# 1 Changes in wage and the work decision here we explore the income and substitution effects of a wage change.

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

2 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 of the sub. effect.

3 Change in the wage rate a b c d Before the wage rate increase the person does best at point a. After the wage rate increase the individual will be happier but what is not clear is if 1)they will work 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 makes. C Leisure

4 Income effect u 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.

5 Income effect in a graph The way we look at the income effect is to not change the wage, 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. leisure consumption

6 Substitution effect u 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. u 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.

7 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. 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 budget to the outer one is the sub. effect. C Leisure

8 Substitution effect is bigger than income effect 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. 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. C Leisure P R Q

9 Substitution effect is smaller than income effect 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. 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. C Leisure P R Q

10 Supply curve of labor wage labor supply In this diagram we see the person supplies more labor at higher wages. This is what we expect to see when the substitution effect is bigger than the income effect.

11 Supply curve of labor with a backward bend wage labor supply Here the backward bend of the supply curve is the result of a wage increase having a larger income effect than a substitution effect. 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.

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