Changes in the wage rate-Income as well as Substitution Effects

Changes in the wage rate - Income as well as Substitution Effects:

If leisure is assumed to be a normal good the income as well as substitution effects work in opposite directions. This happens for the reason that an increase in wages raises the (shadow) price of leisure, but increases the feasible set at the same time. Thus, if leisure is a normal good, an increase in the wage rate reduces the optimal choice if leisure by the substitution effect, but increases the optimal choice of leisure by the income effect. The net effect is that leisure can increase or decrease as wages go up (Show each case graphically!)

Backward-bending Labor Supply Curve:

951_bending labor supply curve.jpg

Increase in wage unambiguously increase a group’s labor force participation rate, but hours of work for a particular worker may increase or decrease, depending on whether substitution effect or income effects dominate. Market labour provides curve is given by adding up the hours that all persons in the economy are willing to work at a given wage.

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To measure the responsiveness of hours of work to changes in the wage rate, we define labor supply elasticity (σ ):

Estimates of the labour supply elasticity (σ): σ = (% change in H)/(% change in w) = (Δh/ h)/(Δw/w)= (Δh/Δw)*(w/h)

Estimates of the labour supply elasticity (σ):

hi = βwi +γVi + other variables

β : marginal bang of a one dollar change in wi on hi.
γ : marginal bang of a one dollar change in Vi on hi.

Sign of β depends on whether substitution as well as income effects dominate.

• β < 0 , if (         ) effect dominates.
• β > 0 , if (         ) effect dominates.
• γ < 0 , assuming that leisure activity is a normal good.

Numerous surveys conclude that σ is roughly around – 0.1.

Three key points are value noting about “- 0.1” consensus approximate of σ:

• Negative therefore income effect is dominating. Secular refuse in hours of work can be attributed to the income effects associated with rising real wages.

• Labour supply is inelastic.

• Keep in mind that this is the consensus approximate of the labour supply elasticity for prime-age men. The available proof suggests that σ probably differs greatly between men and women and between younger and older workers.

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