Labor Supply : Theory and Evidence

1
Labor Supply Theory and Evidence

• Labor supply decisions can be roughly divided
  into two categories
• Decisions about whether to work at all, if so,
• how long to work.
• (2) Decisions about the occupation or general
  class
• of occupation in which to seek offers and
  the
• geographical area in which offers should be
• sought.

2
1. Some Stylized Facts about Labor Supply

• Trends in LFP
• (1) ? ????????1964??34???? ?
• 1987??45,1987???????45??,
• 1999???????,?2007????49.4?
• ? ??????1978??78?????2007?
• ?67.24?
• (2) ? 15-19??????1978??45?????
• 2003 ??12,?2007?????10???
• ? 20-24??????1978??65?????
• 2005??53, ?2005???2007?????
• 53?????
• ? ??????????????????

3

• Trends in Hours of Work
• (1)????????1990-2000????48??
• ??,?2005?1?????45.46??,?
• 2008?7?????46.98???
• ????????1978????50????2005
• ?1??45.82??,?2008?7?????45.98?
• ??
• ?????????1978????46?????
• 1997??47??,????2005?1??44.98?
• ?,?2008?7??????46.67???

4
2. A Theory of The Decision to Work

• The decision to work is ultimately a decision
  about how to spend time.
• Spend time in pleasurable leisure
  activities
• Use time to work (working for pay)
• The discretionary time we have
• (24 hours time spent eating and sleeping)
• can be allocated to either work or leisure.
• Demand for Leisure Supply of Labor.

5

• Basically, the demand for a good is a function of
• three factors
• The opportunity cost of the good.
• Ones level of wealth.
• Ones set of preference.
• The demand(D) for a normal good can be
• characterized as a function of opportunity
• cost(C)and wealth(V)
• D f(C, V)

6

• Where f depends on preferences.
• Demand for Leisure
• (1) The opportunity cost of an hour of leisure is
  very closely related to ones wage rate.
  For simplicity, we shall say that leisures
  opportunity cost is the wage rate.
• (2) Economists often use total income as an
  indicator of total wealth, since the two are
  conceptually so closely related.
• Demand for leisure function becomes
• DL f(W, Y)

7

• (1) If income increases, holding wages(and
  f)constant, the demand for leisure goes up.
• If income increases(decreases), holding
  wages constant, hours of work will go down(up).
• Income effect on hours of work is negative.
• Income Effect ? w lt0

8

• (2) If income is held constant, an
  increase(decrease)in the wage rate will
  reduce(increase)the demand for leisure, thereby
  increasing(decreasing)work incentives.
• Substitution effect on hours of work is
  positive.
• Substitution Effect ? Y gt0

9
Both Effect Occur When Wages Rise Income effect
For a given level of work effort, he/she now has
a greater command over resources than before
because more income is received for any given
number of hours of work. Substitution effect
The wage increase raises the opportunity costs of
leisure, and thereby increases hours of work.
10
If income effect is dominant, the person will
respond to a wage increase by decreasing his/her
labor supply. Should the substitution effect
dominate, the persons labor supply curve will be
positively sloped.
Wage
Backward-bending
W
Desired hours of work
11
3. A Graphic Analysis of the Labor-Leisure Choice
Two categories of goods Leisure(L)and Money
Income ( M ) Since both leisure and money can be
used to generate satisfaction, these two goods
are to some extent substitutes for each other.
M
Indifference Curve A curve connecting the
various combinations of money income and leisure
that yield equal utility.
A
B
IC2
C
D
IC1
L
12

• Indifference curves have certain specific
  characteristics
• Any curve that lies to the northeast of another
  one is preferred to any curve to the southwest
  because the northeastern curve represents a
  higher level of utility.
• Indifference curves do not intersect.
• Indifference curves are negatively sloped.
• Indifference curves are convex.
• When money income is relatively high and
  leisure hours are relatively few, leisure is more
  highly valued than when leisure is abundant and
  income relatively scarce.
• 5. Different people have different sets of ICs

13
M
M
L
L
Person who place high value on an extra hour of
leisure
Person who place low value on an extra hour of
leisure
14
The resources anyone can command are
limited. Budget constraint reflects the
combinations of leisure and income that are
possible for the individual.
M
The slope of the budget constraint is a graphic
representation of the wage rate. Wage rate
OE/OD
E
L
0
D
15
Note Full income wage rate T ?It
represents the maximum attainable income.
M
At point B MUL/MUMgtW or
MULgtWMUM L should
increase At point C MUL/MUMltW or
MULltWMUM L should reduce,
or H should increase
E
B
A
IC2
IC
C
IC1

• An indifference curve that is just tangent to the
  constraint represents the highest level of
  utility that the person can obtain given his or
  her constraint.

L
D
IC2impossible under current condition
IC1possible, but higher level of utility
can be attained ICutility-maximized level A
utility-maximization point
16
The Decision Not to Work
What happens if there is no point of tangency?
M
The persons IC are at every point more steeply
than the budget constraint. Pt. D is not a
tangency point. There can be no tangency if the
IC has no points at which the slope equals the
slope of the budget constraint.
E
L
D
At this point(D)the person chooses not to be in
the labor force.
17
The Income Effect
Nonlabor income Even if this person worked zero
hour per day, he/she will have this nonlabor
income.
M
Note that the new constraint is parallel to the
old one. ?The increase in nonlabor income has
not changed the persons wage rate.
E
B
A
IC2
IC1
L
D
Pure income effect The income effect is
negative as income goes up, holding wages
constant, hours of work goes down.
18
Income and Substitution Effects with a Wage
Increase
The wage increase would cause both an income and
a substitution effect the person would be
wealthier and face a higher opportunity cost of
leisure.
N1?N3 income effect ? L?,
H? N3?N2 substitution effect
?L?, H? N1?N2 observed effect Substitution
effect dominates. L?, H?
Income effect Had the person received nonlabor
income, with no change in the wage, sufficient to
reach the new level of utility, he/she would have
reduces work hours from N1 to N3.
19
N1?N3 income effect ?L?,
H? N3?N2 substitution effect
?L?, H? N1?N2 observed effect Income effect
dominates. L?, H?
Note The differences in the observed effects of
a wage increase are due to differences in the
shape of the indifference curve. i.e., different
preference.
20

• Empirical Findings on the Labor/Leisure Choice

• The time-series study can be used to look
• at trends in labor force participation rates
• and hours of work over time.
• (2)The cross-section study can be used to
• analyze the patterns of labor supply across
• individuals at a given point in time.

21
4. Policy Application
Virtually all government income maintenance
programs-from welfare payments to unemployment
compensation-have work-incentive effect.
(1) Income Replacement Programs
Unemployment insurance, workers compensation,
and disability insurance might be called income
replacement programs. ?All these programs are
intended to compensate workers for earnings lost
owing to their inability to work.
Note All these programs in the U.S. typically
replace roughly just half of before-tax lost
earning. The reason for incomplete earnings
replacement has to do with work incentives.
22
Replacing all of lost income could result in
overcompensation by generating a higher level of
utility than before the loss of income, and would
motivate the recipients of benefits to remain out
of work as long as possible.
M
When employment ceases, the worker receives
benefits equal to E0, he/she will be at pt. T on
a higher IC.
T
E0
IC2
IC1
L
23
(2)Actual Income Loss vs. Scheduled Benefits
Actual Income Loss Workers who are either
totally or partially disabled receive benefits
that replace their actual lost earnings.
If the injured worker earned E0 before injury and
workers compensation replaced all earnings loss
up to E0, then workers compensated budget
constraint would be ABCD line.
M
D
C
B
E0
L
A
Note Throughout the horizontal segment BC, the
individuals net wage is zero. When people cannot
increase their income by working, there is
usually no incentive to work.
24
Using an impersonal schedule of disability
benefits preserves at least some incentive to
work because benefits are not reduced if earnings
increase.
M
E
D
G
? There are greater incentives to work if
benefits are scheduled than if benefits are
calculated to completely replace earnings
losses. Scheduled benefits cause only an income
effect. However, if actual earnings loss were to
become the benefit, there would be an income
effect and substitution effect, and both would
work in the same direction. The benefits would
simultaneously increase income while reducing the
wage rate to zero.
C
B
L
A
Grand benefit according to some schedule without
regard to the individuals actual earnings
loss. ? Budget constraint BE.
25
5. Child Care, Commuting, and the Fixed Costs of
Working
(1) Fixed Monetary Costs of Working
not work at point a with
utility U1 ab fixed per-period monetary
cost ? If the individual works, the budget line
starts from point b.
26

• How large does the wage rate need to be to induce
  this person to work for pay?
• ?The slope of the budget line bd represent the
  wage such that any decrease in this wage will
  cause the individual to drop out of the labor
  force. This is because utility U1 will no longer
  be attainable if he/she work any hour.
• ?The wage represented by the slope of bd is this
  persons reservation wage-the lowest wage for
  which he/she will work.

27

• What would happen to the reservation wages if the
  fixed costs were to increase to ae?
• ?An increase in the fixed costs of work will tend
  to raise the reservation wage of potential
  workers. Consider the change from bg to ef
• ?Increasing fixed costs of work will tend to
  increase the hours of work for some workers but
  cause others to drop out of the labor force.
• ?The net effect on labor supply is ambiguous a
  priori.

28
(2) Fixed Time Costs of Working
If the individual does work he/she incurs fixed
time costs ab. ?The maximum number of hours a
day available for work or leisure is T1.
At wage represented by bh, he/she would be
indifferent between working (pt D) and not
working (pt a). reservation wage
29
Suppose that the fixed time costs of work
increase from ab to ad, then as long as leisure
and income are both assumed to be normal goods,
hours of both work and leisure time will be
reduced.
The increase in fixed time costs of work has an
income effect that reduces the workers demand
for both leisure and the goods income will buy.
Given a constant wage rate, a fall in income
implies that hours of work have been reduced.
Note The increase in time cost has two important
consequences (a)It reduces full income from og
to ok. (b)It reduces total time available for
either leisure or work so long as the
individual continues to work.