Economics

Study Notes

Wage Rises - Income & Substitution Effects (Labour Markets)

Level:: A Level, IB

Board:: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 21 Mar 2021

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)