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Income & substitution effects
Information source

The issue of labour–leisure choice is an essential part of every human’s life. Finding the most suitable and effective solution between the necessary work and desired leisure time accompanies our lives since childhood. Admittedly, it strongly affects human behavior in most aspects, even though often unconsciously. Questions such as: “Can I go playing football unless my homework has been done?” for a kid, “Would I exchange the success at work for not seeing my little kid growing up?” for a young father or “Is it better for me to grow my own vegetables than spending a few hours in the part-time job and subsequently buying it?” for a pensioner. Hundreds of such decisions form our everyday lives. They are often very complex and can not always be resolved by a purely rational attitude. However, using simplification and theoretical models, it can generally be described and predicted, how people act in various situations in order to reach the highest life goal – happiness.
Feeling of being happy is an extremely individual and abstract term. Perception of happiness is as various as the people around the world. For some, holiday under the tent with beloved people can be priceless, for others, even the most materialistically luxurious experience is not enough. In developed countries, significantly high working hours are considered as normal while in others an everyday joy plays the primary role.

Demand for good (or leisure) is determined by three factors:
• The opportunity costs of the good (leisure)
• The level of wealth
• The set of preferences

In my point of view, the issue of the labour-leisure choice should be considered wisely and especially in the long term. I am convinced that labour today (in any form) will result in leisure in the future. Therefore, I have always perceived my own work as an investment with the only risk of foregone opportunity costs (on the elementary basis), which are rather low in the early stages.
My first crucial decision was to study at the university. My wealth was little, comparable with other students dependent on their parents and preferences were unclear. Direct costs were covered by the support from the family and forgone earnings from a job appropriate to a finished secondary school education in the Czech Republic were neglectful. Decision was easy. Work was invested into future leisure. As the university education by itself does not bring a direct monetary feedback coming from the work (at least at this time), I will substitute the term “money” connected with the normal work for “money perspective” regarding education.
Leisure (mostly interpreted by sport and friends) has always been an important part of my life. At the university, I have always concentrated myself on the most “money perspective” subjects and matters. In these, I invested my leisure time and did my best to excel. Other, in my view, unimportant subjects were accomplished on the very acceptable level, as the opportunity costs of other activities (either different work or leisure) were too high. My wealth was on the same level, therefore had barely any effects on my decision at that time.

Gradually, things started changing. Firstly, my financial demands and ambitions began to exceed what my parents were prepared to provide. Secondly and most importantly, I started to perceive the increasing opportunity costs of pure studying. Interesting job possibilities and business opportunities started to arise. I doubted about the effectiveness of education in general and my preferences began to shift from “money perspective - theory” to “money – reality”. Nevertheless, I was not prepared to give up the university entirely and cut off from my leisure time instead.
As a result, I started my own business which nowadays represents the largest part of the section “labour” in my life. Due to the fact, that I was forced to squeeze both university and work duties together, my leisure time began to be relatively scarce and expensive. The following graph can approximately illustrate my indifference curve:

Utility level A represents the same level of happiness. Point T can be regarded as a breaking point. It stands for 7 hrs of work, 9hrs of leisure time and an appropriate salary. From this point, additional work is becoming exponentially expensive as the leisure time is increasingly scarce. On the other hand the difference between 1-3 hrs. of work a day is negligible. This graph is considerably simplified of course, as crucial matters such as the type and frequency of work are not considered.

Income & substitution effects
Income effect suggests that if income increases, while wages and preferences stay constant, the number of demanded leisure hours will rise. Therefore, the income effect is negative.

(ΔY ) stands for the change in income; (ΔH)- for change in working hours.
On the other hand, the substitution effect suggests that if the income is held constant, an increase in the wage rate results in higher working incentives, raising the price of the leisure time and therefore reducing the demand for it. As a result, the substitution effect is positive.

(ΔW ) stands for the change in wage rate while (ΔH) for change in working hours.
Both of these effects are mostly combined and work in opposite directions. According to the theory, it is hard to predict, which effect dominates in the end.
During my work experience, I clearly noticed both of the effects. After 1,5 years’ company existence, a Swiss venture capital group acquired a minority share. My income increased, while the regular reward for the operational activities in the company remained constant. As this was actually the first substantial financial reward for my work, a significant calm down was achieved. This satisfaction brought me further self confidence and all operations began to work in more relaxed way. Due to the fact, that I disposed of the biggest pressure, I again started focusing on leisure activities, for which I had not had time in the very early stages of the business. A typical income effect took place.
However, this little enthusiasm did not last for long and was soon replaced by the substitution effect. Thanks to the new partner and further investments in the business a considerable expansion was achieved, putting the company to a different level. Even though, the overall income was held constant, a brand new dimension of financial perspectives emerged, boosting my work motivation immediately. Even though the wage still remains the same, realistic future wage perspectives represent a sufficient incentive. Costs of leisure time as well as the university work increased. A strong substitution effect took a dominant place expanding the average working hours considerably.

The theory of labour-leisure choice has its roots in the human and natural psychology. It can generally be said that for those, who act rationally, such rules indeed apply. While analyzing my own life, a very clear correlation was found. However, not all aspects of life can so easily be mathematically illustrated and various rational indifference curves put together do not necessarily need to represent an overall happiness, which could be illustrated by the separate curves. Rational thinking certainly does represent a fundament for the “right” choice, however a certain place for the emotional part of decision making should not be forgotten.

6. Information source
Modern Labor Economics, Theory and Public Policy (R.G. Ehrenberg, R.S. Smith)

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