The effect of substitution and income are two components of the effect of rising or falling prices on output. They explain the disproportion in their change. A similar situation is observed in the labor market. We’ll talk about the latter today.
Real life example
We begin our discussion of the topic with a thought experiment. Suppose you are expected to receive a ten percent pay increase. How will your working day change? In fact, there are three answers to this question. And they are all correct. The working day in this example of a ten percent allowance may increase, decrease, or remain constant. And the reason for this three-valuedness is that there is the effect of substitution and income.
Labor market
Economic science considers the supply and demand of not only goods and services, but also labor. Labor is the main production factor. His proposal is the total number of hours (adjusted based on the intensity of the effort) that people are willing to devote to work for a fee. A corresponding curve graphically illustrates it. On the abscissa axis they postpone the amount of labor, ordinates - the size of salaries.
Offer Schedule
The essence of the labor market is that the employee exchanges his working time for money. A longer day means less leisure. The supply curve is affected by two opposite effects. One makes you want to work less, the other more. it income effect and substitution. If the latter dominates, then supply curve moves up. Otherwise, the motivation for work is reduced, and a reverse slope is formed on the chart.
Both trends are an integral part of the economy. Their action explains the behavior of the supply curve in special cases. If you do not know these effects, it is difficult to understand why, for example, people react differently to salary increases.
The concept of substitution
It is logical to begin the study of any question with a definition of key terms. The substitution effect is a change in consumer behavior due to a rise or fall in relative prices. For example, if private universities increase the price of education in them by 10%, and state - only by 2%, then, most likely, more and more students will choose the latter. This can be said about brands, products and services. If the price of Pepsi increases, then more and more people will choose its main competitor - Cola. The situation is similar with red meat and poultry, shopping for clothes and entertainment. Thus, the substitution effect is a change in the volume of demand caused by an increase in the price of a substitute product.
Income effect
Along with substitution, changes in consumer behavior occur due to rising or falling prices due to an increase or decrease in purchasing power. Money alone does not have any value, but you can buy goods and services on it. Falling prices increase the purchasing power of consumers. For example, consider this as an example of the car market. Suppose car prices have dropped significantly. What does this mean? Consumers can either buy their favorite model cheaper, or opt for a better car. If they made a second decision, they increased utility. All products can be divided into two categories. The consumption of the former increases with income. They are called "normal." This group includes education and most other goods. Consumption of the second decreases with rising income. These include, for example, fast food.
The effect of substitution in the labor market
Now back to our main topic. How does the substitution effect work here? The economy explains its effect on the labor market by the presence of leisure. He is an integral part of human life. Leisure is all time that is not paid. It is believed that it is a "normal" product. This means that an increase in income leads to an increase in the amount of free time. Wealthy people retire earlier. In addition, people who get more usually take longer vacations.
On practice
Consider another example from life. Suppose employee income has increased. What will change and how will the effect of substitution affect it? Consider two important things that will happen when revenue increases:
- The demand for leisure activities will increase. Financial security makes you feel more lack of free time. And additional income allows you to make a choice in favor of a vacation or an unplanned weekend.
- The price of leisure is increasing. This is due to the fact that alternative losses are increasing due to a salary supplement.
The first case describes the effect of the income effect. The more money a person has, the higher his consumption of “normal” goods, to which leisure belongs. That is, employees will begin to want to work less. The substitution effect leads to the appearance of a second trend. As the salaries of workers have increased, their free time will now begin to cost them more. Therefore, they will want to work more. Have you noticed a contradiction?
Less leisure or more - that’s the question.
There is no universal rule to find the answer to the question of which trend will prevail. It all depends on personal preferences and, of course, circumstances. For example, if you are only part-time busy, you don’t have enough money, and here you get a salary increase, then most likely, the substitution effect will control your behavior. On the contrary, if a person is in pre-retirement age, but unexpectedly receives an allowance, then in 90 cases out of 100 he will prefer to increase the duration of his leisure due to additional holidays and weekends. This means that his behavior is controlled by the income effect.
Salary Growth and Charity
Statistics show that most of the volunteers are people from the age group of 45-54 years. But these are not the people who earn the most! But why aren't they doing charity work? It turns out that the effect of the substitution effect on the labor market leads to the fact that an increase in wages causes an increase in the price of free time. Leisure in its broad definition includes volunteering. Therefore, people with large salaries do not do it. And it is not a matter of spiritual qualities or the harmful effects of money.
findings
There are many studies that demonstrate that elasticity of supply labor for the price is positive. This means that the substitution effect has a predominant effect on the aggregate indicator. Therefore, it is his study that is critical for the analysis of the labor market.
