Changes in wage and the

work decision
here we explore the income
and substitution effects of a
wage change.

A wage change
The wage rate for a worker is the price at which the
worker can sell labor services. When prices change
in economics, and here we talk about the special
price known as the wage, we like to talk about two
effects of the price change. We talk about the
income effect of a price change and the
substitution effect of a price change.
With the price change our income buys a different
amount and we think of this as the income effect.
With the price change some goods become relatively
more expensive and some cheaper. It is thought that
folks substitute relatively less expensive items for
relatively more expensive goods. This is the essence

Change in the wage rate

C
b
c
a

Before the wage rate increas

the person does best at poin
a. After the wage rate
increase the individual will
be happier but what is not
clear is if 1)they will work
Leisure

more, as they would at area b, 2) they work the same

amount as, as at point c, 3) they work less, as at area d.
Economic theory does not indicate which move will be
preferred for any individual, but we have some general
rules called the income effect and the substitution
effect that help us understand which move a person

Income effect

The basic idea of the income effect is

that as the wage rate rises(falls), even if
the person worked the same amount as
before the wage increase, they would
have more income. Now when people
obtain more income they tend to want
more goods and services(at least those
kinds we call normal). Leisure is one of
those goods we would like more of and
this pulls the person toward area d on
the previous screen.

consumption

Income effect in a graph

leisure

The way we look at the income

effect is to not change the wag
but to give the person more
(nonlabor) income and see how
they react. Since we assume
leisure is a normal good the
person will take more leisure.

Substitution effect

The basic idea of the substitution effect

is that as the wage rate rises, the price
of leisure rises. As the price of anything
rises you and I tend to look for
something else in substitution for the
thing that has had an increase in price.
This means we would want less leisure
as the price of leisure(the wage rate)
rises. On slide 2 this means we would
move more toward area b.

Change in the wage rate

Here with the wage

increase we see the
budget rotate clockwise.
We start on the solid
lower one and end up at
the solid outer one.
Leisure
To see the substitution effect we create a hypothetical
budget. The idea is to have the original wage structure
but have more nonlabor income than what was had
originally. This hypothetical budget is the dashed one
here. The movement from the original budget to the
dashed on is the income effect. From the dashed

Substitution effect is bigger than income effect

Q
P

Here the person starts at

point P and ends up at
point R. The movement
from P to Q is the
income effect and from
Q to R is the substitution
effect.
Leisure

Here you can see that when the substitution effect is

bigger than the income effect that a higher wage will
actually have the worker take less leisure and thus
more work!
With a higher wage the supply of labor rises.

Substitution effect is smaller than income effect

R
Q
P

Here the person starts at

point P and ends up at
point R. The movement
from P to Q is the
income effect and from
Q to R is the substitution
effect.
Leisure

Here you can see that when the substitution effect is

smaller than the income effect that a higher wage will
actually have the worker take more less leisure and
thus less work!
With a higher wage the supply of labor falls.

Supply curve of labor

wage

In this diagram we
see the person
supplies more labor
at higher wages.

labor supply
This is what we expect to see when the substitution
effect is bigger than the income effect.

Supply curve of labor with a backward bend

wage

Here the backward

bend of the supply
curve is the result of
a wage increase
having a larger
income effect than a
substitution effect.
labor supply

From observation is seems that as the wage initially

rises the sub effect is stronger but at some point
additional wage increases begin to have the income
effect dominate.