Study notes

Income & Substitution Effects of Wage Rise

  • Levels: A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Pre-U, Eduqas, WJEC

This analysis looks at the individual labour supply decision and in particular the work-leisure trade off and how this is affected by a change in wages.

  • Most individuals face a choice between hours worked and hours of leisure
  • The opportunity cost of taking leisure is the monetary value of the wages foregone
  • A change in the wage rate has both an income effect and a substitution effect

The income effect of a rise in the hourly wage rate

  • Positive income effect: When higher wages cause people to want to work more hours in order to reach a target / desired income
  • Negative income effect: When a target income has been reached and people prefer spending more time on leisure rather than earning more income

The substitution effect of a rise in the hourly wage rate

  • A rise in the real wage increases the opportunity cost of leisure
  • Therefore higher wages will always cause people to be incentivised to work longer hours via the substitution effect
  • But the income effect may work in the opposite direction

Some people may have a backward bending individual labour supply curve – they may choose to work fewer hours when the wage rate rises (ceteris paribus)

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