less salary and more benefits.