Substitution effect and income effect of wage increases

Wage Increase

Difference Between Substitution Effect and Income Effect

Substitution Effect

The substitution effect states that workers are encouraged to work more when the wages increase. This is because they get more money by working for longer hours and this motivates them to put in more time and effort. This means there is a positive relationship between wage increase and the effort put in by workers. When one increases, the other increases too. Also, the amount of leisure time available for workers goes down because they spend more hours in a day at work. This results in an upward sloping labor supply curve that moves towards the northeast because workers are willing to put in more hours to take advantage of the wage increase.

Income Effect

The income effect of a wage increase means the worker gets more money for the same effort. This means, the worker can enjoy a higher standard of living and a better quality of life. So, there is a possibility that the worker can cut back the hours he or she works to enjoy the financial freedom. So, they are likely to increase their leisure time. This results in an inverse relationship between the wage increase and the amount of time and effort put in by the workers. When the wage increase is due to income effect, the labor supply curve is moves backwards and this results in a curve that is sloping on the northwest.

Difference Between Income Effect and Substitution Effect

The income effect contradicts the substitution effect in many ways. This can be best understood by an example. When the hourly wage increase from $6 to $8, a worker will work for an additional four hours everyday to get an extra income of $32. In this process, he or she will sacrifice four hours of leisure time to earn more money. This is the substitution effect. On the other hand, when a doctor or a performer's wage increases from $300,000 to $400,000 a year, he or she will want to cut back on the working hours to enjoy the additional money. So, their leisure time increases. As these specialists get more money, they want to work less and spend additional time on the activities they enjoy. This is the income effect.

Besides the leisure time, another significant difference is the nature of the relationship between work and money. In the case of substitution effect, work and wage are directly proportional. When the wage increases, the time and effort put in by the worker increases. However, in the case of income effect, the relationship between work and wage is inversely proportional. As wages increase, the amount of time and effort spent by the workers decrease to make room for more leisure time.

The third difference is the nature of the labor supply curve. In the case of substitution effect, the curve is upward sloping because the hours worked increases when wages goes up. On the other hand, the labor supply curve of income effect slopes backwards because less effort is spent on work when wages increase.