Substitution and income effects of a wage change

A change in the wage results in two effects on an individual's labor supply:

· a substitution effect, and

· an income effect.

As the wage rate rises, the opportunity cost of leisure time rises. In response to this higher wage, individuals consume less leisure time and spend more time at work. This is the substitution effect resulting from a higher wage.

An increase in the wage, however, also raises an individual's real income. This leads to an increase in the consumption of all normal goods. Since leisure is expected to be a normal good for most individuals, a higher wage will generally induce individuals to consume more leisure time (and reduce hours of work). Individuals who receive a higher wage can afford to take more time off from work. This is the income effect resulting from a wage increase.

If we assume that leisure is a normal good, an increase in the wage will cause the quantity of labor supplied to:

· increase if the substitution effect is larger than the income effect, and

· decrease if the income effect is larger than the substitution effect.

This may result in a backward-bending labor supply curve (as illustrated below).

In the diagram above, it is suggested that, at relatively low wages, individuals respond to an increase in the wage by working additional hours (since the substitution effect exceeds the income effect). Eventually, though, when the wage becomes sufficiently high, individuals will begin to work less in response to a higher wage rate. (In practice, it appears that most labor supply curves are either upward sloping or vertical.)