Labour Supply, Agricultural Household Models, and Contracts

Traditional analysis of labour supply assumes the potential worker has a time
constraint, which we assume to be 24 hours a day, which is allocated between
work, L, which brings in income, and non-work, which is usually called leisure,
Le. Le in a more general form includes home time, sleep, recreation, etc. The
time constraint is L + Le = 24. Working L hours, at wage w per hour, results in
income, wL. Consumption, C, is a function of income. Utility can be
represented by U(C,Le). The worker maximises the following:
Max U(C,Le) subject to L + Le = 24 and C = wL + M, where M is non-labour
income. This analysis is covered in both Introduction to Economics, and in
Microeconomics so I will only cover the topic briefly. Given that L = 24 – Le,
we can write C = w(24-Le) + M or C + wLe = 24w + M. The right-hand side is
the total endowment of the worker, non-labour income + maximum income if
the worker had no leisure. The left-hand side indicates the two choice variables,
consumption and leisure.
Equilibrium in the model is given by the point of tangency of indifference curve
showing choice between Le and C and the budget line. I will assume that M=0
in the next diagram. This worker will have Le* hours of non-work, 24-Le*
hours of work, which allows her to C* consumption
C.

24w

C* E*

0 Le* 24 Le
If M>0 then the equilibrium will have two possibilities.
C IC* IC**
M + 24w

C* E*
C’=M’ E**

0 Le* 24 Le

The budget line shifts up by the extra income, M. The solution is again
(C*,Le*), given by the tangency point of indifference curve IC* and the budget
line. However, assume non-labour income is M’. The equilibrium now is at the
point E** where C’=M’, and the worker has 24 hours of leisure. In other words,
the worker is better off by not working and achieving IC** than by working and
achieving IC*.

What happened if non-labour income rises?

Assuming Le is ‘normal’, then this is an income effect and will raise Le, shown
in the diagram below. Le rises from Le* to Le**.
 C
IC**
C** E**
C* E*
IC*

Le* Le** 24 Le
In the above diagram the rise in non-labour income changes the budget line
from the red to the green. The new equilibrium is (C**, Le**), showing that if
C and Le are normal goods, the pure income effect will raise both. If the
previous choice was at Le=24, then the rise in M will just raise C, and not affect
working hours.

What happens if the wage rate, w, rises?

The wage rate is the slope of the budget line. A rise in the wage rate will make
the budget line steeper, i.e. for the same number of hours worked, the worker
can buy more C. The effect on Le, and hence L depends on the income and
substitution effect of the wage change. Potentially this can lead to a backward
bending labour supply curve.

Assume for simplicity, M=0. The rise in the wage rate changes the budget line
from the black line to the red line. The substitution effect, Le*L’ implies that Le
falls and C rises. The income effect implies that Le rises, L’L1, but the
substitution effect is greater than the income effect, hence in the new
equilibrium L1<Le*, and hours of work has risen.
C

IC** IC***

IC*

L’ L1 Le* Le’’ 24 Le
However, if the wage rate rises even more, say to result in the green budget line,
then the income effect will be greater than the substitution effect and Le will
rise and L will fall. Hence, at some wage rate, w*, the supply of labour becomes
backward bending. Some claim that this applies only to the labour supply of
men. For women, if the wage rate rises, they substitute out of housework, into
work. Evidence shows that when women’s wage rises, female child labour (if
we include working at home as labour) also rises, which supports this claim. As
mothers increase labour market work, they use their daughters more in
performing house chores.

Farm Households
The farm household is an economic unit that makes both production decisions
and consumption decisions. We assume the household makes these decisions as
a unit. This is called a unitary household model. The household is assumed to
maximise U(Y,Le). It has a fixed land endowment, A and time endowment, T
hours. L (hours of work) + Le (leisure) = T. However, L can either be used in
the family farm, or can be used in the labour market, therefore L = LF + LW, LF
being the hours spend on family farm, and LW on wage labour. If labour input
on the farm is insufficient, the farm may hire additional labour, LO, outside
labour. The production function is a function of L, and fixed land, A, therefore
Q = Q (L, A).

We can assume that wO, wage paid to outside labour, is higher than wF, wage
paid to family labour. This can be explained by extra costs of finding and
commuting to work, or to improve incentives in an efficiency wage framework
(hired worker may be less motivated than family workers, monitoring costs,
etc). Of course, in a competitive perfectly functioning labour market, with
homogenous labour these two wages must be equal). In what follows I will
assume that there is only a unique wage, w, but De Janvrey and Sedoulet
assume that these two wages are different.

Total income of the household is given by Y = pQ + wLW -wLO.The first term is

the value of output sold in the market, the second term is labour income of
family members when they work outside the farm, and the third term is the
labour cost of hiring additional labour. Hence, Y = pQ + w(LW-LO). The
household maximises utility subject to the income equation so:
MaxLF,LW,LO,Le (Y,Le) subject to Y = pQ + w(LW-LO).

Q = Q(L, A) subject to L = LF + LO (Total labour in the farm is family labour +

outside hires) and T = LF + LW + Le.
We can distinguish between five different types of household.

1. Consumer-Worker Household. In this case A=0, i.e. this household is

landless. The household maximises utility Max LW,Le U(Y,Le) subject to
T = LW + Le, i.e. members either have leisure or work for someone else,
and their income constraint Y = wLW. Diagrammatically this household is
represented by the following diagram:

U(Y,Le) LW

wL*

L* T L
The household provides L* hours of labour and has income = wL*. T-L*
is hours of leisure the household enjoys.

2. The second type of household is a pure producer. All family time is

allocated to leisure and the family hires outside labour to do the work on
the farm. Of course, in this case A>0. The maximisation is just like a
firm. The family maximises profit so MaxL П = pQ – wL, subject to
Q=Q(L,A). Diagrammatic representation of this household is as follows:
 Y

wL
pQ(L,A)

Max profit

L* L
Maximum profit occurs when the slope of the production function equals the
slope of the wage cost, w, hence the household will hire L* number of
workers.

3. The third type of household is a pure family farm, which was analysed by
Chayanov. This is a case that all family members work on the farm, none
work outside the farm, and the farm does not hire any additional labour.
In this case the household maximises utility Max LF,Le U(Y,Le) subject to
T = LF + Le, i.e. members either have leisure or work for in their own
farm, and their income constraint Y = pQ. Diagrammatically this
household is represented by the following diagram:
 Y
U(Y,Le)
pQ(L,A)

L* T L
The household maximises utility subject to the production function and
time constraint and provides L* hours of on farm labour and enjoys 24-
L* hours of leisure.

4. Household with excess supply of labour. In this case the family has more
members than required on the fam, hence some of the members work
outside the family farm. This household maximises utility,
MaxLF,LW,Le (Y,Le) subject to Q = Q(LF, A) and Y = pQ + wLW (Income
of the farm is the sale value of output + wage income received by
members who work outside the farm), and the time constraint which is
T = LF + LW + Le (hours working on the farm + hours working off the
farm + hours of leisure). Diagrammatically this household can be
represented by the following diagram:
 Y U(Y,Le)

Q(L,A)

O L* L** T L
The house maximises utility by providing L* hours of work in their own
farm, provide, L*L** hours off farm, and have T- L** hours of leisure.

5. Small Commercial farm. This household has more land than the family
members can cultivate, hence has excess demand for labour, therefore
hires outside labour. The household maximises utility, MaxLF,LO,Le (Y,Le)
subject to Q = Q(LF, A) and Y = pQ – wLO (Income of the farm is the
sale value of output – the amount they have to pay outside workers), and
the time constraint which is T = LF + Le (hours working on the farm +
hours of leisure).
Diagrammatically, this household can be represented by the following:
 Y
U(Y,Le)

pQ(L,A)

O L* L** T L

The household maximises utility by working L* hours on their own farm

and have T-L* hours of leisure. However, they have excess demand for
labour and hence hire L**- L* hours of outside labour.

Contracts
In this section we discuss three types of contract, sharecropping, fixed rent and
wage labour. We assume that the wage, w, is the same for all workers.

Assume the landlord has a plot of land and can produce Q, with production
function Q=Q(L) where L is the labour input. The landlord can produce the
product using three types of contracts.
1. Wage Contract: In this case the landlord maximises profit. Hence his
objective function is: MaxL pQ(L) – wL, where p is the price of Q. We
assume Q’>0 and Q’’<0. The landlord chooses L, the amount of hired
labour, in such a way that maximises the difference between the value of
output and the wage cost, wL. First order condition gives pQ’(L) - w = 0.
Q’(L) is the marginal product of labour, hence the condition is pMPL = w,
or the value of marginal product of labour equals the wage. In diagram
below this implies that the landlord hires L* units of labour. Hence this
contract makes efficient use of labour.

Rupees

0 L* L

2. The landlord can choose a fixed rent contract. Assume the fixed rent is R.
The landlord rents the land to a tenant, who pays R. The tenant’s
objective function is to maximise profit. Profit is the difference between
the value of output, the wage lost because the tenant is not working for
someone else, and R, the fixed rent. Hence the tenant maximises the
following: MaxL pQ(L) – wL - R. The first order condition is exactly the
same as above where pMPL = w, and the tenant will apply labour input up
to L*. Hence this contract also uses L efficiently.
 3. The landlord can enter into a sharecropping contract with the tenant.
Assume the share going to the landlord is r, and the share going to the
tenant is 1-r. This means that the return to the tenant is given by
(1-r)MPL, or the green line in the diagram below. In this diagram PM is
the marginal product of labour and EM is (1-r)MPL. EM is drawn in such
a way that EP/OP = r and OE/OP = 1- r.
The objective function of the sharecropper is: MaxL (1-r)pQ(L) – wL,
which is to maximise the value of her share, less opportunity cost of not
working elsewhere. First order condition in this case is:
(1-r)pQ’(L) – w =0, or (1-r)pMPL = w, hence pMPL = w/(1-r). Since r<1
then [w/(1-r)]>w.

Rupees
P

E
w

0 L** L* M L

This implies that the sharecropper applies L** units of labour to the plot of
land, hence underutilises labour. This was pointed out by Marshall and is called
the Marshallian inefficiency of sharecropping.
 Rupees
P

a
E
w b c
f
d e
0 L** L* M L

From the view of the landlord we can compare these three contracts. Under a
fixed rent R=a+b+c, under a wage contract the return to the landlord is a+b+c
but under sharecropping landlord share is a. Hence the landlord prefers the other
two efficient contracts to sharecropping. The landlord loses b to the tenant and
c is the deadweight loss of sharecropping (the Marshallian inefficiency).

From the point of view of the tenant the sharecropper’s income is b+d under
sharecropping, but his opportunity cost, wL, is d. Hence his income is higher
under sharecropping. This implies that there must be an excess supply of
sharecroppers.

What can the landlord do in this case? A simple action is to change a fixed rent
of b and force the sharecropper to earn only her opportunity cost. However, the
landlord can do better by moving either to a fixed rent, or a wage contract,
eliminate the inefficiency, and raise his income. This argument implies that we
should not observe sharecropping contracts, but we do so there must be other
explanations.
Cheung (1968, but see Basu chapter 12) proposed the following model. The
landlord chosses r and L so maximises his share: Maxr,L rQ(L) subject to the
constraint that the share of the sharecropper must be at least as much as what
she would earn in the labour market. Hence the constraint is (1-r)pQ(L) = wL.

The Lagrangian will be Z = rpQ(L)- λ[wL-(1-r)Q(L)]. First order conditions are:

ꝺZ/ꝺr = pQ(L) – λpQ(L) = 0 therefore λ=1
ꝺZ/ꝺL = rpQ’(L) - λw+ λ(1-r)pQ(L) = 0 therefore pQ’(L) = w
ꝺZ/ꝺλ = (1-r)pQ(L)-wL = 0 therefore r = (pQ(L) – wL)/pQ(L)

Since the wage equals marginal product of labour Cheung argues that the use of
labour is optimal. In the above diagram this implies that area b equals area f,
hence b+e+d=d+f+e, hence the sharecropper gets the same income under the
wage contract and the sharecropping contract. Landlord’s income under
sharecropping, a+c+f, is also the same as landlord income under fixed rent, or
under wage contract, a+b+c. Hence the three contracts are equivalent.

The major problem with this analysis is the assumption that Cheung makes, r is
chosen by the landlord. Historically r seems to be set, mostly at 50-50, hence
the French name for sharecropping, metayage. Again, we need to look at other
factors to explain the sharecropping phenomenon. There are a number of other
explanations, all related to some kind of market failure, so sharecropping, even
with Marshallian inefficiency, is regarded is second best efficient, because the
other circumstances lead to even more inefficiency.

One explanation is risk sharing, which was proposes by Stiglitz (1974, but see
DJ&S page 726). He proposes that climatic variation introduces excessive
amount of risk in producing Q. If insurance markets are non-existent, and they
mostly are, sharecropping provides the best alternative. The sharing of output
reduces risk for the sharecropper, who then is likely to increase effort if he is
risk averse.
A second reason is related to the fact that producing Q requires another input,
X, say fertilizers, and the tenant is liquidity constraint. If the tenant has no
liquidity at all, then the landlord offers a wage contract, and r=1 in the contract
(r,R) and R=0. If the tenant has no liquidity constraint, the landlord offers a
fixed rent contract, and in the contract(r,R) r=0 and R>0. This avoids
Marshallian inefficiency. If the tenant has some but not enough liquidity to buy
the required X, then a sharecropping contract is offered, which involves sharing
of the purchasing of X, as well as the output Q, and hence allows the tenant to
produce more because more X is used.

Hallagan (1978, see Basu pp261-263 but the model is explained here in full)
argues that the explanation lies in differential entrepreneurial ability, E.
Landlord have land. Output produce on each plot requires one unit of labour,
but also E, so Q=Q(E), Q’(E)>0, Q’’(E)<0. E ranges from 0 to 1. The landlord
knows the production function but there is asymmetric information here with
respect of how much E a worker has. We assume f(0) is the output when one
unit of labour is used on one unit of land, when E=0. Let us start with the case
that only wage contracts exist. Each unit of labour is paid w and w<f(0). This
implies that the worker has no incentive to apply E when working on the plot.
Landlord’s income in this case is Y = f(0) – w and workers income is Z = w.
This is obviously not an equilibrium. The reason is that both parties can
improve their position by moving away from this situation. The landlord can
offer a rent contract, R, that the tenant pays, and any output above this goes to
the tenant. Since f(1) > f(0), then there must be a value for R that results in
R=f(0)-w and f(1) - R= w. In this case the tenent prefers the rent contract, and
so does the landlord. Hence, if E=0, the worker prefers a wage contract, if E=1,
the worker prefer a rent contract, and somewhere in the middle of the range of
E, the worker prefers a sharecropping contract.
References:
Ray, D., (1998) Development Economics, chapters 12-13.

Basu, K., (1997) Analytical Development Economics, chapter 12.

De Janvery, A and Sedoulet, E (2016), Development Economics, chapters 20

and 22.

Schaffner, J. (2014), Development Economics, chapters 6-7