Supply of Labor

1
Supply of Labor
2
Labor Supply

• Different questions to be asked
• Work or dont work
• Number of hours of work effort
• Occupational choice
• Locational choice
• Individuals can work at home or work for pay,
  initially we will ignore household production or
  treat it the same as work for pay with the
  payment to household as an implicit wage
  contributing to total household income.

3
Labor Force Participation and Hours Worked

• The most startling change has been the increased
  participation rate of women in work for pay.
• The participation rate for younger and older men
  have fallen.
• Hours worked in the short-run may be largely
  determined on the demand-side (pro-cyclical with
  the business cycle), but labor supply decision
  also impact them, particularly in the
  longer-run).
• Over the last 100 years, the average work week in
  manufacturing has fallen.

4
The Decision to Work

• Household supply labor in the resource markets
  and demand goods and services in the goods and
  services markets.
• The goal of a rational household is to maximize
  their satisfaction or utility.
• Utility flows from goods and services but most
  individuals need to generate income to purchase
  the goods and services. The primary source of
  income in the U.S. (70) is labor income.
• The demand for products comes from utility
  maximization
• QD F (P, Y or W, PR, T, E)

5

• Individuals also value leisure so economist look
  at the supply decision as a household trying to
  maximize utility from income (which is a proxy
  for command over goods and services) and leisure.
• Wealth is the stock of all financial and
  non-financial assets owned by and individual and
  income is the flow of purchasing power a
  household receives in a given time period.
• In the simple case of no wealth or the stock of
  wealth remaining constant, income flows from the
  supply of labor.
• The opportunity cost of leisure is the the
  command over goods and services sacrificed by not
  working or the wage rate.

6
Income and Substitution Effects

• Similar to the scale and substitution effects in
  labor demand, a household has an income and a
  substitution effect when decided between income
  and leisure.
• Following the books convention, since leisure and
  work are inversely related one can define these
  effects either between income and leisure or
  income and hours worked. The only difference is
  the sign.

7

• The income effect the relationship between
  hours worked and the hours worked, holding wages
  constant.
• ?H/?YWlt0 (?O/?YWgt0, where 0 is leisure (ocio in
  Spanish).
• In words, as income increases, ceteris paribus,
  household will take more leisure and work fewer
  hours.
• The substitution effect the relationship
  between hours worked and wages, holding income
  constant.
• ?H/?WYgt0 (?O/?W Y lt0, where 0 is leisure (ocio
  in Spanish)
• In words, as the wage increases (or the
  opportunity cost of leisure), ceteris paribus,
  households will work more.

8

• An increase in wages can be broken down into two
  effects
• IE W?, holding hours of work constant, Y?, so
  households wish to H?
• SE W?, holding income constant, the opportunity
  cost of leisure?, so households wish to H?
• Increases in wages produce ambiguous change in H.
• If SEgtIE ? W? ? H? a positively sloped labor
  supply curve
• IF IEgtSE ? W?? H? a negatively sloped labor or
  back-ward bending supply curve
• Pigeon example and Anderson gas taxes versus
  social security taxes

9
Figure 6.1 An Individual Labor Supply Curve Can
Bend Backward
10
Indifference Curve Analysis

• Assume individuals are rational and try to set H
  and O and Y at levels that maximize their
  utility.
• An easy way to analyze consumer choices is
  graphically with indifference curves.
• Maximize utility F( Y, O) subject to the
  constraint that Y W x (Max hours hours
  worked).
• The problem is that, while possible, it is
  challenging to graph U, Y and O all at the same
  time. Indifference curves resolve that problem
  by holding U constant and observing the
  combination of Y and O that produce that level of
  utility.

11
Figure 6.2 Two Indifference Curves for the Same
Person
12
Rules of Indifference Curves

• Higher indifference curves (ICs) ? higher levels
  of utility (like topographical maps and
  altitude).
• ICs do not intersect
• ICs are negatively sloped and convex
• Both income and leisure is valued
• At high levels of income more income is needed to
  offset any declines in leisure and vice versa.
• Different individuals have different preferences
  and different IC maps.
• Steeper ICs imply more income is needed in
  return for loss of leisure at any given level of
  leisure (leisure preferrer).
• Flatter ICs imply less income is needed in
  return for loss of leisure at any given level of
  leisure (income preferrer).

13
Figure 6.3 An Indifference Curve
14
Figure 6.4 Indifference Curves for Two
Different People
15
Income and Wage Constraints

• The map on which ICs are depicted can also
  represent the income constraint that households
  face.
• Assume that workers can work or take leisure a
  maximum of 16 hours per day (the rest is sleep).
  Then
• Y W x H
• Y W x (16- O)
• And ?Y/?H W
• The income possibilities of an individual can be
  easily graphed.
• Parallel shifts in the constraint represent pure
  income effects, such as non-wage income.
• Rotation of changes in the slope reflect changes
  in wages

16
Figure 6.5 Indifference Curves and Budget
Constraint
17
Graphical Depiction of Income and Substitution
Effects

• Pure income effect is a parallel shift of the
  income constraint.
• Change in wages generate an ambiguous observed
  change in leisure taken or hours worked, but the
  observed change can br broken into two parts IE
  and SE
• IE the change in H when income changes wages
  constant (slope of the income constraint remains
  the same)
• SE the change in H when wages changes and income
  (read utility) remains constant.

18
Figure 6.8 Wage Increase with Substitution
Effect Dominating
19
Figure 6.7 Indifference Curves and Budget
Constraint (with an increase in nonlabor income)
20
Figure 6.9 Wage Increase with Income Effect
Dominating
21
Figure 6.10 Wage Increase with Substitution
Effect Dominating Isolating Income and
Substitution Effects
22
Employing the Model of Labor Supply

• Which effect will be greater?
• The flatter the ICs the greater the substitution
  effect. Since ICs are convex they are flatter
  the more leisure and the less work that any given
  person takes.
• Change in wages will affect income the more that
  a person works and the less leisure they take.
  Therefore, the more a person works the greater
  the income effect.
• Corner solution and the decision to participate
  or not participate in the labor force is
  dominated by the substitution effect.
• If the IC is very steep one may end up with a
  corner solution
• Reservation wage is the wage below which a person
  will not work or the minimum wage that is needed
  to participate in the labor force.
• Reservation wage and minimum number of hours
  needed to work. Illustrated assuming a two hour
  commute.

23
Figure 6.11 The Size of the Income Effect Is
Affected by the Initial Hours of Work
24
Figure 6.6 The Decision Not to Work Is a Corner
Solution
25
Welfare Policies

• Negative net wage programs (workers compensation)
• Income/wage constraint has a spike reflecting
  that if workers return to work they lose all
  benefits
• Creates a significant disincentive to work
• Zero net wage programs
• Paying people the difference between a persons
  earnings and societys assessment of their needs.
• Guaranteed income with a dollar reduction in
  welfare benefits for each dollar of earning, thus
  a zero net wage.
• Welfare reform of 1996
• Five years of lifetime eligibility
• After 2 years, 30 hours of work required to
  maintain benefits
• Benefits are reduced a dollar for each dollar
  earned

26
Figure 6.13 Budget Constraint with a Spike
27
Figure 6.14 Income and Substitution Effects for
the Basic Welfare System
28

• Positive net wage programs
• The reduction in welfare benefits are reduced
  less than one dollar for each dollar of work.
• Negative income tax and the Earned Income Tax
  Credit (EITC)
• Negative income tax
• Guaranteed income level is 8,000 each dollar of
  earnings reduces benefits by .50 (tax rate of
  50)
• New income wage constraint is
• If Y lt 16,000 Y8,000 .5WxH
• If Y gt 16,000 Y WxH
• EITC
• Government reduces your tax obligation by the
  amount of the EITC and if EITC gt income tax mails
  you a check.
• If Y lt 6,900, tax credit .34 of income and
  thus Y 6,900 .34xWxH
• If 6,900lt Y lt 12,900, the maximum tax credit is
  reached and Y WxH 2,353 (2,353 is
  approximately equal to .34x6,900)
• If Y gt 12,900, the EITC is phased out by tax
  benefits by 16 so by Y27,400 no benefits are
  received. (2353/.16 14,706 and
  14,70612,700 27,400)

29
Figure 6.15 The Basic Welfare System A Person
Not Choosing Welfare
30
Figure 6.16 The Welfare System with a Work
Requirement
31
Figure 6.17 Earned Income Tax Credit (One
Child), 2000