Consider the work-leisure model. Assume leisure is a normal good and suppose the wage rate(W) increases, then in this case we will have the following.
Substitution effect: W increases => hours of leisure decrease
Income effect has TWO components:
1. Ordinary income effect: W increases => real income (purchasing power) decreases => hours of leisure decrease
2. Endowment effect: W increases => hours of leisure increase
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a) Now I am confused about the two components of the income effect. Can someone please explain why there are two components and what is the difference?
b) Also, in the "ordinary income effect", how come when W increases, the real income/purchasing power DECREASES? This doesn't make sense to me...if W increases, then I have more money, shouldn't my purchasing power INCREASE?
Any help is greatly appreciated!
First, I agree with your point b) as w increases, income as well as purchasing power increases. Since leisure, by assumption, is a normal good, as income goes up, the desire for more leisure should also go up.
I think of the endowment effect is that we are endowed with a fixed 24 hours per day, and there is only work or leisure. The more one works the higher the marginal value of an hour of leisure. So as hours worked goes up, so does the opportunity cost of work.
I hope this helps.