If someone were to give you a $5,000 raise tomorrow, how would this change your behavior? Economists have a few basic theories for the effects of income changes upon work/leisure consumption, which can be used to predict the effects of tax or welfare policies, among other things. Some people clearly fall under the umbrella of one theory, but many more lie in a gray area of reaction. Here’s a quick quiz to see:
You work at a job paying $15 an hour. Tomorrow, your boss tells you he will be paying you $20 an hour thanks to your superior skills. What do you do?¹
a) Work less hours, because I’ll have more/the same amount of money. It’s Netflix time.
b) Work more hours, because suddenly the “cost” of lying around for an hour just went up—I could have made $20!
c) I think I’ll buy an Xbox/new purse.
If you answered A: It looks like you are experiencing the income effect! Leisure is a normal good—that means that when your income goes up, you demand more of it, and when your income goes down, you demand less of it! Because your income just went up, you will demand more leisure. Enjoy your movie watching!
If you answered B: It looks like you are experiencing the substitution effect! There is a “cost” to leisure—opportunity cost. For each hour you spend lying around you could have been earning money. As your wage increased the relative cost of leisure increased—you are now giving up $20 for each hour you spend doing nothing. When the price of a normal good (see above) increases, the demand decreases, so you will consume less leisure, and work more hours.
If you answered C: You should really evaluate your consumption patterns. Invest yo' earnings!
“But wait,” you say, “those effects are working opposite of each other!”. Right you are, my friend. The beauty of economic theories is that sometimes they completely contradict each other, which accounts for all the people who think very differently than you do! A lot of times, these effects work opposite each other to create an overall neutral effect to income changes. How strong each effect is for a given person depends entirely on their preferences, which can be drawn out graphically as “indifference curves” (more on this later). Here’s another quiz to explain this further:
1) Fred works at an ice cream shop, and hates his job. He has to listen to crying children all day, but the job pays him just enough to get by, so it’s worth it. He gets a 50% raise. Does the income or substitution effect apply to him?
a) income effect (wants more leisure)
b) substitution effect (works more hours)
2) Angela works at a tech company that sounds like “frugal”, and it’s her dream job—work is her life! She gets a promotion & raise. What does she do?
a) Stay 2 extra hours a day—now she has even higher expectations to fill.
b) Start going home at 5.
Now do you see how an individual's preferences might affect which effect applies to them? This is extremely important to consider when implementing any policy changes, particularly income transfers (taxes or welfare, etc.). Oftentimes we have the best intentions, but don’t consider that others may not feel the same way about working or leisure that we do. The substitution and income effect are particularly interesting when it comes to unemployment insurance and the earned income tax credit (EITC), though this is a conversation for another time.
In their most basic form, the income and substation effects describe the reactions actors have to price changes. As the price of an item changes, so does its relative price (what you give up to get it)—which is the substitution effect. As the price increases or decreases, this also either constrains or creates new income, which is the income effect.
The income effect refers to the reaction in demand for goods due to income changes, and the substitution effect refers to the reaction in demand for goods due to changes in the relative prices of the goods.
¹Let’s assume that our quiz characters have no debt, kids, and other annoying things like that. Classic economics, oversimplifying like crazy!