Question

What is the substitution effect vs. the income effect as w falls. Discuss each individually

Answer 1

In Economics, the income effect can be defined as the change in the demand for a good due to a change in consumer's real disposable income. If the price of a commodity falls, the real disposable income of the consumer will increase and this will lead to arise in demand for the good. The substitution effect can be defined as the fall in demand for a commodity as its price increases as the consumer will substitute the dearer good with cheaper ones.

When the income effect and substitution effect of labor supply is discussed, we have to start with the labor supply curve. For each worker, he has a choice between work and leisure. The labor supply curve has a back-ward bend as shown in the figure. this is due to the income effect and substitution effect.

The worker can choose either to work or to leisure. The leisure time is simply the non-work time of a worker. In the figure, on the X axis hours worked is measured and on the Y axis wage rate is measured. Up to a point (W1,Q1) as wage rate increases , the supply of labor also increases. Here the supply of labor means, the time spent on work by a labor. Up to the wage rate W1, the substitution effect is stronger than income effect. That is up to W1Q1, as wage rate increases, the lobor supply by an individual also increases. The substitution effect of work means to the point W1Q1, the worker will give up leisure to do more work as the reward for work is high.But beyond the point W1Q1, the income effect is stronger than the substitution effect. The income effect of the higher wages means, the worker will reduce the hours of work and choose more leisure as he can maintain a targeted income level with fewer hours of work.

So here the main question is what is the income effect and substitution effect when the wage rate falls. When the wage rate falls, the substitution effect becomes stronger and income effect becomes weaker. As w falls, the worker has to give up leisure to work as the reward for the work is low.. Here the income effect effect become weaker the substitution effect, that means the worker could not give up working hours to leisure because, he has to maintain a targeted level of income.