Q. Overall effect of a change in real wages?
The supply of labor
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The supply of labour LS is assumed to be positively related to the real wage W/P
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Total labor supply is determined by utility-maximizing individuals. Total labor supply is also affected by the real wage. An increase in the real wage has 2 effects:
· Income Effect: With a higher income, individuals would want to consume more leisure (as long as leisure is a normal good). Higher real wages will result in a lower labor supply.
- Substitution Effect: A higher real wage would make leisure comparatively more expensive, causing individuals to substitute leisure for consumption. Higher real wages will result in a higher labor supply.
The overall effect of a change in real wages is the sum of income and substitution effects. For some individuals, substitution effect would be stronger than the income effect and they would increase the labor supply as the real wage increases and for some it would be the opposite. In the classical model it's always presumed that aggregate labor supply increases when real wages increase (the substitution effect is stronger than income effect).