Discuss the following:
(i) Discuss the impact of the substitution effect on a wage increase.
(ii) Discuss the impact of the income effect on a wage increase.
(iii) Based on these two effects, how does a wage increase affect the supply of labor?
(i) When wages go up, an additional hour of labor is more expensive in terms of forgone consumption and additional consumption is less expensive in terms of forgone leisure. As a consequence, the worker chooses more consumption and less leisure thereby supplying more labor.
(ii) When wages go up, suppliers of labor are better off. Both consumption and leisure are normal goods, so the income effect leads the worker to choose more of both. Thus, the income effect leads the worker to choose more leisure and supply less labor.
(iii) The income and substitution effects are at cross-purposes when it comes to leisure. Higher wages elicit more labor via the substitution effect. They also make the worker richer which elicits more leisure and less labor via the income effect. Because either effect can dominate, a worker may supply either more or less labor when the wage rate increases.
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