Question

Daniel was earning \(\$ 65\) per hour and working 45 hours per week. Then Daniel's wage rose to \(\$ 75\) per hour, and as a result, he now works 40 hours per week. What can we conclude from this information about the income effect and the substitution effect of a wage change for Daniel?

Short answer

The increase in wage has led to a positive income effect where Daniel’s purchasing power increased since his weekly earnings increased. This implies he can buy more goods and services than before. The substitution effect is also apparent as Daniel chose to work fewer hours, suggesting he substituted his work hours for leisure. The overall effect appears to be dominated by the substitution effect since he chose to reduce his work hours even though his total weekly earnings went up.

Step-by-step solution

Calculate Daniel's weekly earnings before the wage increase

To begin, you need to find out Daniel's earnings from the time he was earning \( $ 65\) an hour. This can be achieved by multiplying his hourly wage by the total number of hours he worked in a week. That is \( $ 65\) per hour * 45 hours = \( $ 2925\) weekly.

Calculate Daniel’s weekly earnings after the wage increase

The next step is to find out Daniel’s earnings after his wages increased to \( $ 75\) per hour. This is done by multiplying the new hourly wage by the number of hours he works in a week. That is \( $ 75\) per hour * 40 hours = \( $ 3000\) a week.

Analyze the income effect and the substitution effect

Daniel’s weekly earnings increased from \( $ 2925\) to \( $ 3000\), which shows that he can now afford more goods than before even with reduced working hours. This is an example of a positive income effect. However, when his wage rate increased, he also chose to work fewer hours. The higher wage rate made leisure more costly in terms of foregone earnings, prompting Daniel to substitute work for leisure. This illustrates the substitution effect. Also, because he worked fewer hours, it supports the notion that for Daniel, the substitution effect dominated the income effect in this scenario.

Key concepts

Wage Change

Wage change refers to any adjustment in the amount of money an employee is paid per hour or per work period. In Daniel's case, his wage experienced an increase from \( \(65 \) to \( \)75 \) per hour. Changes in wages directly influence a worker's budget and can affect both their work and leisure choices.

When wages rise, it means employees are paid more for each hour they work. This can have immediate impacts on their lifestyle and decision-making. A higher wage allows individuals to afford more goods and services, potentially increasing their overall satisfaction and quality of life.

• Higher wages can encourage more productivity and effort while at work.
• They can also lead to a reconsideration of how a person divides their time between working and leisure activities.

Wage changes often serve as a stimulus for considering both the income and substitution effects, as they directly impact a person's financial decisions.

Labor Supply

Labor supply relates to how much labor (in terms of hours worked) individuals are willing to offer at different wage rates. Daniel initially worked 45 hours per week but reduced his hours to 40 after his wage increased.

Typically, as wages increase, people may choose to work more hours because the benefit of working an additional hour is financially rewarded more than before. However, this is not always the case as seen with Daniel. Here are key points to understand about labor supply:

• The decision on how many hours to work is influenced by personal preferences for leisure versus income.
• A person may decide to work fewer hours if they value leisure more than the additional income from working extra hours.

For Daniel, the additional earnings from the higher wage outweighed the need to work the same number of hours, indicating his preference for leisure or other activities over additional work.

Income Effect

The income effect occurs when a change in wages influences a person's purchasing power, leading to changes in consumption and labor. In Daniel's situation, the wage increase from \( \(65 \) to \( \)75 \) per hour allowed him to enjoy more leisure time while still increasing his weekly earnings from \( \(2925 \) to \( \)3000 \).

Here's how the income effect plays out:

• An increase in wages boosts an individual's overall income, allowing them to purchase more goods and services.
• This can lead an individual to work fewer hours because they can afford the same lifestyle or even improve it without working as much.

Essentially, a rise in income means that individuals can maintain or even enhance their standard of living without the need for additional labor hours.

Substitution Effect

The substitution effect arises when a change in wages alters the opportunity cost of leisure versus labor. In Daniel's case, despite the higher wage, he chose to work fewer hours.

This effect can cause individuals to change their allocation of time from work to leisure or vice versa depending on the wage change.

• When wages increase, work becomes more attractive relative to leisure because the opportunity cost of choosing leisure (i.e., the wages forgone) is higher.
• This might prompt individuals to work more hours to take advantage of the higher wages.

However, for Daniel, the substitution effect was such that he valued his leisure time more and chose to work fewer hours while still increasing his total income. In this scenario, the substitution effect can be seen to dominate as Daniel makes financial decisions favoring reduced labor hours.