Income and substitution effect

How come higher wages would make someone work more under the substitution effect and less under the income effect?

Given that the substitution and income effects are generally applied to the relative costs of goods, it sounds weird applying them to wages.

Where’d you see these conclusions?

You can apply the concept of SE and IE to this example as well, you are dealing with two goods here namely work and leisure. For that matter SE and IE can be applied to any situation where you are have to choose between two things (whatever those might be, or alternatively 1 thing and n-1 things).

If you r wages go up, then leisure becomes more expensive, since the opportunity cost of sitting on the couch is now higher. Imagine you get your CFA (or earn the CFA charter to use the Institute’s lingo), and your income increases by 10%. What do you do now, work more since you are getting paid more by the hour, or you could work less so that you earn just as much as before with less work. The answer depends on the two effects. SE makes you want to work more, or consume less of the more expensive good (leisure is more expensive because of higher foregone income). On the other hand, with higher wages, you can maintain a decent standard of living through less work. Depending on your preferences, one of the effects will dominate.

A nice illustration can be found here:

In my practice test. It talks about how income and substitution effect would affect one’s ability to work, given rising wages and the substitution effect being greater than the income effect…

Is it similar to the scenario/effects I outlined above?

A technical consultant makes a high hourly wage. Assuming teh substitution effect is greater than the income effect, higher wages will result in the consultant choosing to work

Answer is:

Substitution effect - more

Income effect - less

Did you read my explanation above at all? It describes why you get these two effects (at least I thought it does- maybe I got off topic there and talked about the weather- not really sure).

Let me know if my explanation is not clear.

So the substitution effect will dominate income effect based upon the preferences and work habits of the individual.

My guess is that the substitution effect (assumed SE>IE) will cause the workers to put in more hours, because he derives greater utility from working than leisure.

Meanwhile, the income effect would cause the workers to put in less hours because at a higher wage, the worker can work less to maintain his/her lifestyle.

So basically, the substitution effect is based upon trading one activity for another based upon which provides better leisure, and the income effect is based upon maintaining a certain lifestyle?

Not quite. I would recommend going through the SE and IE with a the typical 2 Good example, and once you are comfortable with that, apply it to this case.

Recall the definition of the SE and IE:

SE: we replace the good that increased in price with the good that got cheaper (This effect is the same for every individual and every problem you are looking at, only the strength of this effect depends on the individuals preferences). Given that we always examine these cases in a 2-Good world, one product getting relatively more expensive means the other one getting relatively cheaper. In the example above, leisure just got more expensive because for every hour on the couch you are losing more income than before.

IE: When our income changes, how does our consumption of a product change. Typically when we earn more we consume more of both goods (if they are normal). If however one of them is inferior we consume less once our income increases (for instance, when you earn more, you might eat less fast food and go to fancy restaurants instead, so a higher income reduces your consumption of fast food).

Apply this to our example here (say our hourly wage increased from $10 to $15):

SE: The individual is putting in more hours, but NOT because it derives greater utility from working than leisure, but rather because leisure just got more expensive. Sitting on the couch instead of working costs you $15 per hour now instead of $10 (in terms of foregone income), so what do you do? You consume less leisure (which automatically causes you to work more, since you can only choose between two products, work or leisure).

IE: Since leisure is a normal good (you earn more, you want to consume more of it), this wage increase will cause you to increase your demand for it, so you will consume more leisure. again, since there are on 24 hours in the day (and we only have two products to consume- work and leisure), when you consume more leisure, you have to work less, thus reducing your hours worked.

Both effects added together will give you an answer to how many hours the individual works now, and this will depend on how strong the effects are compared to each other.

Sounds good. Thank you so much for the help!

One more question, how does this answer change if the income effect is greater than the substitution effect?

You’re very welcome.

The only thing that changes is the total effect. Each effect will still be the same, but depending on which one of the effects is bigger,the total amount consumed of the respective good changes. Remember:

Total Effect=SE+IE

This is really interesting because it would explain why someone wouldn’t for instance purchase an additional loaf of bread if the price of bread decreased and instead for example save the difference. On the surface, if the price of bread decreases, then you purchase more of it and less of another good. But you can only eat so much bread per week (lets say 1 loaf), so logically, this makes no sense. Bread can go to 1c per loaf and you would still consume 1 loaf. But given Tartaglia’s comments, we suddenly see what the alternative is i.e. create an indifference curve between bread and saving for example.

Cool stuff thanks for the eye opening posts.

But I guess the next question is about the assumption of non satiation which would make my comment incorrect.