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The Opposing Income and Substitution Effects of a Wage Increase on Free Time
Substitution Effect
The substitution effect describes how a consumer's choice is altered by a change in the relative prices of goods. When the price of one good rises relative to another—for example, when a wage increase raises the opportunity cost of free time—the consumer is incentivized to substitute away from the more expensive good. More formally, the substitution effect measures the change in choice (e.g., of free time) due to a price change, while holding the level of utility constant. This isolates the effect of the change in relative cost from the effect of the change in overall purchasing power, which is known as the income effect.
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Economy
The Economy 1.0 @ CORE Econ
CORE Econ
Ch.3 Scarcity, Work, and Choice - The Economy 1.0 @ CORE Econ
Social Science
Empirical Science
Economics
Introduction to Microeconomics Course
Related
Income Effect
Substitution Effect
Activity: Disentangling Income and Substitution Effects of a Wage Rise
Dominance of Income or Substitution Effect Determines the Net Effect of a Wage Rise
Further Reading on the Mathematics of Consumer Choice
Key Sources for Historical Analysis of Work-Leisure Choices
Figure 3.16 - A Model of US Labor Supply and Consumption (1900 & 2020)
Applying the Wage Effect Model to Explain Historical Labor Trends
An individual who is paid by the hour receives a substantial raise. This change in their hourly pay rate creates two conflicting pressures on their decision about how many hours to work versus how much free time to enjoy. Which option below best analyzes these two opposing pressures?
Analyzing a Change in Work Hours
Deconstructing the Effects of a Wage Increase
Following a wage increase, the substitution effect occurs because an individual's total income is now higher for the same hours worked, allowing them to substitute away from work and towards more leisure time.
A person's hourly wage increases. This creates two distinct pressures on their decision of how much free time to take. Match each described pressure with its underlying economic cause.
Explaining Historical Labor Trends
When an individual's wage increases, the opportunity cost of taking an hour of free time rises. This creates an incentive for the individual to work more hours and take less free time. This specific pressure is known as the ________ effect.
Analyzing a Labor-Leisure Choice
Evaluating a Labor Decision
An hourly worker receives a significant wage increase. After considering their new financial situation, they decide to reduce their weekly work hours to enjoy more free time. Based on this outcome, which statement provides the most accurate analysis of the economic pressures at play?
Learn After
The Substitution Effect of a Wage Increase on Free Time
The Always-Negative Substitution Effect for Typical Indifference Curves
The Substitution Effect (Movement from C to D) as a Shift to a Higher MRS