where Y is total income and the right side is the wage rate.

Effects of a wage increase

Effects of a wage increase
If the wage rate increases, this individual's constraint line pivots up from X,Y1
to X,Y2. He/she can now purchase more goods and services. His/her utility will
increase from point A on IC1 to point B on IC2. To understand what effect this
might have on the decision of how many hours to work, one must look at the income
effect and substitution effect.

The wage increase shown in the previous diagram can be decomposed into two separate
effects. The pure income effect is shown as the movement from point A to point C in
the next diagram. Consumption increases from YA to YC and � since the diagram
assumes that leisure is a normal good � leisure time increases from XA to XC.
(Employment time decreases by the same amount as leisure increases.)

The Income and Substitution effects of a wage increase

The Income and Substitution effects of a wage increase
But that is only part of the picture. As the wage rate rises, the worker will
substitute away from leisure and into the provision of labour�that is, will work
more hours to take advantage of the higher wage rate, or in other words substitute
away from leisure because of its higher opportunity cost. This substitution effect
is represented by the shift from point C to point B. The net impact of these two
effects is shown by the shift from point A to point B. The relative magnitude of
the two effects depends on the circumstances. In some cases, such as the one shown,
the substitution effect is greater than the income effect (in which case more time
will be allocated to working), but in other cases the income effect will be greater
than the substitution effect (in which case less time is allocated to working). The
intuition behind this latter case is that the individual decides that the higher
earnings on the previous amount of labour can be "spent" by purchasing more
leisure.

The Labour Supply curve

The Labour Supply curve
If the substitution effect is greater than the income effect, an individual's
supply of labour services will increase as the wage rate rises, which is
represented by a positive slope in the labour supply curve (as at point E in the
adjacent diagram, which exhibits a positive wage elasticity). This positive
relationship is increasing until point F, beyond which the income effect dominates
the substitution effect and the individual starts to reduce the amount of labour
hours he supplies (point G) as wage increases; in other words, the wage elasticity
is now negative.

The direction of slope may change more than once for some individuals, and the
labour supply curve is different for different individuals.

Other variables that affect the labour supply decision, and can be readily
incorporated into the model, include taxation, welfare, work environment, and
income as a signal of ability or social contribution.

Neoclassical microeconomic model � Demand

See also: Labour demand
A firm's labour demand is based on its marginal physical product of labour (MPPL).
This is defined as the additional output (or physical product) that results from an
increase of one unit of labour (or from an infinitesimal increase in labour). (See
also Production theory basics.)