Substitution and Income effect

As the price of a good is raised its supply also increases. Thus we get a normal upward sloping curve. In the same way, a higher wage rate will influence people to work for more hours. This would mean that the worker will spend less on leisure because the price of leisure has gone up, in terms of opportunity cost. This is known as Substitution effect.

As a result, the supply curve will be sloping upwards. But when the hourly rate rises above a certain level a worker may wish to work fewer hours per week, because he can earn higher income within a shorter period of time.This is known as Income effect. This will result in the supply curve bending backward.

This is illustrated in the diagram below.

substitution and income effect


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