Question

Draw and label an individual's backward‐bending labor supply curve, including the axes. Label the parts of the curve where the wage elasticity of labor supply is positive, where it is zero, and where it is negative. Label the parts of the curve where the income effect dominates, where the substitution effect dominates, and where income and substitution effects are equal

Answer 1

Wage Elasticity of Labor Supply is defined as,

Es = % change in the quantity of Labor Supplied / % change in the wage rate

Es will be positive if increase in the wage rate increases the labor supply

Es will be negative if increase in the wage rate reduces the labor supply

Es will be zero if increase in the wage rate has no impact on labor supply

A change in the wage rate creates two kinds of effect: Substitution and Income Effect. Elasticity will depend upon the magnitude of these two effects. If SE dominates the IE, then an increase in the wage rate would cause an increase in the quantity supplied of labor. Therefore, the Es will be positive.

On the other hand, if SE < IE, then any further increase in wage would increase the leisure and reduces the quantity supplied of labor. So, Es in the case will be negative.

When IE = SE, only then the Elasticity of Labor Supply = 0

Please see the diagram below to see the regions where Elasticity of Labor Supply is positive, zero, negative

As seen in the graph below, Substitution Effect dominates the Income Effect below W*, At W* both effects are equal and Income Effect domintes the Substitution Effect after the wage W*.