Substitution and Income Effect
Concisely and coherently put, substitution and income effect are two opposite sides of the same card. That is the summary of the whole concept. These two effects being on the same coin portrays the two economic phenomena both relate to the concept of supply of labour in the market. Both are also because of wage changes in economy.
Substitution Effect
Starting with substitution effect, it indicates a situation whereas when an employee’s wage increases, the individual is inclined to substitute leisure hours with work hours. Therefore, it can be deduced that the employee due to the increase in wage decides to work more and cut down on time spent on leisure. Take the diagram below for example:
Consider Mr. Wilson’s labour supply curve. We can see that at point A where he decides to work for $10 per hour he works for 42 hours. However, at $15/hr, he works for 48 hours. In this case from point A to B we can observe a domination of the substitution effect in this labour supply curve. Furthermore, let’s consider the graph below:
However, before we delve deep into explaining this graph, we need to understand the different variables in question. Both hours and leisure and consumption.
Considering consumption = C. Thus, C = wh+V. Where w = wage, h = total hours worked and V = non-labour income. In the graph above we have total available hours as 110 hours. Para venture we have 80 hours of leisure time. Thus, working hours = Total available hours – Hours of leisure. Therefore, from the graph above, hours worked will be 110-80 which is 30 hours.
From the above graph, we can see the budget line FE, and at point P which is tangent to FE we can observe a total amount of 70 hours of leisure employee Jigida is willing to consume. However, as wage increases from w0 to w1 consumption increases producing a new budget line GE. Thus, the indifference curve shifts from U0 to U1. When this happens there is a drop in leisure from 70 hours to 65 hours where curve U1 is tangent to GE at point R. This clearly explains the substitution effect as a result of an increase in wage in the labour supply market. Remember the formula for calculating work hours; applying this formula we can observe that there is a reduction of about 5 hours in leisure and an increase of 5 hours in work time. Therefore, from 40 hours of work, due to increase in wage work hours increases to 45 hours. Thus, we substitute some hours of leisure for hours of work. The reason behind this is due to the fact that as wage increases, price of leisure increases as well. Thus, it is more expensive to spend on leisure than before when wage was lower.
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