# Substitution and income effect

We have two effects operating in different directions – the substitution effect and the income effect. The substitution effect is where he prefers to work longer hours to obtain a higher income, which allows him to purchase more goods and services. In this scenario, the opportunity cost of leisure, that is the wage he gives up, has increased and he therefore allocates more time to work and less to leisure. The income effect, on the other hand, implies that since he gets paid more per hour than before, his total income has increased (for the same amount of hours) and he might decide to work fewer hours since he prefers to have more leisure.

### Assuming that for Kevin the substitution effect is stronger than the income effect, which of the following applies to him?

Correct. Since the substitution effect is greater than the income effect, he will work more hours and sacrifice leisure time.

Incorrect. Since the substitution effect is greater than the income effect, he will work more hours and sacrifice leisure time.

Between the wage rate and his labour supply (in terms of hours) a positive relationship exists. In other words, as the wage rate increases, his labour supply increases and as the wage rate declines, his labour supply decreases. His supply of labour curve therefore looks as follows:

Indicate whether the following statements  is true or false:

### A rise in the wage increases the opportunity cost of leisure.

Correct. The statement is indeed true. A rise in the wage increases the opportunity cost of leisure.

Incorrect. The statement is true. A rise in the wage increases the opportunity cost of leisure.

### A higher wages will cause people to work more hours via the substitution effect.

Correct. The statement is indeed true. A higher wages will cause people to work more hours via the substitution effect.

Incorrect.  The statement is true. A higher wages will cause people to work more hours via the substitution effect.

### A higher wages will cause people to work more hours via the income effect.

Incorrect. The statement is false. A higher wage will cause people to work fewer hours if the income effect dominates.

Correct. The statement is indeed false. A higher wage will cause people to work fewer hours if the income effect dominates.

### A wage increase raises the quantity of labour supplied through the substitution effect, but it reduces the quantity supplied through the income effect.

Correct. The statement is indeed true.

Incorrect. The statement is true.