The real wage is the amount of real income that a worker receives in exchange for giving up a unit of leisure (an hour, a day, or a week, for example) for work. It is an important determinant of the quantity of labor that is supplied.
Generally, an increase in the real wage affects the labor supply decision in two ways. First, an increase in the real wage raises the benefit (in terms of additional
12Not everyone can choose his or her labor supply as flexibly as Ace; for example, some jobs are avail-able for forty hours a week or not at all. Nevertheless, by choosing to work overtime, part-time, or at a second job, or by varying the number of family members who are working, households do have a significant amount of latitude over how much labor to supply.
Chapter 3 | Productivity, Output, and Employment 79
real income) of working an additional hour and thus tends to make the worker want to supply more labor. The tendency of workers to supply more labor in re-sponse to a higher reward for working is called the substitution effect of a higher real wage on the quantity of labor supplied.
Second, an increase in the real wage makes workers effectively wealthier be-cause for the same amount of work they now earn a higher real income. Someone who is wealthier will be better able to afford additional leisure and, as a result, will supply less labor. The tendency of workers to supply less labor in response to becoming wealthier is called the income effect of a higher real wage on the quan-tity of labor supplied. Note that the substitution and income effects of a higher real wage operate in opposite directions, with the substitution effect tending to raise the quantity of labor supplied and the income effect tending to reduce it.
a pure Substitution effect: a One-Day rise in the real Wage. We can illus-trate the substitution effect by supposing that, after some consideration, Ace decides to work forty-eight hours per week, by working eight hours per day for six days each week. He leaves every Wednesday free to go skydiving. Although Ace could work and earn $60 per hour each Wednesday, his highest utility is obtained by tak-ing leisure on that day instead.
Now imagine that one Tuesday, an eccentric tennis player calls Ace and requests a lesson on Wednesday to help him prepare for a weekend amateur tournament. He offers Ace his regular wage of $60 per hour, but Ace declines, explaining that he plans to go skydiving on Wednesday. Not willing to take “no”
for an answer, the tennis player then offers to pay Ace $600 per hour for an all-day lesson on Wednesday. When Ace hears this offer to work for ten times his usual wage rate, he thinks: “I don’t get offers like this one every day. I’ll go skydiving some other day, but this Wednesday I’m going to work.”
Ace’s decision to work rather than skydive (that is, to substitute labor for lei-sure) on this particular Wednesday represents a response to a very high reward, in terms of additional income, that each additional hour of work on that day will bring. His decision to work the extra day results from the substitution effect.
Because receiving a very high wage for only one day doesn’t make Ace substan-tially wealthier, the income effect of the one-day wage increase is negligible. Thus the effect of a one-day increase in the real wage on the quantity of labor supplied by Ace is an almost pure example of the substitution effect.
a pure income effect: Winning the Lottery. In addition to skydiving, Ace enjoys playing the state lottery. As luck would have it, a week after spending the Wednesday teaching the eccentric tennis player, Ace wins $300,000 in the state lottery. Ace’s response is to reduce his workweek from six to five days, because the additional $300,000 of wealth enables him to afford to take more time off from work—and so he does. Because the lottery prize has made him wealthier, he reduces his labor supply. As the lottery prize does not affect the current reward for giving up an hour of leisure to work—Ace’s wage is still
$60 per hour—there is no substitution effect. Thus, winning the lottery is an example of a pure income effect.
Another example of a pure income effect is an increase in the expected future real wage. Suppose that the aging tennis pro at the posh country club in Ace’s community announces that he will retire the following year, and the country club agrees to hire Ace beginning one year from now. Ace will earn $100 per hour
80 part 2 | Long-Run Economic Performance
(after taxes) for as many hours as he wants to teach tennis.13 Ace recognizes that this increase in his future wage has effectively made him wealthier by increasing the future income he will receive for any given amount of labor supplied in the future. Looking at his lifetime income, Ace realizes that he is better able to afford leisure today. That is, the increase in the future real wage has an income effect that leads Ace to reduce his current labor supply. Because this increase in the future wage does not change Ace’s current wage, and thus does not affect the current reward for giving up an hour of leisure to work an additional hour, there is no substitution effect on Ace’s current labor supply. Thus the increase in the future real wage has a pure income effect on Ace’s labor supply.
the Substitution effect and the income effect together: a Long-term increase in the real Wage. The aging tennis pro at the country club quits suddenly, and the country club asks Ace to start work immediately. Ace accepts the offer and earns
$100 per hour (after taxes) for as many hours as he wants to teach tennis.
On his new job, will Ace work more hours or fewer hours than he did before?
In this case, the two effects work in opposite directions. On the one hand, because the reward for working is greater, Ace will be tempted to work more than he did previously. This tendency to increase labor supply in response to a higher real wage is the substitution effect. On the other hand, at his new, higher wage, Ace can pay for food, rent, and skydiving expenses by working only three or four days each week, so he is tempted to work less and spend more time skydiving.
This tendency to reduce labor supply because he is wealthier is the income effect.
Which effect wins? One factor that will influence Ace’s decision is the length of time he expects his new, higher wage to last. The longer the higher wage is ex-pected to last, the larger its impact on Ace’s lifetime resources is, and the stronger the income effect is. Thus, if Ace expects to hold the new job until he retires, the income effect is strong (he is much wealthier) and he is more likely to reduce the amount of time that he works. In contrast, if Ace believes that the job may not last very long, the income effect is weak (the increase in his lifetime resources is small) and he may choose to work more so as to take advantage of the higher wage while he can. In general, the longer an increase in the real wage is expected to last, the larger the income effect is and the more likely it is that the quantity of labor supplied will be reduced.
empirical evidence on real Wages and Labor Supply. Because of conflicting income and substitution effects, some ambiguity exists regarding how a change in the real wage will affect labor supply. What is the empirical evidence?
Research on labor supply generally shows that the aggregate amount of labor supplied rises in response to a temporary increase in the real wage but falls in response to a permanent increase in the real wage.14 The finding that a temporary increase in the real wage raises the amount of labor supplied confirms the substi-tution effect: If the reward for working rises for a short period, people will take advantage of the opportunity to work more. The result that a permanent increase
13We assume that zero inflation is expected over the next year, so the $100 per hour wage rate in the following year is an increase in Ace’s real wage rate as well as an increase in his nominal wage rate.
14For a detailed review of research on labor supply, see the article by Richard Blundell and Thomas MaCurdy, “Labor Supply: A Review of Alternative Approaches,” in O. Ashenfelter and D. Card, eds., Handbook of Labor Economics, volume 3 (Amsterdam: North-Holland, 1999), pp. 1559–1695.
Chapter 3 | Productivity, Output, and Employment 81
in the real wage lowers the aggregate amount of labor supplied indicates that for long-lived increases in the real wage, the income effect outweighs the substitu-tion effect: If permanently higher wages make workers much better off, they will choose to work less. The size of these effects depends on a person’s family situa-tion (married or not and whether the family has children) and the tax rate (which determines how much income can be kept after taxes are paid).