Question

1. Draw the individual labor supply curve. What is the relationship between SE and IE when the curve is upward sloping, vs. when it is downward sloping?

Answer 1

When the wage rate increases, the income increases by working the same hours and it increases more if working hours increased more.

So with the increase in the wage rate, the income increase, so people like to use more leisure because leisure are a normal good and work is an inferior goods. So with the increase in the income of the consumers, the consumption for the normal good (leisure) increases and work decreases. This is known as the income effect.

With the increase in the wage rate, leisure becomes expensive, so people prefer to substitute leisure with work because by taking leisure, it is very expensive. Hence the people like to more at the higher wage rate. This is known as the substitution effect.

So when the substitution effect is more than the income effects, then the labour supply curve is positively sloped but when the substitution effect is less than the income effects, then the labour supply curve is negatively sloped.

Hence the labour supply curve is backward bending curve and vice-versa in case of wage decreases.

Since income effects leads to less work and substitution effects leads to more work when wage rate increase but when the wage rate decreases then income effects leads to more work and substitution effects leads to less work.

It means both income and substitution effect always moves in the opposite direction.