Question

Demand for Baye’s jeans has suddenly increased and the company’s Chief Executive wants her workforce to work longer hours. In order to achieve this she has two alternatives: (a) increasing the hourly wage, or (b) paying an overtime premium. Discuss the economic rationale of the two alternatives.

Answer 1

Increasing the hourly wage rate has both income and substitution effects.

Higher hourly wages can cause people to want to work more hours (income effect) and it increases the opportunity cost of leisure (substitution effect.). Therefore higher wages can incentivise people to work longer hours via the substitution effect AND the income effect as long as the labour supply curve is not backward bending. This will happen till a target or desired income level is achieved by the worker. After that, the worker will reduce his labour supply since he is getting paid more for the same number of hours.(negative income effect outweighs the positive income effect).

Paying an overtime premium saves the costs of hiring and training new workers and reduces employee-related costs. It generates only substitution effect since the worker has to make a decision at the margin (only his marginal cost is affected)- such overtime pay will increase the number of hours worked unlike a straight increase in ALL hours worked which generates BOTH income and substitution effects and where there is a possibility of the NEGATIVE income effect outweighing the substitution effect.