1 Changes in wage and the work decision here we explore the income and substitution effects of a wage change.

2 Change in the wage rate a b c d Before the wage rate increase the person does best at point a. After the wage rate increase the individual will be happier but what is not clear is if 1)they will work more, as they would at area b, 2) they work the same amount as, as at point c, 3) they work less, as at area d. Economic theory does not indicate which move will be preferred for any individual, but we have some general rules called the income effect and the substitution effect that help us understand which move a person makes.

3 Income effect u The basic idea of the income effect is that as the wage rate rises(falls), even if the person worked the same amount as before the wage increase, they would have more income. Now when people obtain more income they tend to want more goods and services(at least those kinds we call normal). Leisure is one of those goods we would like more of and this pulls the person toward area d on the previous screen.

4 Income effect in a graph The way we look at the income effect is to not change the wage, but to give the person more (nonlabor) income and see how they react. Since we assume leisure is a normal good the person will take more leisure. leisure income

5 Substitution effect u The basic idea of the substitution effect is that as the wage rate rises, the price of leisure rises. As the price of anything rises you and I tend to look for something else in substitution for the thing that has had an increase in price. u This means we would want less leisure as the price of leisure(the wage rate) rises. On slide 2 this means we would move more toward area b.

6 Substitution effect in a graph k j Start out on the indifference curve tangent to the budget line above point j. An increase in the wage rotates the budget clockwise. Now if we take away non-labor in the amount so that the person ends up with the same utility with which they started, then we would be at the point above k – a tangency. leisure income sub. effect is from j to k.

7 income effect in a graph k j To see the income effect we start at point k and give back income so that we are on the new wage budget line. leisure income happen, then the income effect would be stronger than the substitution effect and the person would want more leisure as the wage rose. If the income effect had us move to this area of the budget, a place that could, in theory,

8 Change in the wage rate again a b c d The graph here is the same one as on slide 2. At the initial wage a is still the best point for the person. After the wage increase: Area d will be where the individual ends up if the income effect is stronger than the opposing sub. effect. Area b will be where the individual ends up if the income effect is weaker than the sub. effect. An the individual will end up at point c if the two forces are equal.

9 Supply curve of labor wage labor supply In this diagram we see the person supplys more labor at higher wages. This would be like ending up at point b in the previous diagram.

10 Supply curve of labor with a backward bend wage labor supply Here the backward bend of the supply curve is the result of a wage increase moving the individual to area d on slide 8. We think this only happens when the wage is already fairly high.