The backward-bending supply curve of labour is a thesis that claims that as wages increase, people will substitute leisure for working. Eventually, wages can increase to a point where less labour is offered in the market.[1]
Referring to the graph, if real wages were to increase from W1 to W2 then the worker will obtain a greater utility, due to their higher income. Therefore, they would be willing to increase their hours worked from L1 to L2. Note that this may be hours worked per day, month, year or even lifetime. Over this section of the curve the substitution effect is positive while the income effect is negative. The substitution effect is greater than the income effect giving rise to a positive price effect(+). Therefore, the increase in the real wage rate will cause an increase in the number of hours worked.
However, if the real wage increased from W2 to W3, then the number of hours worked would fall from L2 to L3. This is because the income effect has now become greater than the substitution effect. This is because utility gained from an extra hour of leisure is greater than the utility gained from the income earned working. Basically, beyond the wage of W2 we see that the worker is being paid enough to sustain their current lifestyle without having to work more hours, therefore creating the backwards bend in the curve.
The above only examines the effect of changing wage rates on workers already subject to those rates. It does not consider the additional labour supplied by workers previously in lower-paid sectors, who are attracted to the jobs where the individual supply curve has passed its peak. This may be substantially delayed due to the time necessary for those new entrants to gain the requisite skills in the higher-paying field.
So as we can see from these assumptions, this condition is rare in aggregate under real world conditions, though at any time, individual workers may have a personally backwards bending labour supply curve. Early retirement can sometimes be considered an example of the phenomenon over an entire lifetime: a person with inherited wealth would be located at infinity and zero (as would an unemployed individual), as it may be that their standard of living could not be increased by any work whatsoever: a person in this situation will sometimes work as a form of recreation in itself.
Overtime can reduce or negate the effect of a backward bending labour supply curve, by increasing wages only for hours worked beyond a certain amount. That increases the substitution effect at high labour supply but does not increase the countervailing income effect by as much as a higher flat wage rate would. This can cause workers to work more hours than they would under any flat wage rate, high or low.
Also, the graph is not to scale and reflects only a small portion at the far end of an individual's supply curve of labour and then only at a point in time. In the real world, one can think of jobs that will pay a lot but require extra long work weeks. Workers may choose such a job for a while, but as their lives changes, assets build, and family or personal relationships develop, they might opt for much less pay to have more regular hours. That also accounts for shift premiums to induce workers to work less desirable shifts.