Question

Distinguish between an Income Effect and a Substitution Effect of an increase in the wage rate.

Answer 1

Answer - The supply of labor by an individual worker depends on various factors. One of the most important factors that affect supply of labor by an individual worker is wage rate. Wage rate creates two type of effect on supply of labor. Substitution effect is the effect which works in the direction of increasing the supply in the market. Substitution effect encourage worker to reduce leisure hours which results more labor supply in the market.

Income effect reduces working hours and encourages increasing leisure hours. It results decrease in the labor supply in the market.

Net effect of substitution effect and income effect determines the change in labor supply in the market. Normally an individual labor supply curve bends backward because income effect becomes dominating. Individual worker will increase supply of labor till substitution effect is greater that income effect.

Rise in wage rate increase supply of labor in the market but after a certain level of wage rise in wage rate reduces supply of labor in the market. It happens because income effect dominates over substitution effect. Thus individual supply curve of labor is a backward bending supply curve of labor. The diagram is given below.  

IC is ''income effect'' and SE is ''substitution effect''