Chapter 2: Labor Supply

1
Chapter 2 Labor Supply
2
Labor Force Status of the Adult Civilian
Population, June 2000
3
Measuring the labor force

• 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

4
Unemployment Rates Over Time
Major trends 1. Unemployment rates have
become less volatile 2. Big jump in
unemployment during the Great Depression
5
Recent Trends in the Unemployment Rate from the
Bureau of Labor Statistics
6
Measurement issues with the unemployment rate

• Labor Force measurement relies on subjectivity
  and likely understates the effects of a
  recession.
• To be considered unemployed a person must be on
  temporary layoff or claim that he or she has
  actively looked for work in the past 4 weeks.
• Hidden unemployed persons who have left the
  labor force, giving up in their search for work.
• May also be people who claim to be looking for
  work but who have little intention of working.
• EPR is a better measure of fluctuations in
  economic activity than the UR.

7
Facts about 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

8
Trends in labor supply of men
9
Trends in labor supply of women
10
Average weekly hours of work of production
workers, 1947-2000
11
Worker performance

• Framework used to analyze labor supply behavior
  is the Neo-Classical 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, C is consumption, L is leisure
• Higher U means happier person

12
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)

13
Different Preferences

• Steep and flat indifference curves

Note that the individual on the left values
leisure more than the person on the right.
14
The Budget Constraint

• C wh V
• w is the hourly wage rate, h is hours worked and
  V is nonlabor income.
• Consumption labor earnings plus nonlabor income
• Because you divide your time between work and
  leisure, ThL, you can rewrite the budget
  constraint as
• C w(T L) V
• CwLwTV (a depressing view of the budget
  constraint)
• Budget constraint sets boundaries on the workers
  opportunity set of all the consumption baskets
  the worker can afford

15
Depicting the budget constraint
Budget Constraint C w(T L) V The slope
of the BC is the wage rate, w.
16
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

17
Optimal consumption and leisure
Consumption ()
What is this persons hourly wage? How much does
this person earn per week at their optimal
consumption bundle? How many hours a week does
this person work at their optimal consumption
bundle?
1200
Y
A
P
500
U1
U
E
100
U0
Hours of Leisure
110
70
0
Hours of Work
110
0
40
18
Changes in Non-Labor Income
An increase in non-labor income This person will
consume more leisure (and spend fewer hours
working). This change is called the Income
Effect.
Consumption ()
1300
1200
P1
500
P0
U1
U0
E1
200
E0
100
Hours of Leisure
110
70
0
80
Hours of Work
110
0
40
19
Wage change

• When there is a wage change, two things are
  happening
• Change in affordable set Income Effect
• Change in the price of leisure Substitution
  Effect

Consumption ()
1400
Wage increase
1000
P
U
E
100
110
70
0
Hours of Leisure
20
The Income Effect and the Substitution Effect

• The Income Effect the impact of an increase in
  income, holding wages constant.
• If wages go up, then the workers affordable set
  will increase. As a result, the income effect
  will lead to a decrease in hours worked since
  leisure is a normal good.
• The Substitution Effect the impact of a change
  in wages, holding utility constant.
• If wages go up, then leisure becomes more
  expensive, as a result, the substitution effect
  will lead to an increase in hours worked.
• These two effects work in opposite directions

21
Ambiguous relationship between hours worked and
wage rates

• If the Substitution Effect is greater than the
  Income Effect, then hours of work increases 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.

22
More leisure at higher wage

• When the Income Effect dominates

Consumption ()
G
U1
R
Q
U0
D
F
P
V
SE
E
IE
110
0
Hours of Leisure
85
75
70
23
More work at a higher wage

• When the Substitution Effect dominates

Consumption ()
U1
G
R
D
Q
U0
D
F
P
V
E
SE
IE
110
0
Hours of Leisure
80
70
65
24
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

25
Graphical Depiction of the Reservation Wage
Consumption ()
If the wage rate is such that the slope of the
budget constraint is greater than the slope of
the IC through E, then the individual will work a
positive number of hours.
H
G
E
T
0
Hours of Leisure
h
26
Graphical Depiction of the Reservation Wage
Consumption ()
If the wage rate is greater than the slope of the
IC through E, then the individual will work a
positive number of hours. If the wage rate is
less than the slope of the IC through E, then the
individual will work zero hours.
H
The blue line is tangent to the IC at point
E. SlopeReservation Wage
E
T
0
Hours of Leisure
27
Reservation wage and non-labor income
Consumption ()

• As non-labor income increases, so does the
  reservation wage.
• You have to pay wealthy people more to induce
  them to work.

H
E1
E0
T
0
Hours of Leisure
28
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)

Wage
IE dominates
SE dominates
Reservation wage
Hours of Work
29
The elasticity of labor supply

• Labor supply elasticity

• Labor supply elasticity less than 1 means
  inelastic.
• When estimates are negative, the income effect
  dominates
• When estimates are positive, the substitution
  effect dominates.
• As time period increases, labor supply becomes
  more elastic.

30
Estimates of labor supply elasticity

• Tremendous debate
• Almost as many estimate of the labor supply
  elasticity as there are empirical studies.
• The one thing we know about the elasticity of
  labor supply is that it lies somewhere on the
  real line.
• The consenus is -0.1
• Interpretation 1 percent increase in wages is
  associated with a 0.1 percent decrease in hours
  worked
• Labor supply inelastic
• The income effect dominates

31
Problems with estimated elasticity of labor supply

• Measurement Error introduces a negative
  relationship between wage and hours

• How do you define the wage rate for salaried
  workers?
• What is the wage rate for those who are not
  working?

32
Labor supply of women

• Substantial cross-country differences in womens
  labor force participation rates
• Labor force participation rates for women are
  high in the United States relative to other
  countries.
• Labor force participation rates tend to be lower
  in less developed countries.
• Over time, womens participation rates have
  increased
• In most studies on women, substitution effects
  dominate income effects.

33
Cross-Country Relationship Between Growth in
Female Labor Force and the Wage, 1960-1980

• 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.

34
Survey Results
35
Changes in hours worked, 1950-2000

• Data are from the U.S. Bureau of the Census
  decennial censuses, 1950-2000.
• Hours worked per person the average number of
  hours worked per person over the age of 15.
• Hours worked per worker the average number of
  hours worked per worker over the age of 15.
• Employment to population ratio percentage of the
  population aged 15 and over employed.
• Note the relationship between the above three
  variables

36
Changes in hours worked by gender

• Hours worked per person decreased for men and
  increased for women.
• Change driven primarily by changes in the
  employment to population ration.

37
Decline in hours worked for men

• Decline in hours worked per person for men driven
  by older men.
• Decline in hours worked per person for older men
  is driven by
• A decline hours worked per worker
• A decline in the employment to population ratio

38
Increase in hours worked for women
Married women, spouse present
Single women
The increase in hours worked per person for women
is driven by an increase in hours for married
women (and particularly for those with children
under the age of 6).
39
Accounting for shifts in hours worked per person

• Increases in the relative wages of females to
  males.
• May have provided women with an incentive to
  enter the labor force.

40
Accounting for shifts in hours worked per person

• Technological innovations that shift female labor
  from home to the market.
• May have made it easier for women to enter the
  labor force

41
Accounting for shifts in hours worked per person

• Increases in Social Security benefits to retired
  workers
• May have prompted people to retire early.

42
Accounting for shifts in hours worked per person

• Changes in family structure.
• Increase in number of single and divorced people
  in population (15 and older).

43
Policy application Welfare

• The first major national attempt to provide
  relief to low-income families occurred during the
  great depression, mostly temporary.
• Modern welfare system introduced in the early
  1960s as part of the Johnston administrations
  War on Poverty.
• Poverty levels established for given family size.
• Goal of welfare program was to bring families up
  to or above established poverty levels.
• Grants were typically only available to
  single-parent households.
• Tremendous opposition to these programs because
  it was argued that they discouraged people from
  working and created a dependency on public
  assistance.

44
Welfare benefit example

• 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
U1
500
U0
Hours of Leisure
0
110
70
45
The effect of welfare on hours worked

• No endowment income, wage10/hour.
• Government grant of 500/week if earnings is
  zero.
• Cash grant reduced by 50 cents for every dollar
  that worker earns (Benefit Reduction Rate).
• Effective wage rate is 5/hour.

Consumption ()
Slope-10
F
H
P
Q
Slope-5
P
U1
500
G
U0
SE
IE
E
Hours of Leisure
0
70
110
Income effect and substitution effect work in the
same direction.
46
Policy application The Earned-Income Tax Credit

• The EITC is a tax credit given to low-income
  workers.
• You have to work to receive the credit.
• Claim the credit when you fill out your income
  tax forms.
• The credit is larger the more children you have.
• The EITC started in the mid-1970s.
• By 2002 it had become the largest cash
  entitlement program in the United States,
  granting over 31 billion a year to low-income
  households annually.

47
The EITC and the Budget Line (for a mother with
two children under age 18)

• 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.

48
The effects of the EITC on labor supply

• EITC should increase labor force participation.
• EITC should decrease hours worked.

49
Labor Supply Over the Life-Cycle(Chapter 3)

• Static model of Chapter 2 is not a complete
  depiction of how we allocate our time
• We want to consider how individuals make labor
  supply decisions over their lifetimes.
• Wage rates change over the workers life cycle
• Wages are low when young
• Wages rise with time and peak around age 50
• Wages decline or remain stable after the age of
  50
• Change in wage over the life cycle is an
  evolutionary wage change altering the price of
  leisure.

50
Responses to Evolutionary Wage Changes

• These evolutionary wage changes are predictable
• Have no impact on lifetime income.
• No income effect.
• A person will work more hours when wages are
  higher.
• The profile of hours of work over the life cycle
  will have the same shape as the age-earnings
  profile
• Intertemporal substitution hypothesis people
  substitute their time over the life cycle to take
  advantages of changes in the price of leisure

51
The Life Cycle Path of Wages and Hours for a
Typical Worker
Wage Rate
Hours of work
50
Age
50
Age
52
Contrast with Static Model of Labor Supply

• In static models of labor supply, wage increases
  increased a workers opportunity set
• In a life-cycle model, wage changes are
  predictable and do not increase a workers
  opportunity set.
• The two models complement rather than contradict
  each other.

53
Intertemporal Substitution Hypothesis

• There should be a positive relationship between
  changes in hours or work and changes in the wage
  rate
• For example, as a worker ages, increases in the
  wage rate should increase hours of work

54
Labor Force Participation Rates over the Life
Cycle in 2002

• Pattern in labor force participation is broadly
  consistent with theory.
• Picture also suggests that intertemporal
  substitution is low.

55
Retirement

• Simple model of retirement behavior.
• No part-time work once you retire.
• A worker who is 60 years will live till he or she
  is 80 years old.
• Lifetime incomes are higher the longer workers
  put off retirement.
• V60 PDV of lifetime earnings if the worker
  retires at age 60
• V80 PDV of lifetime earnings if the worker
  retires at age 80

56
The retirement decision
Point E gives a workers leisure-consumption
bundle if he retires at age 60. Point F gives
the leisure-consumption bundle if the worker
never retires. A utility-maximizing worker
chooses point P, and retires for 10 years.
Consumption ()
F
V80
P
U1
U0
V60
E
Retirement
20
10
0
57
Effect of an increase in the wage on the
retirement decision
An increase in the wage rotates the budget line
around point E, and generates both income effects
and substitution effects as the worker moves from
point P to point R. The figure assumes that
substitution effects dominate and the worker
delays his retirement. High wage earners tend
to retire later.
Consumption ()
G
R
U1
F
P
U0
E
10
20
5
Years of Retirement
58
Effect of an increase in pension benefits on
retirement decision
Consumption ()
Pension benefits, benefits that you collect from
the time of retirement until death. An increase
in pension benefits rotates the budget line
around point F. How will this affect labor
supply? The income and substitution effects both
encourage the worker to retire earlier.
If you retire at 80, you get no pension benefits
(because youre dead)
If you retire at 60, you get 20 years of pension
benefits
U1
U0
F
R
10
20
15
Years of Retirement
59
Policy Application the decline in work
attachment among older workers

• Older workers have lower participation rates
• This can be attributed to work disincentives
  created by higher Social Security benefits
• Another factor the Social Security Earnings
  Test retirees between ages 65 and 69 can earn up
  to 17,000 per year without affecting their
  retirement benefits
• If earnings exceed 17,000 then every 3 of
  income reduces the Social Security benefit by 1,
  an implicit 33 marginal tax rate

60
The Impact of the Social Security Earnings Test
on Hours of Work
The Social Security earnings test (which taxes
retirees when they earn more than 17,000 per
year) generates the budget line HGFE. Once SS
benefits have been taxed away completely, the
budget constraint has original slope.
Consumption ()
H
47,000
27,000
10,000
T
0
Hours of Leisure
61
The Impact of the Social Security Earnings Test
on Hours of Work
The repeal of the earnings test moves retirees to
budget line H?E. Worker 1 no change in hours
of work Worker 2 decrease hours or work Worker
3 might increase or decrease hours, depending on
whether substitution or income effect
dominates. The earnings test was repealed in
2000. Effects on labor supply still not known.
62
Welfare reform

• August 1996, President Clinton signed into law
  welfare reform legislation that ended welfare as
  we know it.
• This new legislation was called The Personal
  Responsibility and Work Opportunity
  Reconciliation Act.
• Ends Aid to Families with Dependent Children
  (AFDC) and creates Temporary Assistance to Needy
  Families (TANF).
• Key features of the reforms
• Gives states a great deal of latitude in setting
  benefit levels and eligibility rules.
• Time limits (often lifetime time limits which
  vary by state60 months)
• Work requirements (or work-related activities)

63
Pros and Cons of Welfare Reform

• The fear was that this would lead to a race to
  the bottom and that the social safety net would
  disappear, especially for those who might need
  welfare for long periods of time.
• The hope was that this would give workers strong
  incentives to leave the welfare rolls and gain
  work experience.
• The next few slides are taken from Fighting
  Poverty Lessons from Recent U.S. History by
  Rebecca Blank (supplemental reading 2).