Income and Substitution Effects

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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. For temporary wage increases the substitution effect dominates.