Question

17. Explain the substitution effect as it relates to the labor supply curve. Give an example. Then explain the income effect as it relates to the labor supply curve. Give an example.

Answer 1

Supply curve shows an increase in supply as wages rise.it slopes from left to right.In labour market we can often witness a backward bending supply curve .this means after a certain point higher wages can lead to a decline in labour supply.

Substitution effects states that a higher wage makes work more attractive than leisure.so if there is higher wages then supply increases because work gives greater remuneration.

Example -If real wage rate rises the opportunity cost of leisure increases.this tend to make worker supply more labour.

Income effect states that a higher wages means worker can achieve a target income by working fewer hours.Therefore if wages increase,it become eaiser to get enough income through working fewer hours.

Example - If real wage rate rises worker earn a higher income for a given number of hours.if leisure is normal good then demand for it increases as income increases.this increase in income tends to make workers supply less labour so they can spend the higher income on leisure.this is income effect.