Question

Explain (no need to graph) the income and substitution effects of a wage rate increase to this worker.

Answer 1

Any change in the price of a good (increase or decrease) has two effects

a) Substitution Effect b)Income Effect

Substitution effect measures how a change in price of the good affects demand of that good compared to other goods

Income Effect measures how a change in demand for a good is affected by a change in real disposable income of a consumer.

The income and substitution effect also take place whenever there is a change in wage rate in the labour market.

The worker faces a trade off between work and leisure when there is a change in wage rate.It means they face a choice between hours worked and hours of leisure.

If wages increase ,then working more becomes relatively more profitable than leisure and hence the worker will substitute leisure by work.They will be more inclined to do work and work extra hours. This is the Substitution Effect

Higher wage rate provide incentive to the worker to work more in order to reach the target income level or desired standard of living. Here we have a positive income effect .But when the desired level of income is reached ,the income effect can work opposite to substitution effect .It is because with higher wages , they will be more inclined to work less hours and spend more time on leisure.It is because they can maintain a target level of income by working fewer hours.It is called the negative income effect .

So if income effects moves in the same way as substitution effect ,people will tend to work more and spend less time on leisure.

If negative income effect outweighs positive substitution effect then worker will work less and leisure more .

So we may find a backward bending labour supply curve .

If the worker is lazy and prefers leisure more then negative income effect will outweigh the positive Substitution effect .

But if the worker is hardworking and prefers to work more then Substitution effect will dominate the income effect .