The combined effect (both income and substitution) of a wage increase is that
A) the substitution effect always dominates, leading to more work at a higher wage.
B) the income effect always dominates, leading to less work at a higher wage.
C) if the substitution effect outweighs the income effect, the labour supply curve slopes upward, but if the income effect outweighs the substitution effect, the labour supply curve is backward bending.
D) if the substitution effect outweighs the income effect, the labour supply curve is backward bending, but if the income effect outweighs the substitution effect, the labour supply curve slopes upward.

Question

Quizplus · Accepted Answer

The correct answer is C, which states that if the substitution effect outweighs the income effect, the labour supply curve slopes upward, but if the income effect outweighs the substitution effect, the labour supply curve is backward bending. The substitution effect leads individuals to work more when the wage increases because the opportunity cost of leisure becomes higher. However, the income effect leads individuals to work less when the wage increases because they can afford to work fewer hours and still maintain their same level of consumption. The relative strength of these two effects will determine the overall impact on labour supply, and if the substitution effect outweighs the income effect, the labour supply curve will slope upward. However, if the income effect outweighs the substitution effect, the labour supply curve will become backward bending at higher wage rates.

The Combined Effect (Both Income and Substitution) of a Wage