Hi everyone. Let me talk to you today about the income and substitution
effects. These two effects are very powerful: they
can explain a lot of things that we see around us.
For instance, they can explain why in almost every rich country now
people are working much, much, much less compared to the great grandparents
who lived 100 years ago.
This chart shows you the evolution of GDP per capita
and total annual hours worked in three countries:
Netherlands, France, and the US. Let's focus on the case of Netherlands.
As you can see, income per capita in this country rose
from around 1200 to 22000 during the course of the
20th century - an increase of 22-fold. Interestingly, at the same time total
annual hours worked declined from around 3000 hours per year to
1500 hours, in other words, total annual hours almost halved in
Netherlands. So we gather from this chart that on
average people in Netherlands, France, and the US
are now much, much richer and work much less compared to
their great grandparents who lived around 1900.
Now the interesting question is why? Which factor can explain the
evolution of these two trends happening at the same time - people becoming richer
and at the same time working less? The answer to that is increasing wages.
Obviously, we know the relationship between
increasing wages and GDP per capita: as wages rose
people became richer, but what's the relationship between
increasing wages and total annual hours worked?
To understand that, we need to know about the income effect
and the substitution effect. So let me explain these two effects with
an example. This is Sarah - she is a journalist
working for Financial Times. Her wage is $15 per hour and based on
this wage she works
six hours a day. That means that she has
18 hours of free time. Now let's assume for
whatever reason Financial times decide to increase Sarah's wage from $15
per hour to $25 per hour. Perhaps Sarah has become,
you know, more and more productive and Financial Times fear that if they don't
increase her wage she might go to a better company. Now the main question
is this: how would Sarah react in relation to this increase
in her wage? Would she work more or would she work less?
In other words what would happen to her hours of free time?
Now this increase in wages puts Sarah in an interesting economic dilemma.
On the one hand she starts to think this: she thinks that
every hour of my [Sarah's perspective] work is now worthmore than before. Previously if I didn't
work I would lose $15 per hour. Now
I would lose $25 per hour. So I should work more and substitute
free time for work. We call this the substitution effect - this voice in
Sarah's mind. But at the same time Sarah thinks that
life is not just about working more and more
and earning more money. She says this to herself: I can now
afford to have more free time, why? Because I can work
less and still maintain or even improve my
current level of earning and consumption.
We call this income effect: as people become richer and richer they become
more willing and able to afford more time.
They for therefore they decide to work less.
Now the main question is that:
what would happen to Sarah? Which of these
effects becomes stronger in her head? Whether the income effect will dominate
the substitution effect or the other way around?
That depends on Sarah's preference regarding the work-life balance.
If for instance if she puts a lot of value
on having free time then the income effect would
dominate the substitution effect and Sarah would end up working less. In other
words, she would increase her hours of free
time. However, if Sarah valued
work more than free time then the substitution effect would dominate the
income effect and therefore Sarah would decide to work more and
therefore decrease her hours of free time.
Now let's visualize the two concepts of income effect
and substitution effect using the example of Sarah.
Here the x-axis represents the hours of free time per day for Sarah, which can
range from 8 to 24, and the y-axis represents her total
level of consumption and earning per day. Now the
red line is Sarah's visibility set, which is
determined by her wage. If you remember initially her wage was $15 per
hour. Now the red line here represents
all the possible lifestyle options that Sarah can choose from.
For instance, at the one extreme she can decide not to work at all
and have 24 hours of free time but in return her total level of
consumption/earning would go down to zero, and at the
other extreme she can decide to work a lot of hours per day only to have eight
hours of free time and in return her total level of
consumption would go down to $225 per day.
Now in reality we know that given the wage rate of $15 per hour Sarah
would actually choose A, which means that she would work for
six hours and have 18 hours of free time per day.
Now based on her decision we can say
that her preference or her indifference curve would
look something like this blue curve. Remember that we don't see people's
preferences or indifference curves. People's indifference curves are in
inside their head, we can only speculate about their
preferences based on the actual decisions that they take, and we know
that given this wage rate Sarah actually decides to have 18 hours
of free time. Now let's move on. If you remember
subsequently Financial Times decide to increase Sarah's wage from $15
to $25 an hour and here this is represented by
an expansion of Sarah's feasibility set. Now what would Sarah do? Would she
increase her hours of free time or reduce her hours of free time? Would she
work more or less? Let's think of a
hypothetical scenario. Let's assume that after the wage
increase Sarah would choose D. That means that she would
in effect work more and reduce her hours of free time. We can
immediately tell that, you know, substitution effect
must have dominated the income effect for Sarah.
Sarah, you know, puts a higher value on work than having free time,
but let's visualize each of these now. Let's start with the income effect.
With income effect we should ask a hypothetical question. Here's the tricky bit.
Let's assume Sarah
had become rich,
her income has increased but her wage had remained the same, for
instance a friend of her just gave gave her some
money so her income increased but her wage remained the
same. In other words she became richer but the opportunity cost of her time
remained the same. Now the question is this: what
would Sarah do given this, you know, shift of income?
We can see that she would decide to go from A to C, which means that she would
decide to work less and increase her hours of free time.
This is the income effect. Now after isolating the income effect
whatever remains must be the substitution effect.
Now what does this substitution effect tell us?
It tells us that Sarah decided, you know, to work more and decrease her
hours of free time, why? Because the opportunity cost
of having free time went up for Sarah after her increase in wages.
So as I said from the very beginning, as you can see the
substitution effect dominated the income effect for Sarah
and overall she decided to work more after getting a promotion from Financial Times.
Now let's go back to our original
question: what factor can explain the evolution of GDP per capita and total
annual hours worked in these three countries? As we said it
was increasing wages. The rise in wages unleashes two opposing
effect: the first one is income effect - as people
become richer they become more willing and able to
afford more free time, so therefore they decide
to work less and enjoy more leisure time; but at the same time,
with increasing wages, the opportunity cost of having a free time goes
up for people, therefore people get an incentive to work
more and reduce their leisure. Now if we take a step back and look at
what happened during the course of 20th century, we can
immediately tell that the income effect must have dominated the substitution
effect, why? Because people had decided to work much much less,
as their wages have increased. Now let me use the same tools of feasibility sets
and indifference curve to explain the changes happening in Netherlands
during the course of 20th century. Now this
is the wage rate, the feasibility set for an
average person in the Netherlands at the beginning of the 20th century
and as we discussed during the course of the 20th century
we had a massive increase in wages, which is represented by
an expansion in the feasibility set. Now based on these wages, you know, at the
beginning of the 28th century people were choosing point A in terms of
hours of free time and consumption, and gradually during this century they
moved from A to D, and as you can see their level of
consumption increased and at the same time they had more leisure,
they had more free time per day. Now let's visualize the cool
concepts of income effect and substitution effect. For income effect,
we imagine the hypothetical scenario imagining that
the people in the Netherlands became rich but the wages
didn't change, and here the green line captures the income
effect: as people in the Netherlands became richer and richer
they decided to work less and enjoy their free time
and whatever remained must be the substitution effect. This effect captures
the fact that as wages rose in the Netherlands
the opportunity cost of leisure went up so
people decided to work more, but as we discussed the income effect
dominated the substitution effect, and therefore overall
people are now working much much less compared to the great grandparents who
lived in 1900. Now in the end let me leave you
with an interesting question. So far we talked about the Netherlands but
if we see this graph we see an interesting outlier and that's
the US. We see that the wages have been growing
and growing since 1960 but the total hours are
worked have remained almost the same, why?
And to answer that question you need to go back to the CORE textbook.
Thank you.