a worker, there is a choice between work and leisure. In this essay, using the model outlined
in seminar sheet 6, will be explaining the income and substitution effects
associated with an increase in the hourly wage rate of an individual.
The income and
substitution effect are explained using indifference curves and budget lines.
An indifference curve
represents all the different combinations of two particular goods or services,
within a commodity space, that give the same amount of utility to a consumer.
In this example the two goods we are analysing are ‘the amount of wages’ and ‘the
mount of leisure time’. The amount of wages on can earn is virtually limitless
however the second good is constrained because there are only 24 hours in a day
to spend in leisure or in work. The shape of indifference curves are bowed,
with the slope getting shallower as we move along the x-axis. This is a
representation of how the marginal rate of substitution, which is the rate at
which a consumer is willing to exchange one for the other whilst keeping his
level of utility (satisfaction) constant, diminishes down the curve.
More than one
indifference curve can be drawn, with each one representing all the
combinations that give a particular level of utility. Although the amount of
utility they represent cannot always be specified, curves drawn further out to
the right represent bundles that give the consumer higher levels of utility,
whilst curves further in to the left represent bundles that give lower levels
The second component
which is used to help explain the income substitution effect is the budget line
(or budget constraint) the budget line shows how much of each good, one can
consume given one’s available income, and the prices or cost of the goods being
considered. If the consumer’s income increases, the budget line will shift outwards
parallel to the previous line because they will have more available income to
buy more of each good and in the same way a decrease in income will cause the
budget line to shift inward as they will have less available income to buy each
The rational consumer
will want to consume at the highest possible indifference curve that his budget
allows him to, so if we were to plot the budget curve and indifference curve on
the same graph, where the budget line is tangential to the further indifference
curve to the right is the optimum point of consumption for that individual.
This is the combination of the two good that the ‘rational consumer’ will buy
to gain maximum utility, with respect of his given budget.
When there is an
increase in income the budget moves further out to the right where it will be
tangential to another indifference curve, which is also further out the right,
giving the consumer a new optimum consumption point on an indifference curve
representing higher levels of utility.
When we impose both a budget constraint and indifference curve on the
graph given in seminar sheet six we can see the effects of the income and
substitution effect as a result of an increase hourly wages (income).
effect is where the rise in hourly wages, increases the opportunity cost of
spending time in leisure. A wage increase will result in the individual being
more willing to substitute some hours of leisure for work, due to the fact that
work becomes relatively more profitable than leisure. This makes them more
willing to trade their hours of leisure for hours of work because working to
earn money at a higher wage rate becomes more appealing relative to the amount
of leisure hours the individual is willing to give up. The utility lost with
the hours of leisure are made up for by the utility gained from receiving more
money for every hour of work. This is shown on the graph by the pivot of b1 to
b1a. The number of leisure hours decreases from L1 to L2, whilst the amount of
wages earned increases from w1 to w2. Notice how b1a is also tangential to I1
at point ‘B’ representing how utility is maintained.
In addition to this,
is the income effect of higher wages. This is where workers will reduce the
amount of hours they work because they can maintain their desired target level
of income through fewer hours of work. As shown in the graph, an increase in
income moves the individual’s budget constraint (B1A) to further out to the
right (B2) where it becomes tangential to a new indifference curve (I2) with a
higher utility at ‘optimum point’ point ‘C’. The new position of the budget
constraint (in terms of how it intercepts the x and y axis further up each
axis) shows that with the increase in income the individual can even have more
hours spent in leisure, whilst also earning a higher wage than before.
The work leisure trade of model has strengths in the way that it is
simple and allows us to think about behaviour and policy without too many
complications. However it also has some flaws that we must consider. In the
real world it is unrealistic to assume that every individual can easily choose
how many hours they work in a day. Many individuals work on fixed hour
contracts so, even if the hourly wage rate were to increase they still might
not have the option to choose how many hours they work a week. also we must
understand that individuals might have other motivation for work aside from
wages. It might be the case that employees work long periods of time purely for
the satisfaction of completing a job as opposed to simply working for the
money, so we must consider that these types of motivations can outweigh the
desire for wages.
If the substitution
effect is stronger than the income effect an individual is likely to work more
hours, following a increase in wage rate. However, in some cases individuals
have an ideal wage rate that they want to get to, which when exceeded they are
happy to work fewer hours. At this point the income effect becomes stronger
than the substitutions effect and individuals tend to want to work fewer hours
despite the wage increase. It is in this case where a backwards bending labour
supply curve can occur. Individuals who have an ideal wage goal tend to have
backwards bending labour supply curves.
As shown on the
graph, hours worked increases with wage rate all the way up to the individuals
target income at Q1, where afterwards the individual prefers to spend more time
in leisure as opposed to working to gain more money. This reduction in labour as
a result of price increase is also known as the negative income effect.
Whether this occurs
or not, is ultimately up to the individual. For example; If the individual has
moderate demands and is more interested in spending his time in leisure, his
goal may be purely to make £40,000 (for example) a year and then afterwards
maximise his leisure time. So in the event that he exceeds these earnings he is
willing to spend more time off of work (in leisure). However if the individual
has larger expenses and little interest in leisure activities the substitution
effect is likely to be dominant, giving the individual an increased incentive
to work longer, in order to boost his income and buy more goods.
To conclude, it seems apparent that a potential cause for the backwards
bending labour supply curve could be high levels of income tax. For people in
higher income brackets, high levels of tax could be a disincentive to work
because they have to work even harder for extra income. Another reason for the
backwards bending labour supply curve occurring could be the existence of
benefits. Benefits may cause people to not want to work and spend their time on
leisure. This is a problem because it causes the supply of labour to be low,
resulting in low outputs for firms and businesses within the economy. Potential
suggestions of government policies to solve the problem of a backward bending
supply curve could be to lower income tax for individuals at higher tax
brackets. This will increase the incentive to work as individuals can earn a
lot more for additional they put in, increasing labour supply. So in short
cutting taxes result in higher wages and increase levels of supply boosting
national income, which the allows the government to gain more tax revenue from
cutting taxes. However, there is always the danger that some workers may
respond to the tax reduction by working less, as they can achieve their target
income with less hours of work.