Use the concepts of income effect and substitution effect to explain why a temporary increase in the real wage increases the amount of labor supplied, but a permanent increase in the real wage may decrease the quantity of labor supplied.

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Lucian Soto

1 September, 09:57

Use the concepts of income effect and substitution effect to explain why a temporary increase in the real wage increases the amount of labor supplied, but a permanent increase in the real wage may decrease the quantity of labor supplied.

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Genesis Hernandez · Answer 1

Answer: A temporary increase in real wage may increase the labor offered because the substitution effect has more weight than the income effect. In this case the substitution effect is produced because an increase in real wage increases the additional benefit for a worker. On the other hand, the income effect is less because the wage increase is temporary.

A permanent increase in real wage produces a larger income effect and in this case the income effect exceeds the substitution effect. This causes the worker to earn more in less time, so the worker decreases working hours (decrease the quantity of labor supplied).