Question

a wage subsidy has been proposed as the best way to increase the incomes of the working poor. the subsidy would involve government topping up the hourly wage rate of the individual who has been designated "working poor". discuss the possible income and substitution effects associated with a wage subsidy.

Answer 1

Income Effect

This means the change in consumer spending habits after there is a change in the general price and income level. This reflects the impact of the increased purchasing power in the consumption pattern of the consumer.

For example, Mrs. A has been spending a portion of their income on rice. Due to some reason, the price of rice decreases. So now Mrs. A can spend the amount they will originally spending on rice to buy the rice at less price or decide to consume something else. This demonstrates the effect of Substitution.

Wage Subsidy

Coming back to the question, now that the Government has introduced more 'wage subsidy', the wages of workers will increase.

This will have a different impact on the income and substitution effect as it is highly dependent on the type of worker.

To have leisure time or to work more for higher rewards, these are two options available to the workers.

So if the worker is quite lazy and doesn't like to work much, they will choose leisure time instead of working more after they are able to receive higher wages for their present work. This is the income effect, which is describing how a worker can live a suitable life with his/her increased earnings.

As for the substitution effect, the worker who is hard worker, dreams to earn more or is in the need of the money because of debt and other circumstances, will want to spend more time working. Thus, higher rewards will attract workers to work extra hard.

These two effects are related to each other but the effect that dominates at the end will determine the outcome.

However, as we can see, there is also the element of hourly wage present, this means that the worker can afford to work less. In this case, the pendulum would swing towards the side of the income effect.

Therefore, in the end it all comes down to the Individuals choice that plays a major role.

SL Wage Rate Incomeffect> Substitution effect Substitution effect> Income effect Labour Hours worked