A vice president of a company argues that the president of the company should raise workers’ wages if the president wants less absenteeism. The president says that wages probably should be cut so that the workers could not afford to miss so much work

Question

Evaluate the two views using the income and substitution effects in your analysis.

Please provide the best answer for the statement.

Answer 1

The analysis must be based on the idea that most workers prefer leisure to working for the president of the company. Therefore, the higher their income, the more leisure they can afford (income effect). On the other hand, the higher their wage, the more costly it will be to give up an hour of work, and the less leisure “time-off” they will substitute for work (substitution effect). The income and substitution effects tend to work in opposite directions.
If the income effect outweighs the substitution effect, then the vice president is wrong. Paying the workers more will enable them to work shorter hours and earn enough to afford their added leisure despite the partly offsetting effect of the substitution effect that has made leisure more expensive per hour.
If the substitution effect outweighs the income effect, then the vice president is right and the president is wrong. Paying the workers less will cause them to work fewer hours because they don’t lose as much for each hour not worked. The effect of the lower income will partially offset the lower price of leisure, but not enough to cut the rate of absenteeism. In fact, absenteeism may increase.
Either could be correct. The solution depends on the strength of the income and substitution effects for the workers, and that, in turn, depends on many factors such as their present income status, the opportunities for using one’s leisure time, and so on.