Question

When wage changes, the amount of hours worked can either increase or decrease depending on the relative strengths of the income and substitution effects.

a) Define the income and substitution effects.

b) Suppose you initially work 8 hours. Your wage increases and you decide to work 7 hours. Which effect dominates?

c) State the range of values that the substitution effect could be in part (b) in terms of hours of leisure. In other words, what is the largest and smallest the substitution effect could be?

Answer 1

Ans a) If a cost of good increases, then there will be two different effects – known as the income and substitution effect.

The income effect mark how the price change affects the income of the consumer. If price increases, it efficiently cuts disposable income, and hence the demand will be low.

For e.g-With the higher price of meat, it means that after buying some meat, the consumer has a lower income to spare. Therefore, consumers will buy less meat because of this income effect.

The substitution effect states that rise in the price of a good will inspire consumers to buy alternative goods. It measures how much rise in the price of goods encourages consumers to buy changed goods, considering the same level of income.

For e.g-If the price of egg increases, then the higher price may encourage consumers to switch to different food sources, such as buying vegetables.

Ans b) Here Income effect dominates.

This is due to the increase in wages for which workers will reduce the number of hours they work so that they can maintain a target level of income through fewer hours.