Chapter 2

Labor Supply

McGraw-Hill/Irwin Labor Economics, 4th edition

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

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Introduction to Labor Supply

Labor facts
- Working men: decline in labor force participation from 90% in 1947 to 75% in 1990 - Working women: rise in labor force participation from 32% in 1947 to 60% in 1990

- Work hours fell from 40 to 35 per week during the same time period

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Measuring the Labor Force

Current population survey (CPS)
- Labor Force = Employed + Unemployed
LF = E + U Size of LF does not tell us about intensity of work

- Labor Force Participation Rate

LFPR = LF/P P = civilian adult population 16 years or older not in institutions

- Employment: Population Ratio (percent of population that is employed)

EPR = E/P

- Unemployment Rate
UR = U/LF

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Measurement Issues

Labor Force measurement relies on subjectivity and likely understates the effects of a recession Hidden unemployed: persons who have left the labor force, giving up in their search for work EPR is a better measure of fluctuations in economic activity than the UR

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Facts of Labor Supply

More women than men work part-time More men who are high school drop outs work than women who are high school drop outs White men have higher participation rates and hours of work than black men

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Average hours worked/week, 1900-2005

60 55 50 45 40 35 30 1900

Weekly hours

1920

1940

1960 Year

1980

2000

2020

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Worker Performance

Framework used to analyze labor supply behavior is the NeoClassical Model of Labor-Leisure Choice Utility Function measure of satisfaction that individuals receive from consumption of goods and leisure (a kind of good) U = f(C, L), where - U is an index - Higher U means happier person

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Indifference Curves
Downward sloping (indicates the trade off between consumption and leisure)
Higher curves = higher utility Do not intersect

Convex to the origin (indicating that opportunity costs increase)

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Indifference Curves
Consumption ($)

500 450 400

40,000 Utils
25,000 Utils
Hours of 100+ 125 150

Leisure

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Indifference Curves Do Not Intersect

Consumption ($)

Z
U1 U0

Leisure

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Differences in Preferences across Workers

Steep and flat indifference curves:

Consumption ($) Consumption ($)

U1 U1 U0 Hours of U0 Hours of

Leisure

Leisure

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The Budget Constraint

C = wh + V
Consumption equals labor earning (wages hours) plus nonlabor income (V)

Because of time, rewrite as - C = w(T L) + V

Budget constraint sets boundaries on the workers opportunity set of all the consumption baskets the worker can afford

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Depicting the Budget Constraint

Consumption ($)

wT+V

Budget Line

Hours of Leisure

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The Hours of Work Decision

Individual will choose consumption and leisure to maximize utility Optimal consumption is given by the point where the budget line is tangent to the indifference curve At this point the Marginal Rate of Substitution between consumption and leisure equals the wage rate

Any other bundle of consumption and leisure given the budget constraint would mean the individual has less utility

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Optimal Consumption and Leisure

$1200 $1100 A Y

$500

P U1 U*

$100 0 110 70 40 110 0

E U0

Hours of Leisure Hours of Work

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Two Effects
Increase in nonlabor income allows worker to jump to higher indifference curve, indicating the Income Effect - Leisure can be treated as a normal good or as an inferior good As wages change holding real income constant, changes in consumption-leisure bundle indicate the Substitution Effect

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The Effect of a Change in Nonlabor Income on Hours of Work

Consumption ($)
F1 F0 P0

P1
U1 E1

$200

U0

$100

E0

70 80

110

Hours of Leisure

An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P0 to point P1. If leisure is a normal good, hours of work fall.

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The Effect of a Change in Nonlabor Income on Hours of Work

Consumption ($)
F1 P1 U1 $200 P0 E1

F0

U0

$100

E0

60

70

110

An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P0 to point P1. If leisure is an inferior good, hours of work increase.

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Ambiguous Relationship: Hours Worked and Wage Rates

If the Substitution Effect is greater than the Income Effect, then hours of work increase when the wage rate rises

If the Income Effect is greater than the Substitution Effect, then hours of work decreases when the wage rate rises.

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More Leisure at a Higher Wage

When the Income Effect dominates:
Consumption ($)
G U1 R D U0 F V E D P Q

70 75

85

110

Hours of Leisure

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More Work at a Higher Wage

When the Substitution Effect dominates:
Consumption ($)
U1 G R D U0

Q
D P E

F V

65 70

80

110 Hours of

Leisure

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To Work or Not to Work?

Are the terms of trade sufficiently attractive to bribe a worker to enter the labor market?
Reservation wage: the minimum increase in income that would make the person indifferent between working and not working - Rule 1: if the market wage is less than the reservation wage, then the person will not work - Rule 2: the reservation wage increases as nonlabor income increases

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The Reservation Wage

Consumption ($)
H Has Slope -whigh

Y G X E U0
Has Slope -w

UH

Hours of Leisure

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Labor Supply Curve

Relationship between hours worked and the wage rate - At wages slightly above the reservation wage, the labor supply curve is positively sloped (the substitution effect dominates) - If the income effect begins to dominate, hours of work decline as wage rates increase (a negatively sloped labor supply curve) - Labor supply elasticity % change in hours worked/% change in wage rate Labor supply elasticity less than 1 means inelastic

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Estimates of Labor Supply Elasticity

When estimates are negative the income effect dominates
Labor supply tends to be inelastic

As time period increases, labor supply becomes more elastic

Measurement error tends to overemphasize the importance of the income effect

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Labor Supply Curve

Example of backward bending labor supply:
Wage Rate ($)

25

20

10

20

30

40

Hours of Work

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Labor Supply of Women

Substantial cross-country differences in womens labor force participation rates

Over time, womens participation rates have increased

In most studies on women, substitution effects dominate income effects

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Derivation of the Market Labor Supply Curve from the Supply Curves of Individual Workers
Wage Rate ($) Wage Rate ($) Wage Rate ($)

hB hA ~ wA ~ wB 0 (b) Brenda ~ wB hA 0 (c) Market hA + hB Hours of Work

~ wA

(a) Alice

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Cross-Country Relationship: Growth in Female Labor Force and the Wage, 1960-1980
7 6
Netherlands

Female Participation

5
Australia

Growth Rate of

4 3
USSR Israel Britain France Germany Italy Sweden

Japan

Spain

2 1
United States

0 1 2 3 4 5 6 7 8 9

Percentage Change in Wage

Source: Jacob Mincer, Intercountry Comparisons of Labor Force Trends and of Related Developments: An Overview, Journal of Labor Economics 3 (January 1985, Part 2): S2, S6.

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Policy Application: Welfare Programs and Work Incentives

Cash grants reduce wage incentives
Welfare programs create work disincentives Welfare reduces supply of labor by granting nonlabor income, which raises reservation wage

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Effect of a Cash Grant on Work Incentives

A take-it-or-leave-it cash grant of $500 per week moves the worker from point P to point G, and encourages the worker to leave the labor force.
Consumption
($) F

P G 500 U1 U0 0 70 110

Hours of Leisure

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Effect of a Welfare Program on Hours of Work

Consumption ($)
F U0 U1
slope = -$10

H D
slope = -$5

Q P $500 R D G

E 0 70 100 110

Hours of Work

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Policy Application: The Earned-Income Tax Credit

EITC should increase labor force participation of nonworkers of targeted groups

EITC produces an income effect

- Hours worked should change

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EITC and Labor Supply

In the absence of the tax credit, the budget line is given by FE. The EITC grants the worker a credit of 40 percent on labor earnings as long she earns less than $10,350. The credit is capped at $4,140. The worker receives this maximum amount as long as she earns between $10,350 and $13,520. The tax credit is then phased out gradually. The workers net wage is 21.06 cents below her actual wage whenever she earns between $13,520 and $33,178.
This is shown in the next slide, (not drawn to scale).

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The EITC and the Budget Line

Consumption
($)
F G
33,178

Net wage is 21.06% below the actual wage

17,660

H
Net wage equals the actual wage

J
14,490 13,520 Net wage is 40% above the actual wage

10,350

E 110

Hours of Leisure

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The Impact of the EITC on Labor Supply

The EITC shifts the budget line, and will draw new workers into the labor market. In (a), the person enters the labor market by moving from point P to point R. The impact of the EITC on the labor supply of persons already in the labor market is less clear. In the shifts illustrated in (b) and (c), the worker reduced hours of work.

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End of Chapter 2