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 term real wages refers to wages that have been adjusted for inflation. This term is used in contrast to nominal wages or unadjusted wages.

The use of adjusted figures is in undertaking some form of economic analysis. For example, in order to report on the relative economic successes of two nations, real wage figures are much more useful than nominal figures.

If nominal figures are used in an analysis, then statements may be incorrect. A report could state: 'Country A is becoming wealthier each year than Country B because their wage levels are rising by an average of £500 compared to £250 in Country B'. However, the conclusion that this statement draws could be false if the values used are not adjusted for inflation. An inflation rate of 100% in Country A will result in its citizens becoming rapidly poorer than those of Country B where inflation is only 2%. Taking inflation into account, the conclusion is quite different: 'Despite nominal wages in Country A rising faster than those in Country B, real wages are falling significantly as the currency halves in value each year'.

The importance of considering real wages also appears when looking at the history of a single country. Looking back over the decades, annual wages were considerably less than they are today. If only nominal wages are considered, the conclusion has to be that people used to be a great deal poorer than today. However, the cost of living was also much lower. In order to have an accurate view of a nation's wealth in any given year, inflation has to be taken into account -- and thus using real wages as the measuring stick.

Real wages are a useful economic measure, as opposed to nominal wages, which simply show the monetary value of wages in that year.