Question

Which of the following describes the substitution effect?

A. As wages increase, an individual's total potential income rises, making him more likely to choose leisure over labor. A consumer buys more milk each time they purchase cereal
B. As wages increase, an individuals leisure becomes less costly, making him more likely to choose leisure over labor. As hamburgers becomes cheaper consumers purchase more steak
C. As wages increase, an individual's leisure becomes more costly, making him less likely to choose leisure over labor. As the price of Coca Cola rises consumers purchase more Sprite.
D. As wages increase, an individual's total potential income rises, making him less likely to choose leisure over labor. As a consumer increases their income they purchase more desserts, a normal good.

Answer 1

The substitution effect is characterized by an individual choosing more labor and less leisure as the leisure becomes more costly with an increase in wages. It is reflected when an individual responds to wage changes by adjusting the allocation between earning income and taking leisure, based on the relative cost of leisure. An example is a consumer choosing more of a cheaper alternative when the price of their preferred product increases.

Step-by-step explanation:

Which of the following describes the substitution effect? The correct answer is C: As wages increase, an individual's leisure becomes more costly, making him less likely to choose leisure over labor. An example of the substitution effect in a different context is when the price of Coca Cola rises, consumers purchase more Sprite because the latter has now become a relatively cheaper alternative.

In the context of a labor-leisure choice, every wage change has a substitution and an income effect. The substitution effect of a wage increase is to choose more income, as it becomes relatively cheaper to earn due to the increased wage, while leisure becomes relatively more expensive because the opportunity cost of not working has gone up. Conversely, the income effect of a wage increase would lead to an increase in the consumption of both leisure and income if they are considered normal goods.