Income and Substitution Effects in Labor Economics

Labor Economics

Labour economics seeks to understand the functioning of the market for labour. Labour markets function through the interaction of workers and employers. Labour economics looks at the suppliers of labour services (workers), the demanders of labour services (employers), and attempts to understand the resulting pattern of wages, employment, and income.

It is an important subject because unemployment is a problem that affects the public most directly and severely. Full employment (or reduced unemployment) is a goal of many modern governments.

Real Wage

The real wage describes the quantity of goods that the worker gets for a number of hours of labor. the real wage is the nominal wage adjusted to the level of inflation. It determines how much labor workers will want to supply in the economy.

Income Effect

When wages increase, the income effect states that a worker feels wealthier and that he needs to work less to have the same income. The effect will result in the laborer placing a greater demand on goods, services, and non-market activities so that he/she will cut down on supply of labor.

Substitution Effect

The substitution effect is simply when the laborer feels that because the wage has increased the worker realizes that by involving himself in non-market activities he is missing the opportunity to increase savings. Therefore, the result will be an increase in the supply of labor.

Gender Differences

Men and women are observed to react in a different way to changes in wages. For men, the substitution effect dominates, while for women, the income effect outweighs the substitution effect. In general though, we assume that substitution effect dominates the economic behavior of people. In this project, we are going to analyze the causes, effects and consequences of this generalization.