I understand the impact that an increase in wages will have on aggregate supply (it should increase supply because of the greater incentive to work harder) Now, how does this correlate with the substitution effect? Does it have to do with price inflation, meaning that as supply increases, the prices of goods will eventually increase, causing consumers to change their consuption pattern, i.e. the substitution effect? Or does it simply have to do with the increase in income brought forth from the higher wages - which causes consumers to purchase more expensive goods? Am I way off the reservation here? any help would be much appreciated
I think that increasing wages has two effects: the income effect and the substitution effect. They work in opposite directions. If you are paid twice as much, you might think, “I’m going to work half the hours and spend more time on the golf course.” That’s the income effect. Or you might think, “The opportunity cost of staying home and watching TV for half the week is too high; I’m going to work twice as much.” That’s the substitution effect. It isn’t always clear which effect predominates.