Generally when prices increase in a market in the economy, there are a few aspects which will change as follows, known as the income and substitution effect. If prices rise, this means that disposable income for people will decrease, this will affect the quantity demanded for goods and services, this is referred to as the income effect.
Similarly, when prices rise or incomes decreases, consumers replace those more costly goods and services with cheaper alternatives, this is the substitution effect. This can also be observed in the labour market, price is replaced by the hourly wage rate and in this case the good is leisure. With regard to the substitution effect, when the hourly wage rate increases, it also increases the cost of the alternative option, in this case that alternative option is leisure. This would prompt people to take less holidays, and work longer hours. As for the income effect, when the hourly wage rate of an individual increases, the most obviously direct effect is that the individual would work more to gain more income. However, when the individual’s ideal income has been reached, leisure becomes increasingly desirable over work, this concept will be explored later in the essay.
However, in this model, the assumption is that the individual has the power to choose heir work and leisure hours, whereas, in reality these terms are not usually as flexible. This is due to contracts with fixed working times, or those who do not have regular work times (shift workers). Furthermore, this is highly dependent on the wage level this individual is working at and the level of necessity this income is to them, as every worker has different social backgrounds, some have higher need for income rather than leisure, therefore a higher substitution effect.
Figure 1 depicts this, the x-axis has a limit to the fact that there are only 24 hours in the day, when the wage is at £200/day the individual got to choose to have 16 hours of leisure as it is the optimal amount to work as shown by the indifference curve I1 at point A (the point between the budget constraint and indifference curve show the maximum utility). As the hourly wage rate increase to £300/day the optimal amount of hours of leisure is 15 hours as by substitution effect theory. However, income effect is shown by the green dashed line parallel to the first budget constraint, this shows that the actual hours of leisure at this rate of income is 18 hours. Therefore the anticipated effect is that there will be a 2 hour increase in hours of leisure when hourly wage increases by £100 pounds a day in this case.The backward bending labour supply emerges when workers reach their target income to sustain a certain lifestyle with the hours they are working, which means that an increase in income will not incentivise them to work extra hours, observing a decrease in labour supply. For example in figure 2, when the individual is working at W1, the incentive is to work the 8 hours required(usually a normal work day), but as their wage increase to W2, the incentive to work also increases despite having to give up 3 more hours of leisure time compared to W1. As wages continues to increase to W3 (the individual’s target income), this person has reached an income which they are satisfied with, simultaneously marks the end of the substitution effect.
George J Borjas stated in his text, “The upward-sloping segment of the labor supply curve implies that substitution effects are stronger initially; the backward-bending segment implies that income effects may dominate eventually”, which supports how income and substitution effects endorses the backward bending labour supply curve. As the reason for this curve to emerge is the escalated desire for leisure instead of work which was explained earlier by the income effect, there are a few circumstances which would derive this backward bending supply curve: decrease in taxation in general, Decrease in direct and indirect taxation may lead to people valuing leisure more, this is because people’s disposable income are increasing, therefore the need for more hours to achieve their optimal income will decrease, which leads to the decrease of labour supply, therefore the backward bending labour supply curve occurs. This can be linked to the laffer curve as the percentage of tax increases past the maximum point (much like the maximum utility point on an indifference curve) the tax revenue generated actually decreases from that point on.There are many ways to prevent the backward bending labour supply curve from emerging. One of which is to give other non-income related incentives such as implement more positive mental strategies to improve productivity without increasing their income.
This way morale will increase which motivates people to work more as they now have a sense of purpose. This prevents the income effect to occur therefore reduces the possibility of the labour supply curve bending backwards. Another way is to present projects periodically, which makes people feel a sense of accomplishment when the job is done, increasing working hours without increasing wages.