Answer to Question #194136 in Macroeconomics for SYEDA ZAINAB

Question

Briefly explain the concept of the income-leisure trade-off. What would be the substitution effect and the

income effect of a wage change?

Answer 1

Indifference curve analysis could be used for explaining of choice of an individual between income and leisure.The greater the amount of this sacrifice of leisure, which implies that the greater the amount of work being done, the greater income an individual would earns.

In case of price change, rise in wage rate in turn has both the substitution effect and income effect. The net combined effect on the supply of labor depends upon the magnitude of the income and substitution effect of the rise in rate of wage.

Leisure is a normal commodity which implies that increase in income would lead to the increase in leisure being enjoyed. The income effect of the rise in rate of wage on leisure is positive which leads to an increase in the hours of leisure enjoyed and decrease in labor supply.

The rise in rate of wage increases the opportunity cost or the price of leisure, which in turn makes enjoyment of leisure relatively more expensive.

As a result of rise in wage rate,the individual in turn substitutes work and income for leisure which causes an increase in supply of labor. This is a substitution effect of the rise in wage rate which leads to reduction in leisure and increase supply of labour.

Income effect of the rise in wage rate would lead to a reduction in supply of labor while the substitution effect in turn increases it. If the income effect is in turn stronger than the substitution effect, then the net combined effect of rise in wage rate would be reduction in labour supply.

If substitution effect is relatively larger than the income effect, then the rise on wage rate would tend to increase labor supply.