Wage Rises - Income & Substitution Effects (Labour Markets)

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)