ELM Part 2- Economic models Manuela Samek

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ELM Part 2- Economic modelsManuela Samek

• References
• Adnett N. (1996) European Labour Markets, chapter
  2.1,2.2 4.2, 4.35.5,5.67.2,7.3,7.4
• Blanchard O. (2006) European Unemployment,
  Economic Policy no.45 Jan.2006

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Some questions looking for an answer

• The labour market performance of EU countries
  presents some problems which need to be
  addressed
• Why the EU is not able to create enough jobs for
  its active population? What factors influence
  labour demand?
• Why participation and employment rates in some
  countries are very low especially for women and
  for the less educated? What factors influence
  labour supply?
• Why unemployment is so persistent, especially
  among some groups of the population?
• Why there are differences across countries? What
  is the role of labour market institutions?
• What policies may be introduced to improve the
  labour market performance of EU countries?
• Economic models try to answer to these questions

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Economic models

• Economic models of labour supply help to explain
  labour supply decisions and differences in
  participation rates across different groups of
  the population. They also help explaining the
  influence of working hours regulation, the
  taxation and the welfare systems on labour supply
  decisions
• Economic models of labour demand explain how
  firms decide if and how much labour to employ in
  the productive process. Models of labour demand
  with adjusting costs consider the relation
  between employment protection legislation and
  labour market performance
• Search and matching models help the analysis of
  search behavior and the matching of labour demand
  and supply, in order to derive what variables
  affect unemployment duration and labour market
  mismatches
• Wage determination models help to explain why
  wages are not flexible and what variables affect
  wage bargaining and its effects on the wage
  dynamics and structure.
• Human capital models help to explain why
  individuals invest in education and training an
  what are the individual and social returns of
  this investment.

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THE ECONOMIC APPROACH TO THE LABOUR MARKETMain
assumptions of the baseline neoclassical model (1)

• In the labour market buyers (firms, labour
  demand) and sellers (individuals, labour supply)
  of labour exchange labour services for pay. Wages
  are the price of labour services.
•  Agents (buyers and sellers) are rational on the
  basis of their tastes and constraints they try to
  maximise their objective function. The objective
  of buyers (firms) is to maximise profits the
  objective of sellers (individuals) is to maximise
  utility.
•  

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Main assumptions of the baseline neoclassical
model (2)

• Markets are competitive. There are many sellers
  and buyers which are price takers they cannot
  affect wages or prices which are completely
  flexible and are set only by the movements of
  demand and supply. The equilibrium wage and price
  are those determined by the equality of demand
  and supply.
•  Individuals and firms are homogenous
•  Individuals and firms have a complete
  information on labour market conditions
•  There are no constraints to labour and firms
  mobility

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Labour supply

• At the aggregate/macroeconomic level, labour
  supply is the results of the aggregation of
  individuals decisions relative to
• Labour market participation
• Fertility decisions and migration flows which
  define the size of the working age population
• The labour force (LF) function/curve
  represents the size of the labour force at
  different levels of the real wage (W/P).
• We assume that aggregate participation
  increases with the real wage.
• At the microeconomic /individual level, labour
  supply is the result of the individual choice
  between work (which determines consumption
  possibilities) and leisure (which increases the
  well being of the individual).
• We assume that the individual may freely
  choose the amount of work to supply in the labour
  market.

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LABOUR SUPPLY at the individual level (1)

• The labour supply function (Ls) represents the
  behaviour of the sellers of labour.
• It indicates the amount of work that individuals
  or households are willing to supply at each wage
  rate. Labour supply depends on
•        Individual tastes and preferences
•        The real wage rate
•        Non labour income (which reflects the
  system of welfare support such as subsidies or
  unemployment benefits).

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LABOUR SUPPLY at the individual level (2)

• The individual maximise her/his utility function
  (which depends on her/his preferences in relation
  to consumption and leisure and is represented by
  utility or indifference curves) under an income
  and time constraint (which depends on the income
  she/he may get either working or not and the time
  available)

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LABOUR SUPPLY (3)

• On this basis decision to participate to the
  labour markets depends on the comparison between
  the (net of taxes) market real wage and the
  reservation wage. The individual participate only
  if the market wage is greater then the
  reservation wage.
• The reservation wage is the wage below which
  individuals do not wish to work. The reservation
  wage depends on non labour income and
  preferences.
• Changes in non-labour income and tastes shift the
  position of the supply curve, while changes in
  the real wage result in movements along the
  supply curve

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Labour supply at the individual level
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LABOUR SUPPLY (3)

• Any rise in the real wage (W/P) generates two
  opposite effects
• a) the increase in the opportunity cost of
  leisure and home production generates a
  subsitution of work for leisure, so labour supply
  increases (substtituion effect)
• b) the increase in income will consent to
  buy more leisure and reduces labour supply
  (income effect)
• In the short run we assume that, given
  individuals preferences and non-labour income,
  the quantity of labour supplied is a positive
  function of the real wage (we assume that the
  substitution effect is higher than the income
  effect for a relevant range of wages)

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Effect of an increase in real wageincome effect
gt substitution effect
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Effect of an increase in real wageincome effect
lt substitution effect
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LABOUR SUPPLY (4)

•  A rise in non labour income (such as
  unemployment benefits) reduces labour supply, by
  increasing the reservation wage
• All factors which affect the reservation wage and
  the market wage affect labour supply family
  composition, welfare subsidies, taxes. But also
  employment and working time regulations affect
  labour supply, especially in the case of
  secondary workers (such as married women) .
• In household labour supply models, the secondary
  worker considers the primary workers wage as non
  labour income. Hence changes in the wage of one
  component of the household, affect not only
  his/her labour supply, but also the labour supply
  of other components.

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Effects of subsidies (non labour income) on
labour market participation
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Individual labour supply curve
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The effect of child care subsidies on labour
market participation
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Estimations of labour supply

• Usually labour supply is estimated using the
  following regression
• L?0 ?1W ?2Xe
• Empirical studies show that usually
• men labour supply is not sensible to changes in
  real wages (UNELASTIC) (?the income effect
  compensate the substituion effect)
• Women labour supply is usually sensible to
  changes in real wages (ELASTIC) (?the substituion
  effect is usually prevalent)

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Tab 3.4
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Extensions of the basic model

• Main extensions of the basic model
• Household models to consider interactions among
  households components in labour supply decisions.
  These models are very useful to explain women
  labour supply.
• Life cycle models to considier the possibility of
  changes in preferences and market wages during
  the life cycle of individuals. Very useful to
  explain how labour supply changes with age
• Human capital models to consider the possibile
  interactions among consumption choices,
  investment in human capital and labour supply

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Main predictions of economic models of labour
supply

• Labour supply decisions reflect individual and
  household conditions, preferences, non labour
  income and market wages.
• The probability to participate to the labour
  market and hours supplied usually increase when
• the market wage increases, but over a certain
  level of hours worked and market wage, further
  increases in wages may reduce hours worked
• Non labour income declines
• The costs to be undertaken in order to work
  decline, especially for secondary workers
• Restrictions on working hours oblige individuals
  to accept second best solutions and may reduce
  the labour supply of secondary workers,
• Taxation and welfare policies affect labour
  supply differently for the different components
  of the household