Assumptions:  there are only two possible uses of time: labor and leisure,  each individual selects the combination of hours of work and leisure that maximizes his or her level of satisfaction (utility).

Opportunity costs  For individuals who are working, the opportunity cost of an additional hour of leisure time is the wage rate.  Individuals choose not to work if the value of leisure time exceeds the market wage.

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Change in the wage A change in the wage generates:  a substitution effect, and  an income effect

Substitution effect  the opportunity cost of leisure time rises as the wage rate increases.  as leisure time becomes more costly, individuals consume less leisure time and spend more time at work.  this is the substitution effect resulting from a higher wage.

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Income effect  as the wage rate rises, an individual’s real income rises.  this leads to an increase in the consumption of all normal goods.  if leisure is a normal good, the higher wage rate will induce the individual to consume a larger quantity of leisure time (and reduce hours of work).  This is the income effect resulting from a wage increase.

Net effect  If leisure is a normal good, an increase in the wage rate will cause the quantity of labor supplied to:  increase if the substitution effect is larger than the income effect, and  decrease if the income effect is larger than the substitution effect.

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Utility function  It is assumed that the individual’s utility level is a function of two goods: real income (Y), and leisure time (L).  In mathematical terms, this utility function may be expressed as: U=U(Y,L)

Indifference curve U=Uo Y L

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