The income and substitution effects of a change in the wage rate

Question

Quizplus · Accepted Answer

The income and substitution effects of a change in the wage rate always work in opposite directions. The substitution effect involves a change in the relative prices of leisure and consumption, which leads to a change in the quantity of labor supplied. A higher wage rate increases the opportunity cost of leisure and encourages individuals to work more. The income effect involves a change in the purchasing power of income, which affects the quantity of labor supplied indirectly through changes in the quantity and quality of consumption. A higher wage rate increases the income effect, which may lead individuals to work less if the income effect dominates the substitution effect. Therefore, the income and substitution effects always work in opposite directions.

The Income and Substitution Effects of a Change in the Wage