Tema 1

Chapter 1: Labor Supply (LS, Theory)
Mercado de Trabajo, 3º de GANE

Yolanda F. Rebollo Sanz
Universidad Pablo de Olavide – Department of Economics
2
 Parte del contenido de este tema es MATERIAL DE REPASO -DE PRIMERO DE
GANE.
 I’m going to spend about 2/3 lectures talking about labor supply.
 Today’s lecture will cover the theory of static labor supply (a review).
 Main References: You should read/study (for the theoretical section)

 Labor economics George J. Borjas: Chapters 1 and 2
 Modern Labor Economics Theoy and Public Policy Chapters 6 and 7
3
Review questions from chapter 1 (borjas´book):
 What is labor economics? Which types of questions do labor economists analyze?

 Who are the key actors in the labor market? What motives do economists typically
assign to workers and firms?
 Why do we need a theory to understand real-world labor market problems?
 What is the difference between positive and normative economics? Why are positive
questions easier to answer than normative questions?

4
Outline of chapter 1
 1. Main Indicators of the Labor Market (concepts already learnt)

 A theoretical Framework to explain basic facts of the labour supply: The
Model: (Materia de Primero, A repasar por el alumno)
 Indifference Curves
 Budget restriction
 The Hours of Work Decision: Comparative Statics
 Individual´s and market labour supply
 Applications (real novelty of the chapter..)

 Welfare Programs: Income Replacement Programs
o Policy Application: The Earned Income Tax Credit (2-10 Borjas)
 Labor Supply over the Life Cycle
 Labor Supply over the Business Cycle
5
Outline of chapter 1 (detailed)
 Main Indicators of the Labor Market (concepts already learnt)

 Measuring the Labor Force (2-1, Borjas, Student)
 Basic Facts about Labor Supply (2-2 Borjas)
 A theoretical Framework to explain basic facts: The Model: (Materia de
Primero, A repasar por el alumno)
 The Worker’s Preferences (2-3 Borjas)
 The Budget Constraint (2-4 Borjas)
 The Hours of Work Decision (2-5 Borjas)
o Mathematical Appendix (Borjas):
o 1.The neoclassical Labor-Leisure Model
o 2. The Slutsky Equation: Income and Substitution Effects
 The Hours of Work Decision: Comparative Statics

 To Work or Not to Work? 39 (2-6 Borjas)
 The Labor Supply Curve (2-7 Borjas)
6
Outline of chapter 1 (detailed)
 Welfare Programs: Income Replacement Programs

 Policy Application: Welfare Programs and Work Incentives (2-10 Borjas)
 Policy Application: The Earned Income Tax Credit (2-10 Borjas)
 Labor Supply over the Life Cycle
 Labor Supply over the Business Cycle
7
Basic Facts about Labor Supply
8
1-2. Basic Facts about Labor Supply (2-2 Borjas)
 Two very important secular trends

 Gigantic increase of the labour supply of women
 Shortening working lives of men
1. A theoretical Framework to explain basic
facts of the labor supply: The Model:
The theory of labour supply (Static Model)
10
When you finish school, if you could afford to work less
than 40 hours/week, or afford to not work at all, yet still
live comfortably, how many of you would still wish to
work? At all? Full Time all year?
Worker´s Preferences Budget Restriction

Hay que ver las ganas
que tengo de trabajar y
lo bien que me las
aguanto
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1. Introduction: ¿Why theoretical models are needed?
 This chapter focus on issues of worker behavior.

 In this first part of the course we discuss and analyze various aspects of labor
supply.
 Labor supply decisions can be roughly divided into two categories.
 The first, which is addressed in this chapter includes decisions about whether to
work at all and, if so, how long to work—including how many hours in a day and
years in a lifetime.
 Questions that must be answered include whether to participate in the labor force, whether
to seek part-time work or full-time work, and how long to work both at home and for pay.
 The second category of decisions, which are not addressed here deals with the
questions that must be faced by a person who has decided to seek work for pay: the
occupation or general class of occupations in which to seek offers and the
geographical area in which offers should be sought.
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 Trends in Labor Force Participation and Hours of Work
13
 The theory helps us understand how the facts are generated, and where the
facts can help shape our thinking about the way labor markets work.
 Model: simplify; The realism of assumption to the extent to which it helps us
understand and predict how labor markets work.
 Models in labor economics typically contain three actors: workers, firms, and the
government. It is typically assumed that workers maximize their well-being and that firms
maximize profits. Governments influence the decisions of workers and firms by imposing
taxes, granting subsidies, and regulating the “rules of the game” in the labor market.
 Learning labor economics can help you have a better understanding of the real labor
economics problems and predict the labor market outcomes.
 For instance, from the labour supply model:

 A. we can tell a simple “story” that explains and helps us understand many of the stylized
facts such as the recent trends in labor supply
o Large increase in labor force participation for women
o Small drop in labor force participation for men
o Drop in average number of weekly hours worked
 B. Useful for discussing responses to changes in labour market conditions or policies
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A theory of the decision to work
The theory of labour supply: Static Model
15
1. The theory of labour supply: Static Model
 The framework that economists typically use to analyze labor supply behavior
is called the neoclassical model of labor-leisure choice.
 The starting point of the so-called “neo-classical” theory of the labour supply: To
hold a paid job, you must ﬁrst have decided to do so..
 Every single working-age person make choices regarding work hours, home duties
and leisure. (Spain?).
 This model isolates the factors that determine whether a particular person works
and, if so, how many hours she chooses to work.
 The neoclassical model of labor-leisure choice is designed to describe how
individuals make decisions about
 i) whether to work, : labor force participation
 ii) and how much to work: part-time versus full-time jobs
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1. Main elements of the model
 1.PREFERENCES: Utility Function

 2. Restrictions: Budget Line
 3. Optima Decision: Preferences + Restrictions
 i) To work or not to work
 ii) How much to work
 Comparative statics: ceteris paribus…

 Some assumptions (needed for more advanced analysis)
 No frictions or adjustment costs
 Linear tax systems
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The Worker’s Preferences
The Utility Function: The decision to work is ultimately

a deision about how to spend time
18
2.1 The theory of labour supply: The Worker’s Preferences
 One may think that workers do not have any decisión about hours of work
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2.1. The Worker’s Preferences : The choice between labour and leisure
 PREFERENCES: Utility Function: The choice between labour and leisure

 Individuals maximize utility:
 The representative person receives satisfaction both from the consumption of goods
(denoted by C) and from the consumption of leisure (denoted by L -time).
 Consumption (C –value of the consumption) =Total monetary value of all the goods that the
person purchases during the period.
o The person consumes many different types of goods during any given period. To simplify matters, we
aggregate the monetary value of all the goods that the person consumes: For example, if the person
spends €1,000 weekly on food, rent, car payments, movie tickets, and other items, the variable C
would take on the value of €1,000.
o Note: Consumption is the same as Income since there are not savings.
₋ Implicitly we are assuming that all prices are unitary to make the correspondence between
quantity and monetary value. This is just a normalization.
 Leisure (L)= Number of hours of leisure that a person consumes during the same time
period.
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2.1. The Worker’s Preferences : The choice between labour and leisure
 Utility Function: The choice between labour and leisure

 The utility function { transforms the person’s consumption of goods
and leisure into an index U that measures the individual’s level of satisfaction or
happiness. This index is called “utility”.
 The higher the level of index U, the happier the person. We make the sensible assumption
that buying more goods or having more leisure hours both increase the person’s utility. In
the jargon of economics, C and L are “goods,” not “bads.
 Preferences assumed to take ‘usual’ form: quasi-concave: This means both leisure and
consumption exhibit diminishing marginal returns
o ¿What diminishing marginal returns means?: economic intuition?
0 Leisure (L) 0 Consumption (C)

21
2.1. The Worker’s Preferences : Indiference Curves
 The set of pairs (C,L) by which the consumer obtains the same level of utility
U, i.e such that U(C,L) = U, is called an indifference curve.
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 Indifference curves have four important properties

 1. Indifference curves are downward sloping: We assumed that individuals prefer
more of both C and L.
 2. Higher indifference curves indicate higher levels of utility.
 3. Indifference curves do not intersect.
 4. Indifference curves are convex to the origin.
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 1. Indifference curves are downward sloping: individuals prefer more of both

C and L.
 Different combinations of C and L might yield the same U.
 For example, the person might say that she would be indifferent to C=$500 and L=100
hours of leisure or C=$400 worth of goods and L=125 hours. The locus of such points is
called an IC —and all points along this curve yield 25,000 utils.
 ¿Why IC can not be upward sloping?:

 If IC were upward sloping, a consumption basket with more C and more L would yield the
same level of U as a consumption basket with less C and less L.
 This clearly contradicts the assumption that the individual likes both C and L. The only way
that we can offer a person a few more hours of L, and still hold utility constant, is to take
away some of the goods.
 2. Higher IC indicate higher levels of utility.

 The consumption bundles lying on the IC that yields (U2=40,000 utils) are preferred
to the bundles lying on the curve that yields U1=25,000 utils.
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 3. IC do not intersect.
 Consider a situation where IC are allowed to intersect.
 Because two points X and Y lie on the same IC, the individual would be indifferent between
the bundles X and Y. Because points Y and Z lie on the same IC, the individual would be
indifferent between bundles Y and Z.
 The person would then be indifferent between X and Y, and between Y and Z so that
she should also be indifferent between X and Z. But Z is clearly preferable to X,
because Z has more goods and more leisure. IC that intersect contradict our
assumption that individuals like to consume both goods and leisure.
(C)
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 4. IC are convex to the origin.

 Because we have assumed that both leisure and the consumption of goods are
desirable activities, the marginal utilities of leisure and consumption must be
positive numbers.
∆𝑼
 The marginal utility of leisure ( 𝑳 >0)= the change in utility resulting from an
∆𝑳
additional hour devoted to leisure activities, holding constant the amount of goods
consumed.
∆𝑼
 The marginal utility of consumption ( 𝑪 > 𝟎 ) = the change in utility if the
∆𝑪
individual consumes one more dollar’s worth of goods, holding constant the number of
hours devoted to leisure activities.
 The absolute value of the Slope of an IC is the ratio of marginal utilities of

consumption and leisure: The Marginal Rate of Substitution (MRS): What
happens to a person’s utility as she allocates one more hour to L or buys an
additional dollar’s worth of goods?
∆𝑪 𝑴𝑼𝑳
 MRS(C,L)= =
∆𝑳 𝑴𝑼𝑪
 As we move along an IC (from right to left), the slope of the IC measures the rate at which a
person is willing to give up some L in return for additional C, while holding utility constant.
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 4. IC are convex to the origin.

 A person whose preferences are convex always prefers mixtures of goods to
extremes of either good.
 If we draw a line between two points on the same indifference curve, then each
point on the line is a mixture of the two end-points.
 When the indifference curves are convex, all points on the line between the end-
points give higher utility than the end-points.
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 4. IC are convex to the origin:

 The MRS falls as one moves southeast along an IC (the amount of C(€) one must
give up to compensate for 1 more hour of L descreases).
 With low hours of leisure, individuals are willing to give up a large amount of C to get 1
more leisure hour.
 With high hours of leisure, individuals are willing to give up a small amount of C to get 1
more leisure hour
o At L=3 (Work=21 hours), one must give up 4 units to compensate for 1 more hour of L (Point A).
o At L=8 (Work=16 hours), one must give up 1 units to compensate for 1 more hour of L (Point B).
(C)
A
C=4 MRS= -slope of indiff curve
B
C=1
0 3 4 8 9 24 L Leisure Hr
24 0 Work Hr 28
 4. IC are convex to the origin:
𝜕𝑈/𝜕𝐿
𝑀𝑅𝑆(𝐶, 𝐿) = −
(C) 𝜕𝑈/𝜕𝐶
A
C=4 MRS= -slope of indiff curve
B
C=1
/ /
(A)> (B)
/ /
0 3 4 8 9 24 L Leisure Hr
24 0 Work Hr
29
2.1. The Worker’s Preferences : Different Individuals then different preferences
 Differences in Preferences across individuals

 A map of IC illustrates the way a particular individual views the trade-off between L
and C
 some persons may like to devote a great deal of time and effort to their jobs (low L),
whereas other persons would prefer to devote most of their time to L (high L). These
interpersonal differences in preferences imply that the IC may look quite different for
different workers.
 Interpersonal differences in the “tastes for work” are obviously important determinants of
differences in labor supply in the population. Workers who like leisure a lot will tend to
work few hours. And workers who do not attach a high value to their leisure time will tend
to be workaholics
In absolute values: For a particular (C,L)

combination
𝑀𝑅𝑆 𝐶𝑖𝑛𝑑𝑦 > 𝑀𝑅𝑆 𝑀𝑖𝑛𝑑𝑦
/ /
(Cindy)> (Mindy)
/ /
tastes for work: low tastes for work: high
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 Differences in Preferences across Workers 𝑀𝑅𝑆 =

𝜕𝑈/𝜕𝐿
𝜕𝑈/𝜕𝐶
 Cindy’s IC is very steep: her MRS on C takes on a very high value. She requires a
sizable monetary bribe (in terms of additional C) to convince her to give up an
additional hour of L. Cindy likes L a lot.
 Mindy, has flatter IC: her MRS takes on a low value. Mindy does not require a large
bribe to convince her to give up an additional hour of L.
In absolute values: For a particular (C,L) combination
𝑀𝑅𝑆 𝐶𝑖𝑛𝑑𝑦 > 𝑀𝑅𝑆 𝑀𝑖𝑛𝑑𝑦
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 Differences in Preferences across Workers

 Defining some linking between theory and empirical models
 For the most part, economic models gloss over these interpersonal differences in
preferences. The reason for this omission is that differences in tastes, although
probably very important, are hard to observe and measure. It would be extremely
difficult, if not impossible, to conduct surveys that would attempt to measure
differences in indifference curves across workers. Moreover, the reliance on
interpersonal differences in tastes provides an easy way out for anyone who wishes
to explain why different workers behave differently. After all, one could simply
argue that different behavior patterns between any two workers arise because
worker A likes leisure more than worker B, and there would be no way of proving
whether such a statement is correct or not.
 Economic models instead stress the impact of variables that are much more easily
observable—such as wages and incomes—on the labor supply decision. Because
these variables can be observed and measured, the predictions made by the model
about which types of persons will tend to work more are testable and refutable.
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The Budget Constraint
Time and Income
33
2.2 The person’s budget constraint:
 The optimal combination of C and L is constrained by total time (T) and total
income ( ).
 The budget line, delineates the frontier of the worker’s opportunity set (=the set of
all the consumption baskets that a particular worker can afford to buy).
 The budget constraint shows the combinations of income and leisure that a worker could
get given a wage rate. The monetary value of C must equal total income
 Total Income: Labor and Non-Labor income 

 Total Income=the sum of labor earnings (wh) and nonlabor income ( V ).
 Non-labor Income (V):
o Part of the person’s income (such as property income, dividends, lottery prizes, subsidies…..) is
independent of how many hours she works. Subsidies…. (school, rents, food…), grants
 Labor Income (wh): h=number of hours the person will allocate to the labor market during
the period and “w” be the hourly wage rate.
o Initially, we assume that “w” is constant for a particular person, so the person receives the same “w”
regardless of how many “h” she works.
₋ In fact, the “marginal” wage rate (that is, the “w” received for the last hour worked) generally
depends on how many “h” a person works. Persons who work > 40 hours per week typically
receive an overtime premium, and the “w” in part-time jobs is often lower than the “w” in full-time
jobs. For now, we ignore the possibility that a worker’s marginal wage may depend on how many
“h” she chooses to work. 34
 and V=0 
 A more general situation {V>0}
C = w(T-L)
C =V + w(T-L)
wh (T=h) +V
wT (T=h)
slope = -w
slope = -w
V>0 E
V=0
0 Leisure T Leisure T
0
35
 Graph the budget constraint (w=constant):

o
slope = -w
36
 The person has two alternative uses for her time: h or L. The total time allocated to
each of these activities must equal the total time available in the period, T hours per
week, so that T=h+L.
 o
 Point E indicates that if the person decides h=0 -not to work at all- and T=L, she can still
purchase V dollars’ worth of C. Point E is the endowment point.
 The “price” of leisure: If the person is willing to give up 1 hour of L, she can then move up
the budget line and purchase an additional “w“ dollars’ worth of goods. Each additional
hour of L that the person is willing to give up, allows her to buy an additional w dollars’
worth of goods. In other words, each hour of L has a price, and the price is given by the “w“.
 If the worker gives up all her leisure activities, she ends up at the intercept of the budget
line and can buy (wT+V ) dollars’ worth of goods.
 Worker’s opportunity set: The C and L bundles that lie below the budget line are
available to the worker; the bundles that lie above the budget line are not.
 The specification of the budget constraint implies that the worker does not save in
this model. The worker spends all of her income in the period under analysis
37
 Different examples of budget constraints: The slope of the budget constraint is

“w”.
 At w=$5, a worker could get a maximum income of $120+V per day ($5/hour * 24 ).
 At w=$10, a worker could get a maximum income of $240+V per day.
 At w=$15, a worker could get a maximum income of $360+V per day.
C = V+ w(T-L)
$360+V
$240+V slope = -w
$120+V
V E
0 24 Leisure
38
 Different examples of budget constraints: Tax on wage income (t=tax-rate)

 w=gross hourly wage
 w(1-t)=net –after taxes- hourly wage
C =Y + w(T-L) C =V+w(1-t)(T-L )
wT+V
slope = -w
w(1-t)T+V
slope = -w(1-t)
V
V
0 Leisure T 0 Leisure T
39
 Different examples of budget constraints: Labour Costs (e.g. Daycare,

transportation)
 T versus Real Time for L and C
C =V+w[(T-D)-L)]
Time is needed for “D”

 …
C =V+w(T-L)
wT+V
slope = -w slope = -w
V V
V+LC
0 Leisure T 0
Real Time T
for L and C 40
 Different examples of budget constraints: Fixed hours of work

 Example: Full-time / Part-time
 Discontinuous budget constrains when the worker can only choose to work part-
time versus full time. Imagen that T refers to weekly hours (T=16*5=80)
 Full time: C =1(H=40)wH + V,
 Part-time C=1(H=20)wH + V, or V
w40+V
w20+V
40 60 T
Leisure 41
 Different examples of budget constraints: wage rates might depend on the

number of hours worked.
 For instance hourly wages might by higher for overtime hours {wot >wnt }
Kinks Overtime: non constant wage
C =V + w(T-L)
wT+V slope = -wot
slope = -w
slope = -wnt
V
V
0 Leisure T
0 40 T
42
 Exercise 1 (Borjas 1-3). Tom earns $15 per hour for up to 40 hours of work each week.
He is paid $30 per hour for every hour in excess of 40. Tom faces a 20 percent tax rate
and pays $4 per hour in child care expenses for each hour he works. Tom receives $80
in child support payments each week. There are 110 (non-sleeping) hours in the week.
Graph Tom’s weekly budget line.
43
 Exercise 1 (Borjas 1-3). Tom earns $15 per hour for up to 40 hours of work each week.
He is paid $30 per hour for every hour in excess of 40. Tom faces a 20 percent tax rate
and pays $4 per hour in child care expenses for each hour he works. Tom receives $80
in child support payments each week. There are 110 (non-sleeping) hours in the week.
Graph Tom’s weekly budget line. Solution
 If Tom does not work, he leisures for 110 hours and consumes $80.
 For all hours Tom works up to his first 40, his after-tax and after-child care wage equals (80 percent of
$15) – $4 = $8 per hour. Thus, if he works for 40 hours, he will be able to leisure for 70 hours and
consume $80 + $8(40) = $400.
 For all hours Tom works over 40, his after-tax and after-child care wage equals (80 percent of $30) – $4
= $20. Thus, if he works for 110 hours (70 hours at the overtime wage), he will not leisure at all, but he
will consume $80 + $8(40) + $20(70) = $1,800.
Dollars of
Consumptio
n $1,400
$400
$80
70 110 Hours of Leisure 44

 1) Exercise 1 (Borjas 1-3). (Cont.)
45
The Hours of Work Decision:
Maximing the utility function subjet to Budget

restriction
46
2.3 The Hours of Work Decision
 Labour Supply Decision

 At the intensive margin: hours of work decisión (Interior Solution)
 At the extensive margin: to work or not to work
 Next slides contrast the extensive margin(the “extent” to which you work at
all: the participation decision) with the intensive margin(the “intensity” of
how much work you: the hours decision ).
47
2.3 The Hours of Work Decision:(maths)
 Maximization: Combining preferences with budget constraints:
Max U(C, L) Max U(C, L)

s.a C = w*h + V s.a C = w*(T-L) + V
T=h+L
Max U(w*(T-L) + V, L)
 First order condition solution {since we have simplified to single variable

problem, L}
-w + w
  
48
Max U(C, L)
s.a C = w*h + V
T=h+L
⁄
⁄
w
In point A: 𝑅𝑀𝑆 𝐶, 𝐿 > w. The

individual values leisure more than
work
To the right of point P: 𝑅𝑀𝑆 𝐶, 𝐿 <

w The individual values leisure less
than work
49

 The person will choose the level of C and L that lead to the highest possible level of
the utility index U —given the limitations imposed by the budget constraint.
 The optimal combination of C and L for the worker, therefore, is given by the point where
the budget line is tangent to the IC. This type of solution is called an interior solution
because the worker is not at either corner of the opportunity set.
 The budget line FE describes the opportunities available to a worker with V=$100
(nonlabor income per week), w=$10 per hour, and T=110 hours of nonsleeping time
to allocate between work and L activities (assuming she sleeps roughly 8 hours per
day).
 Point P gives the optimal bundle of C and L chosen by the utility-maximizing worker. The
highest IC attainable places her at point P and gives her U * units of utility. At this solution,
L=70 hours of leisure per week, works a 40-hour workweek, and C=$500 worth of goods
weekly.
 The worker would obviously prefer to consume a bundle on indifference curve U1 , which
provides a higher level of utility. For example, the worker would prefer to be at point Y…..
Given her w and V, however, the worker could never afford this point
 In contrast, the worker could choose a point such as A, which lies on the budget line, but
she would not do so. After all, point A gives her less utility than point P.
50
2.3 The Hours of Work Decision: Interpreting the Tangency Condition
 At the optimal point P, the budget line is tangent to the IC: the slope of the IC
equals the slope of the budget line.
𝑴𝑼𝑳 𝑴𝑼𝑳
 𝑴𝑼𝑪
or 𝑪 𝒘
 At the chosen level of C and L, the MRS (the rate at which a person is willing to give
up L hours in exchange for additional C) equals the “w” (the rate at which the
market allows the worker to substitute one hour of L time for C).
 The economic intuition behind this condition is easier to grasp if we rewrite it as
 MUL gives the additional utility received from an extra hour L and this extra hour costs w
dollars.
 MUC =the number of utils received from spending an additional dollar on C.
 The tangency solution at point P implies that the last dollar spent on leisure activities buys
the same number of utils as the last dollar spent on C.
o If this equality did not hold (so that, for example, the last dollar spent on C buys more utils than the
last dollar spent on L), the worker would not be maximizing utility. She could rearrange her “C” plan
so as to purchase more of the commodity that yields more utility for the last dollar.
51
2.3 The Hours of Work Decision: Review question
 Question: How many hours will a person allocate to leisure activities if her indifference curves
between consumption and goods are concave to the origin?
0 Leisure (L)
52
2.3 The Hours of Work Decision: Review question
 Question: How many hours will a person allocate to leisure activities if her
indifference curves between consumption and goods are concave to the origin?
 Answer: A worker will either work all available time or will not work at all.
 As drawn in Figure 1, point B is preferred to points A and C. Thus, the worker chooses not to
enter the labor market. As drawn in Figure 2, point C is preferred to both points A and B.
Thus, the worker chooses not to consume any leisure and to work all available time.
Figure 1 Figure 2
Goods Goods
C
C
U1
U1
A A
U0 U0
B B
Hours of Leisure Hours of Leisure
53
3. The Hours of Work Decision: Income
Effect
Changes in Non-labor income {holding constant the wage}
54
3. The Hours of Work Decision: “V” Changes
 ¿What Happens to Hours of Work When……?

 Let´s start “playing” with the model: This type of theoretical exercise is called
comparative statics, and is one of the main tools of economic theory.
 Comparative statics= We hold all elements constant except for one, and see what
effect changes to that one element have on an individual’s decision.
 The methodology isolates how the outcomes experienced by a particular individual
respond to a change in the value of one of the model’s parameters.
o For example, we can hold preferences and income constant and change wage to see how wage affects
choice of leisure hours.
o Alternatively, we can hold preferences and wages constant and see how a change in income affects
choice of leisure hours.
55
3. The Hours of Work Decision: “V” Changes (Income Effect)
56
 Meyer, Viscusi, and Durban (1990): What is the effect of Worker’s

Compensation benefit generosity on return to work times?
 Kentucky and Michigan increased generosity for high income workers. No change
for low income workers.
 WC claims data from before and after the change for both types of workers.
 Found that better benefits led to large increases in time off work {income effect in
terms of neoclassical labor supply model}.
57
 What is the effect of Worker’s Compensation benefit generosity on return to

work times?
58
 An increase in V expands the worker’s opportunity set through a parallel

shift in the budget line
 The increase in V to $200 weekly shifts the endowment point to E1 (new budget line F1E1).
The slope of the new budget line is the same –w constant-
 The increase in V allows the worker to jump to a higher IC (U ): Increases in “V” make the
1
worker better off: the expansion of the opportunity set opens up many additional –C and L-,
combinations
 ¿Hour of work?: We cannot predict how an increase in V affects hours of work unless we
make an additional restriction on the shape of ICs.
o Figure 2-6a: the additional “V” increases both expenditures on C and the number of L hours used. As
a result, the length of the workweek falls to 30 hours.
o Figure 2-6b the additional “V” reduces the demand for L hours, increasing the length of the
workweek to 50 hours.
 The impact of the change in nonlabor income (holding wages constant) on the
number of hours worked is called an income effect
59
 V increases from 100 to 200$: Here hours of Leisure increases
The worker maximizes utility at point P0 :

- V=$100 weekly, endowment point E0 .
- Given the worker’s wage rate, the budget line
is then given by F0 E0 .
60
 V increases from 100 to 200$: Here the optimal solution is different: hours of
leisure fall
ESTE SUPUESTO SE DESCARTA PORQUE EMPIRICAMENTE

NO ES ASI PORQUE EL OCIO LO CUENTA COMO UN BIEN NO
NORMAL
The worker maximizes utility at point P0 :

- V=$100 weekly, endowment point E0 .
- Given the worker’s wage rate, the
budget line is then given by F0 E0 .
- Then V increases from 100 to 200$
61
 V increases from 100 to 200$: two “potential” solutions

 We need an assumption to set the final solution
62
3. The Hours of Work Decision: “V” Changes
 V:
 ¿Hour of work?: We cannot predict how an increase in V affects hours of work
unless we make an additional restriction on the shape of ICs.
 The additional restriction we make is that leisure is a “normal” good (as opposed to
leisure being an “inferior” good).
 This assumption resolves the conflict in favor of Figure 2-6a.
 An increase in V then raises the demand for leisure hours and thus reduces hours of work.
 The income effect, therefore, implies that an increase in V, holding w constant, reduces
hours of work
63
 Some empirical testings of the income effects: labor supply and lottery wealth
 Regression Model: 𝒊𝒕 𝒍 𝒍 𝒊𝒕 𝒍 𝒊𝒕
 𝒊𝒕 𝒍
 gross labor earnings
64
4. The Hours of Work Decision:
Income and Substitution Effects
¿ changes in wages
65
4. The Hours of Work Decision: the Wage Changes
 Wage increase from $10 to $20 an hour: The “w” increase rotates the budget
line around the endowment point.
 The opportunity set moves from FE to GE.
 A “w” increase does not change the initial endowment point: the dollar value of the
goods that can be consumed when one L=T (work=0) is the same regardless the w.
 Two potential “alternative” optimal points: We cannot make an unambiguous
prediction. Two forces are at play (Substitution versus Income effects)
 1. An increase in income increases the demand for all normal goods, including L. The
increase in “w” thus increases the demand for L, which reduces hours of work.
o The optimal C and L moves from P to R. At the new equilibrium, L is higher (from 70 to 75 hours),
hours of work fall from 40 to 35 hours.
 2. The increase in “w” also makes L more expensive. When w=$20 an hour, she gives up $20
every time she decides to take an hour off. A “w” increase thus reduces the demand for “L”
and increases hours of work.
o The optimal C and L changes from P to R. At the new equilibrium, L is lower (from 70 to 65 hours),
hours of work increases from 40 to 45 hours.
o L is a expensive commodity for high-wage workers and a relatively cheap commodity for low-wage
workers. High-wage workers should then have strong incentives to cut back on their leisure
activities.
66
 Wage increase from $10 to $20 an hour:
67
 Wage increase from $10 to $20 an hour:

 Substitution versus Income effects: Let´s think the move from point P to point R as a
two-stage move: from P to Q and from Q to R (Figure 9).
 i) The first-stage move: The move from point P to point Q is an income effect: It arises from
a change in the worker’s income, holding w constant. The income effect isolates the change
in the consumption bundle induced by the additional income generated by the wage
increase. Because L and C are normal goods, point Q must lie to the northeast of point P (so
that more is consumed of both goods and leisure). The income effect thus increases the
demand for leisure (from 70 to 85 hours) and reduces hours of work by 15 hours per week.
 ii) The second-stage move from Q to R is called the substitution effect: It isolates the impact
of the increase in the price of leisure (“w” increases) on hours of work, holding real income
(or utility) constant. By moving along an IC, the worker’s utility is held fixed. As w rises, the
worker devotes less time to expensive leisure activities (from 85 to 75 hours) and increases
her consumption of goods. Through the substitution effect, therefore, the “w” increase
reduces the demand for L and increases hours of work by 10 hours. The substitution effect
implies that an increase in the wage rate, holding real income(or utility) constant, increases
hours of work.
68
 ¿What Happens to Hours of Work When the Wage Changes? (cont.)
In Figure 1-9a, the decrease in hours of work In Figure 1-9b, the income effect decreases hours of
generated by the income effect (15 hours) exceeds work by 10 hours, whereas the substitution effect
the increase in hours of work associated with the increases hours of work by 15 hours. Because the
substitution effect (10 hours). The stronger income substitution effect dominates, there is a positive
effect thus leads to a negative relationship between relationship between hours of work and the wage rate
hours of work and the wage rate.
69
 Empirical Findings on the Income and Substitution Effects
70
 Empirical Findings on the Income and Substitution Effects: differences by

gender
71

gender
72

gender
73
4. The Hours of Work Decision: (Review Question)
 Just to practice
 1) Show the effect of a wage decrease on an individual’s income-leisure choices. Isolate the
income and substitution effects. Is the worker on the forward-rising or backward bending
portion of the labor supply curve?
 2) Indicate in each of the following instances whether specified events would cause a worker
to want to work more or fewer hours:
 (a) The wage rates rises and the substitution effect is greater than the income effect.
 (b) The wage rate falls and the income effect is greater than the substitution effect.
 3) TAXES AND LABOR SUPPLY One of the beliefs of the Reagan administration (which took
office in 1981), echoed in the language of the Republican congressional majority in 1995, is
that high rates of taxation are at the root of the economic problems faced by the United States.
The argument was that high taxes reduce the incentive to work, save, and invest, it is said. If
tax rates were to go down (increasing take-home pay), it is argued, more people would go to
work, people already working would work harder, and more investment and capital formation
would take place. ¿Is this what the neoclassical theory of labor supply predict?
 4) the size of the Income effect is affected by the initial hours of work. ¿Is this true?
74
4. The Hours of Work Decision: the Wage Changes (Review Question)
 Just to practice
 3) TAXES AND LABOR SUPPLY One of the beliefs of the Reagan administration (which took
office in 1981), echoed in the language of the Republican congressional majority in 1995, is
that high rates of taxation are at the root of the economic problems faced by the United States.
The argument was that high taxes reduce the incentive to work, save, and invest, it is said. If
tax rates were to go down (increasing take-home pay), it is argued, more people would go to
work, people already working would work harder, and more investment and capital formation
would take place. ¿Is this what the neoclassical theory of labor supply predict?
 Answer
 Economic theory shows that tax cuts could increase or decrease labor supply. Nobody disagrees that
reducing taxes on income increases the “net wage.” The issue is: What is the impact of higher net wages
on the supply of labor?
 An increase in wages have both a substitution effect and an income effect. Higher net wages increase the
price of leisure. Increasing the price, or opportunity cost, of leisure leads to additional work effort as
people find an incentive to substitute other goods, bought with income from working, for leisure. This is
the substitution effect of higher wages. But higher net wages also make people better off. By working the
same number of hours, workers can earn more income. That added income can be spent on any
combination of goods, including leisure. Because I have a higher income, I may decide to consume more
leisure; the result is that I actually work less. This is the income effect of higher wages
 The income and substitution effects of higher wages work in opposite directions. If the income effect is
larger than the substitution effect, higher net wages will actually reduce the supply of labor
75
 4) The size of the Income effect is affected by the initial hours of work. ¿Is this
true?
 Answer:
76
 5) Suppose that there are three utility functions for consumption (C) and leisure (T):
o w = $25, V= 0, and the consumer has 4000 hours at her disposal to use for leisure or work.
 (a) Determine T, C and hours of work at equilibrium for all three cases.
 (b) What is the value of non-labour income necessary to reduce work to zero for all three cases?
 (c) Non-labour income is again zero. Determine T, C and hours of work if:
o (I) the wage rate rises to $50
o (II) the wage rate falls to $10
 (d) Using your answers to parts (a) and (c), determine whether or not the labour supply curve for the
three utility functions is backward-bending, forward-bending, or perfectly vertical.
 (e) Suppose that this consumer receives non-labour income of $4,000. For each of the three utility
functions given to you in this question, determine the consumer’s reservation wage.
77

 The netherlands case
78

 International Evidence 1: Regression Model
 𝒊𝒕 𝒊𝒕 𝒊𝒕
 i=countries, t=time {Panel data} .. ?, whenever substitution effects dominate
79

 International Evidence 1: Regression Model
 𝒊𝒕 𝒊𝒕 𝒊𝒕
 Previous figure depicts the annual number of hours worked against GDP per capita
in the US, France and the Netherlands, between 1870 and 2000. Which of the
following is true?
 A. An increase in GDP per capita causes a reduction in the number of hours worked.
 B. The GDP per capita in the Netherlands is lower than that in the US because Dutch people
work fewer hours.
 C. Between 1870 and 2000, French people have managed to increase their GDP per capita
more than ten-fold while more than halving the number of hours worked.
 D. On the basis of the evidence in the graph, one day French people will be able to produce a
GDP per capita of over $30,000 with less than 1,000 hours of work.
80

 International Evidence 2: 𝒊𝒕 𝒊𝒕 𝒊𝒕
 https://ourworldindata.org/grapher/annual-hours-of-free-time-per-worker-and-income
81

 International Evidence 2:
 In many countries there has been a huge increase in living standards since 1870. But in some
places people have carried on working just as hard as before but consumed more, while in
other countries people now have much more free time. Why has this happened?
 You can see that the higher-income countries seem to have lower working hours and more free
time, but there are also some striking differences between them. For example, the Netherlands
and the US have similar levels of income, but Dutch workers have much more free time. And
the US and Turkey have similar amounts of free time but a large difference in income.
82

 International Evidence 3: Using the model to explain free time and consumption per
day across countries
83

84

85

 International Evidence 3:
 The US and South Korea: Point Q is at the intersection of the indifference curves for the US and
South Korea. At this point Americans are willing to give up more units of daily goods for an
hour of free time than South Koreans.
 Point Q in the last step of the figure is the point of intersection of the two indifference curves shown for
South Korea and the US. At that point the US indifference curve is steeper than the South Korean one.
This means that the average American is willing to give up more units of daily goods for an hour of free
time (this is the MRS) than the average South Korean, which is consistent with the idea that South
Koreans work exceptionally hard. So it may be important to take account of differences in preferences
among countries, or among individuals.
86

 International Evidence 4: The figure below illustrates what has happened to
working hours in many countries during the 20th century (the UK is in both charts
to aid comparison).
 How would you describe what happened?
 How are the countries in Panel A of the figure different from those in Panel B?
 What possible explanations can you suggest for why the decline in working hours was
greater in some countries than in others?
 Why do you think that the decline in working hours is faster in most countries in the first
half of the century?
 In recent years, is there any country in which working hours have increased? Why do you
think this happened?
87
 Empirical Findings on the Income and Substitution Effects

 International Evidence 4:
88

 International Evidence 4: Some projections
89
5. The Hours of Work Decision
Some Examples that adds Labor Regulation to the model
90
5. The Hours of Work Decision : Extensions
 Applying and Extending the Model: The Income-Leisure model can be

extended (altered) to explain/study various conditions.
 Under-employment
Overemployment
Involuntary Unemployment..

 A) Hour of work:
 1) What happens if you offer overtime past 40 hours of work per week?
 2) What would cause a worker to take on a second job?
 3) How would workers react to fixed versus flexible hours?
₋ What if only options are part-time work, or nothing?: Examples of under-employed
₋ What if only options are full-time work, or nothing ?: Examples of over-employed
91
5. The Hours of Work Decision : Regulation on hours of work
 Why working less than desired-“optimal”? (Under-Employment)

 If an individual is free to choose the number of hours of work, given “w” she would
choose point U1, with h=14 and L=10 (T=24). Think on low pay jobs.
 If the individual is constrained to work a standard workday of 8 hours or not all, she
will choose point U2. (h=8, L=16). At U2, her MRS is less than the “w” and so she
feels underemployed.
 What is a potential solution to her underemployment situation?
 Consumption/day C(€)
Wh+V
U1
U2
V E
H
0 10 16 24 Leisure 92
 Why working more than desired-“optimal”? (Over-Employment)

 If an individual is free to choose the number of hours of work, she would choose
point U1, L=18 and h=6.
 If the individual is constrained to work a standard workday of 8 hours or not all, she
will choose point U2 At U2, her MRS is more than the wage rate and so she feels
overemployed.
 What is a potential solution to her overemployment situation?
C/day C($)
W U3
U1:RMS(C,L)=w
U2
U2:RMS(C,L)>w
U1
H
0 16 18 24
Leisure
93
 Overtime: working more than the

standard work week at a job
 The worker may prefer to work fewer
hours, at a given wage rate, than the firm
asks them to work. Such workers are over
employed. In order to entice workers to
work more hours (or because of
legislation), firms may offer a higher
wage rate (over time premium) for all
work done past a certain number of
hours/week (ex/ overtime pay for all
work past 40 hrs/week).
 Below we see how overtime entices
workers to work more in the Income-
Leisure framework. At an overtime wage
of w2=1.5*w1 entices the individual to
work hO hours > hP hours.
94
6. The participation decision
(Extensive margin)
What factors motivate a person to enter the labor force in

the first place? (The extensive margin )
95
6. To Work or Not to Work
 The decision of whether to work or not boils down to a simple question:

 Are the “terms of trade” -the rate at which L can be traded for additional C -
sufficiently attractive to bribe her into entering the labor market?
 For V constant, the working decision will depend on “w”: The individual does not
enter the labor market at low “w” (wL=wlow ), but does enter the labor market at
high “w” (wH=whigh).
 With h=0, L=T, receives U0 units of utility (V=0, E initial point) . The individual can choose
to enter the labor market and trade some of her leisure time for earnings that will allow her
to buy consumption goods.
o 1. For w=wlow the budget line is GE . No point on this budget line can give her more utility than U0 .
If the worker were to move from the endowment point E to any point on the budget line GE, she
would be moving to a lower IC and be worse off (For example, at point X ) , therefore, the individual
chooses not to work.
o 2 For w=whigh the budget line is HE. Then moving to any point on this steeper budget line would
increase her utility. At point Y, the woman gets UH utils. At w=whigh , therefore, the individual is
better off working.
o 3. As we rotate the budget line from wlow to whigh , there is a “w” (𝑤 = reservation wage) , that
makes the individual indifferent between working and not working. The 𝑤 gives the minimum
increase in income (“w”) that would make a person indifferent between remaining at the
endowment point E and working that first hour. Graphically: 𝑤 is given by the absolute value of the
slope of the IC at point E
96
6. To Work or Not to Work: The reservation wage
 Every map of indifference curves has a reservation wage
97
 Every map of indifference curves has a reservation wage 𝒓
𝑳,𝑼𝟎
𝒓 𝟎
𝑪,𝑼𝟎
98
 Every map of indifference curves has a reservation wage

 At 𝒓 the individual is indifferent between working or not
Wage
𝒓
w
w*
 Hours of leisure
 Hours of work
 An example: Reservation Wage with Fixed Time Costs of Working
100
 Policy/Empirical Implications:
 1. A high 𝒓 makes less likely that a person will work.
 𝒓depend on the person’s tastes for work, which helps to determine the slope of the IC, as
well on many other factors. Work lovers will have lower 𝒓 than leisure lovers….
 The assumption that L is a normal good implies that the 𝒓 rises as V increases
 2. Holding 𝒓 constant, high-wage persons are more likely to work.

 The theory predicts a positive relation between the person’s wage rate and her probability
of working.
o A rise in “w”, increases the labor force participation rate of a group of workers (positive correlation
between “w” and labor force participation rates):
o This correlation helps explain the rapid increase in the labor force participation rate of women
observed in the many OCDE countries in the past century.
o This prediction contrasts with our earlier result that a wage increase has a theoretically ambiguous
effect on hours of work, depending on whether the income or substitution effect dominates: ¿Can
you explain it?
101
 The theory predicts a positive relation between the person’s wage rate
and her probability of working.
 This prediction contrasts with our earlier result that a wage increase has a
theoretically ambiguous effect on hours of work, depending on whether the income or
substitution effect dominates: ¿Can you explain it?: Answer
 The disparity between these two results arises because an increase in the wage
generates an income effect only if the person is already working.
o A person working 40 hours per week will surely be able to consume many more goods when the
wage is $20 per hour than when the wage is $10 per hour. This type of wage increase makes leisure
more expensive (so that the worker wants to work more) and makes the person wealthier (so that
the worker wants to work less).
o In contrast, if the person is not working at all, an increase in the wage rate has no effect on her real
income. The amount of goods that a nonworker can buy is independent of whether her potential
wage rate is $10 or $20 an hour. An increase in the wage of a nonworker, therefore, does not generate
an income effect. The wage increase simply makes leisure time more expensive and hence is likely to
draw the nonworker into the labor force.
102
 Policy Implications ( we will look at these issues next chapter):

 ¿How can I test this hypothesis?:
 Empirical Implications {Testing Hypothesis}: positive correlation between educational
attainments and labor force participation…
₋ 𝑃𝑟𝑜𝑏 ℎ > 0 = α + 𝛽𝑋 + 𝜀 , ℎ =hours of work. i=individuals
₋ Hypotesis: 𝛽 > 0, 𝑋 =years of education
 Positive correlation between average wages (local labor markets) and labor force
participation
₋ 𝑁 = α + 𝛽𝑤 + 𝜀 , 𝑁 =numero de activos en mercado local “i”, 𝑤 =average wages en mercado local
“i”
₋ Hypotesis: 𝛽 > 0,
 Use the CPS surveys to test this hypothesis….Some interesting references: Estimates of the
effect on labor market participation indicate, indeed, that it increased participation among
eligible individuals.Meyer, Bruce D. 2002. “Labor Supply at the Extensive and Intensive
Margins: The EITC, Welfare, and Hours Worked.” AEA Papers and Proceedings, Vol. 92, No.2:
371-379.
103
6. To Work or Not to Work: Review Question:
 What is the effect of an increase in the price of market goods on a worker’s reservation
wage, probability of entering the labor force, and hours of work? (Note: so far, we have
assume that the price of consumption is unitarian –p=1, we can rewrite the optimality
𝒘 𝑴𝑼𝑳,
condition as follows:
𝒑 𝑴𝑼𝑪
104
 Question: What is the effect of an increase in the price of market goods on a worker’s
reservation wage, probability of entering the labor force, and hours of work?
 Answer: Suppose the price of market goods increases from p to p and the person’s non-labor
income is V.
 If she chooses not to work, she can purchase V/p units of consumption after the price change, whereas
she could have consumed V/p units of consumption prior to the price increase. Thus, her endowment
point has moved from E to E.
 Under normal conditions, including that leisure is a normal good, the indifference curve is steeper as we
move up a vertical line, indicating that the slope of the indifference curve is steeper at E than at E. Thus,
an increase in the price of goods lowers the reservation wage and makes the person more likely to work.
Goods
E
V/p
E
V/p
0 T Hours of
Leisure
105
 (cont.) Answer: (assume that V = 0)

 The increase in the price of goods shifts the budget
line from FE to GE, moving the worker from P to
point R.
 This shift induces both an income effect and a
substitution effect.
Goods
 The price increase lowers the person’s real wage,
increasing the demand for leisure (fewer hours of F
work) (the substitution effect: from P to Q)
 The price increase also reduces the worker’s wealth, P
lowering the demand for leisure (more hours of work) Q
(the income effect: from Q to R).
 As drawn the income effect dominates the substitution G R
effect and the price increase lowers the demand for
leisure (increases hours of work). E
T
 It is, of course, possible for the substitution effect to Hours of Leisure
dominate the income effect (not pictured), so that
hours of work decreases. Thus, without further
restrictions on preferences, an increase in the price of
market goods has an ambiguous effect on hours
worked. 106
 Question of thought: Think about a high-wage versus a low wage worker: ¿Which effect
will dominate when wages increases?
 ¿Substitution effects dominate income effects for high-wage earnings relative to low wage
workers?
 Question of thought: Think about a leisure lover individual relative to a work lover
individual: ¿Which effect will dominate when wages increases?
 In general: Income Effects are stronger whenever the worker is already working many hours. If the time
devoted to work is already high, an increase in hourly wages mean a large increase in income (w*h)
 In the opposite site: if time devoted to work is short , the increase in “w” does not generate a large
income effect
 When dealing with the participation decisión, increases in hourly wages lead to a dominant sustitution
effect (sustitution effects tend to be stronger than income effects).
107
 Exercises (Borjas 1-4). Cindy gains utility from consumption C and leisure L. The most
leisure she can consume in any given week is 110 hours. Her utility function is U(C, L)
= C  L. This functional form implies that Cindy’s marginal rate of substitution is C / L.
Cindy receives $660 each week from her great-grandmother–regardless of how much
Cindy works. What is Cindy’s reservation wage?
 Solution: The reservation wage is the MRS when not working at all. Thus, wRES = MRS at
maximum leisure equals
 MRS (h=0, T=L)=C/L = $660/110 = $6.00.
108
 Examples: Corner Solution: the participation decision

.
109
 Examples
 If a person has a low wage rate (WN is flat), higher
non-labor income (NH), or steep indifference
curves (I1), he is less likely to participate in the Income/day
labor force (U1). I2
W’
 If a person has a high wage rate (HW’), low non-
labor income (0), or flat indifference curves (I2),
she is more likely to participate (U2). I1
W
 The reservation wage is the lowest wage necessary U
to induce someone to work. 2
 College students are less likely to participate in the

labor force than other persons. Why?
U
 N1
H
0 10 24 Leisur
e
110
7. The Labor Supply Curve: desired
hours of work for each level of wages
Individual´s and aggregate
111
7. The Labor Supply Curve: Individual Labor Supply
112
 Labor supply curve = The predicted –theoretical/empirical- relation between

hours of work and the wage rate.
 The individual labor supply: the relation between the optimal number of hours
worked and the wage rate
 The utility-maximization problem: the person’s optimal consumption bundle at alternative
wage rates. (reservation wage)=$10.
o At w<=10, the person supplies zero hours to the labor market .
o At w>$10, the person chooses to work some hours (if w=13, hours= 20; if w=20, hours= 40; if w=25,
hours= 30).
o Once w>$20, however, the income effect dominates and hours of work decline as the wage rises,
creating a segment of the labor supply curve that has a negative slope.
o Note that, as drawn, the figure implies that substitution effects dominate at lower wages and that
income effects dominate at higher wages.
 The shape of the labour supply:
o Initially, the labor supply curve is positively sloped as hours and wages move together.
o The type of labor supply curve illustrated in Figure 1-8b is called a backward-bending labor supply
curve because it eventually bends around and has a negative slope.
113
 The Individual labor supply curve.
(b) Relation between Optimal Hours

(a) Optimal Consumption Bundles
of Work and the Wage Rate 114
7. The Labor Supply Curve: Aggregate labor market
 The labor supply curve in the aggregate labor market (industry)

 It is given by adding up the hours that all persons in the economy are willing to
work at a given wage
 An economy with two workers, Alice and Brenda. Alice has reservation wage ; Brenda
has a higher reservation wage .
 No one would work if the wage is below , and that only Alice would work if the wage is
between and . At wages higher than , market labor supply is given by the total
number of hours worked by Alice and Brenda, or .
 The labor supply curve in the market, therefore, is obtained by adding up the supply curves
of all workers horizontally.
o The market labor supply (industry) always has positive slope (differently to the individual labor
supply)
₋ When wage increases, though some workers might choice to work less hours, there will be
additional workers desiring to work (at lower wages their individual labor supply is zero)
115
 The labor supply curve in the aggregate labor market (industry)
116
7. The Labor Supply Curve: Changes in Taxes
 ¿How a change in taxes could affect the labor supply of an individual? :

Reduction in income taxes
 What the theory tells us?
 Income and substitution effects work in opposite directions at the individual level
 At the aggregate level, workers preferences, and the observed hours of work (the starting
point matters)
 How can I test this empirically? : let´s use what is called “natural experiments”
 Natural experiment: unexpected and large change in one variable and the size of the change
is different between groups (even some of them are NOT affected).
 A study by Alexander Bick and Nicola Fuchs-Schúndeln, “Quantifying the

Disincentive Effects of Joint Taxation on Married Women’s Labor Supply,”
American Economic Review Papers and Proceedings 107 (May 2017): 100–
105, also estimates that female labor supply increases as income tax rates fall.
117
 The labor supply
118
7. The Labor Supply Curve: Labour supply elasticity
 To measure the responsiveness of hours of work to changes in the wage rate,

we define the labor supply elasticity as
% change in hours worked
 Labour supply elasticity: % change in wage
 The labor supply elasticity gives the percentage change in hours of work associated with a 1
percent change in the wage rate.
 The sign of depends on whether the labor supply curve is upward sloping (Δh/Δw )>0 or
downward sloping (Δh/Δw) < 0. It is positive when substitution effects dominate and
negative when income effects dominate. Hours of work are more responsive to changes in
the wage the greater the absolute value of the labor supply elasticity.
o If the elasticity is zero, it is perfectly inelastic: there is relatively little change in hours of work for a
given change in the wage rate.
o If the elasticity is negative, it is backward bending.
o If the elasticity is positive and less than 1, it is relatively inelastic.
o If the elasticity is positive and more than 1, it is relatively elastic: indicating that hours of work are
greatly affected by the change in the wage.
 Suppose that the worker’s wage is initially 10 per hour and that she works 1,900 hours per
year. The worker gets a raise to 20 per hour, and she decides to work 2,090 hours per year
119
7. The Labor Supply Curve: Wages and Elasticity of labor supply
120
7. The Labor Supply Curve: Wages and Elasticity of labor supply
121
7. The Labor Supply Curve: Individual labor market (maths)
Max U(C, L) Max U(C, L)

s.a C = w*h + V s.a C = w*(T-L) + V
T=h+L
Max U(w*(T-L) + V, L)
 First order condition solution {since we have simplified to single variable

problem, L}
-w + w
  
122
 Exercise 1: Deriving a Person´s Individual Labor Supply: , T=24

 A) Obtain the individual´s labor supply curve
 B) Explain how is the slope of the labor supply curve respect to wages {graph it}
 C) Obtain the reservation wage
123

 A) Obtain the individual´s labor supply curve {solution}
 Two equations : Optimality condition+Budget restriction:
 1. 𝑈𝑡𝑖𝑙𝑖𝑡𝑦 𝐹𝑢𝑛𝑐𝑡𝑖𝑜𝑛: 𝑈 𝐶, 𝐿 = 𝐶𝐿 , T=24

𝑴𝑼𝑳 𝑴𝑼𝑳
o Optimality Condition (tangency condition in maths) :𝑾 = , 𝑴𝑼𝑪 = →,
𝑴𝑼𝑪 𝑾
₋ 𝑀𝑈 = = 2𝐶𝐿 and 𝑀𝑈 = =𝐿
𝒘𝑳
o 𝐿 = →𝑪=
𝟐
 2. Budget Constraint C=wh+V
 1+2: = wh+V
( )
o = wh+V →
o Optimal number of “desired” hours of work in relation to wage rates and non-labor income, given particular
𝟐𝑽
preferences (defined by the form of the utility function) 𝒉∗ (𝑽, 𝒘) = 𝟖 −
𝟑𝒘
𝟐𝑽
o Individual Labour Supply: for V fixed 𝒉∗ (𝑽, 𝒘) = 𝟖 −
𝟑𝒘
o Optimal hours of work depends posetively on “w” and negatively on “V”
124

 B) The slope of the individual labor supply:
o Positive Slope ∀ 𝑤?
o Is there any wage level for which this individual labor supply equation backward vending?
 Let´s take the derivative repect to wages:
𝒉∗ (𝑽,𝒘)
 , it is convex or concave
o The slope of the labor supply is non-linear

o The marginal increase of hours of work when wage increases is always positive though it is
decreasing, for 𝑤 → , =0
o Individual Labor Supply for: 𝑉 > 𝑉 > 𝑉
w
𝐿𝑆(𝑉 )
h
125
 Exercise 1: Deriving a Person´s Individual Labor Supply:

 C) The reservation wage: h=0, C=V, =
o The reservation wage is (𝒉∗ (𝑽, 𝒘𝒓 )=0), (𝒘𝒓 = )
o Optimal hours of work depends posetively on w and negatively on V: The reservation wage is
increasing with “V”
 Note: The labor market supply is the aggregation of these individual decisions
𝑵
 The labor market supply is the aggregation of these individual decisions: 𝒊
∗
o Empirical Model : 𝑳𝒂𝒃𝒐𝒓 𝒎𝒂𝒓𝒌𝒆𝒕 𝒔𝒖𝒑𝒑𝒍𝒚: 𝒉∗ = 𝜹𝟎 + 𝜹𝟏 𝑾 − 𝜹𝟐 𝑽+
126
Question of thought: Female Labor Force Participation
 Exercise 2: Question of thought: Female Labor Force Participation (question)

 Real wage have increased by well over 100% since 1900 and per capita wealth has increased
by about 80% during the same period. Although data are somewhat sketchy before 1947, the
available evidence suggests that male and female wages grew at about the same rate (until
recently). Per capita wealth also grew at about the same rate for men and women.
Nevertheless, over this period of time male hours of work and male labour force participation
have declined somewhat while at the same time female participation and hours of work have
increased strongly. How can you explain this difference in behaviour of males and
females? Is it a paradox for labour supply analysis?
127
 Exercise 2: Question of thought: Female Labor Force Participation . Answer

 The above discussion stressed the importance of decomposing price changes into a substitution and an
income effect. Whereas the Slutsky-decomposition might seem abstract at first sight, it is very helpful in
explaining real life phenomena.
 One example is the trend in hours and labour force participation of males and females during the 20th
century. Differences between males and females can occur because of differences in substitution and
income effects (among other reasons).
 If both male and female wages increase but as a consequence males work less and females more, it must
be that for males the substitution effect is smaller than the income effect and that the substitution effect
is bigger than the income effect for females.
 So really two questions need to be answered:

o why is the substitution effect for females bigger than for males?
o and why is the income effect for women smaller than for men?
128
 Question of thought: Female Labor Force Participation Answer

 and why is the income effect for women smaller than for men?
 If women worked less than men at the beginning of the 20th century, their income effects are small.
However, it is hard to believe that initial differences in pay are the only factor that triggered an increase
in female labour supply. Moreover, since we assume that all information about the demand side of the
labour market is revealed through a given wage rate in the labour supply model, we should be able to
answer why otherwhise identical male and female workers earned different wages at the beginning of
the 20th century.
 why is the substitution effect for females bigger than for males? A more likely explanation
for the increase in female labour supply is through the substitution effect.
 An increase in the wage of female workers has a much bigger positive effect on labour supply compared
to men. The reason is the substitutability between time spent at home time and time spent working for
pay outside the home.
129
 Question of thought: Female Labor Force Participation (Cont) Answer

 why is the substitution effect for females bigger than for males?
 Consider Figure 3. Panel (a) gives the labour supply decision for females with on the horizontal axis the
time spent in household work, supposed to be a good. Panel (b) analysis the supply of labour by men
with on the horizontal axis time spent in leisure.
130
 Question of thought: Female Labor Force Participation (Cont) Answer

 why is the substitution effect for females bigger than for males?
 Consider Figure 3. Panel (a) gives the labour supply decision for females with on the horizontal axis the
time spent in household work, supposed to be a good. Panel (b) analysis the supply of labour by men
with on the horizontal axis time spent in leisure.
o The reason why the indifference curves in both panels differ is that household work might be more easily substituted
than leisure.
₋ If women are in charge of the household, reduced time devoted to household chores as cooking, cleaning and child
care can be easily replaced through the purchase of a microwave oven, prepared foods, an electric dishwasher or
the service of a baby-sitter.
₋ In contrast, leisure activities normally include time as an essential input and the possibilities for economizing on
time are limited. It follows from Figure 3 that even if initial wages are identical, women tend to increase their
supply of labour more, ceteris paribus. Finally, since only relative prices matter in the economy, it is most likely that
female labour supply would have increased relative to men since the price of doing household work drastically
decreased during the 20th century due to technological improvement.
131
 Exercise (Borjas 1-6). Shelly’s preferences for consumption and leisure can be
expressed as
 U(C, L) = (C – 100)  (L – 40).
 This utility function implies that Shelly’s marginal utility of leisure is C – 100 and her marginal
utility of consumption is L – 40. There are 110 (non-sleeping) hours in the week available to
split between work and leisure. Shelly earns $10 per hour after taxes. She also receives $320
worth of welfare benefits each week regardless of how much she works.
 (a) Graph Shelly’s budget line. If Shelly does not work, she leisures for 110 hours and consumes $320. If
she does not leisure at all, she consumes $320 + $10(110) = $1,420. Shelly’s weekly budget line,
therefore, is:
Dollars of
Consumptio
n $1,420
$32
0
110 Hours of
Leisure
132
 (b) What is Shelly’s marginal rate of substitution when L = 100 and she is on her
budget line?
 If Shelly leisures for 100 hours, she works for 10 hours and consumes $320 + $10(10) = $420.
Thus, her MRS when doing this is:
MU L C  100 420  100 320
MRS      $5.33
MUc L  40 100  40 60
 (c) What is Shelly’s reservation wage?
 The reservation wage is defined as the MRS when working no hours. When working no hours,
Shelly leisures for 110 hours and consumes $320. Thus,
320  100 220
w RES    $3.14
110  40 70
 (d) Find Shelly’s optimal amount of consumption and leisure.

 Her optimal mix of consumption and leisure is found by setting her MRS equal to her wage and
solving for hours of leisure given the budget line: C = 320 + 10(110 – L).
w  MRS
 Thus, Shelly will choose to leisure 86 hours, work 24 hours, and consume $320 +C $10(24)
 100
=
$560 each week. 10 
L  40
320  10(110  L)  100

 10 
L  40
10 L  400  1320  10 L
L  186. 133
 Borjas 2-6
134
 Borjas 2-6
135
Review/Exam Questions
 Some questions we answer (Make sure you can answer these questions)
1. How people make choices between consumption and leisure.
2. What the reservation wage is.
3. How the shape of the labour supply results from the combination of substitution and income
effects.
4. What happens to the reservation wage if nonlabor income increases, and why?
5. What economic factors determine whether a person participates in the labor force?
6. How does a typical worker decide how many hours to allocate to the labor market?
1. What if only options are full-time work or nothing?
7. What happens to hours of work when nonlabor income decreases?
8. What happens to hours of work when the wage rate falls? Decompose the change in hours of
work into income and substitution effects. Indicate in which instances the worker is on the
backward bending portion of the labor supply curve
9. What happens to the probability that a particular person works when the wage rises? Does such
a wage increase generate an income effect?
10. Indicate in each of the following instances whether specified events would cause a worker to
want to work more or fewer hours (make the corresponding graph and identify the income and
substitution effect):
1. The wage rates rises and the substitution effect is greater than the income effect.
2. The wage rate falls and the income effect is greater than the substitution effect.
11. What are the wage elasticities of labour supply.

12. Use the income and substitution effects arguments to explain the different trends in the activity
rate of women versus men during the last century (wages has increased) 136
The End of the Baseline Model
137

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Chapter 1: Labor Supply (LS, Theory)

Mercado de Trabajo, 3º de GANE

 Main References: You should read/study (for the theoretical section)

 What is labor economics? Which types of questions do labor economists analyze?

 1. Main Indicators of the Labor Market (concepts already learnt)

 Applications (real novelty of the chapter..)

 Main Indicators of the Labor Market (concepts already learnt)

 The Hours of Work Decision: Comparative Statics

 Welfare Programs: Income Replacement Programs

 Two very important secular trends

The theory of labour supply (Static Model)

Worker´s Preferences Budget Restriction

 This chapter focus on issues of worker behavior.

 Trends in Labor Force Participation and Hours of Work

 For instance, from the labour supply model:

The theory of labour supply: Static Model

 1.PREFERENCES: Utility Function

 Comparative statics: ceteris paribus…

The Utility Function: The decision to work is ultimately

 PREFERENCES: Utility Function: The choice between labour and leisure

 Utility Function: The choice between labour and leisure

0 Leisure (L) 0 Consumption (C)

 Indifference curves have four important properties

 1. Indifference curves are downward sloping: individuals prefer more of both

 ¿Why IC can not be upward sloping?:

 2. Higher IC indicate higher levels of utility.

 4. IC are convex to the origin.

 The absolute value of the Slope of an IC is the ratio of marginal utilities of

 4. IC are convex to the origin.

 4. IC are convex to the origin:

 4. IC are convex to the origin:

 Differences in Preferences across individuals

In absolute values: For a particular (C,L)

𝑀𝑅𝑆 𝐶𝑖𝑛𝑑𝑦 > 𝑀𝑅𝑆 𝑀𝑖𝑛𝑑𝑦

tastes for work: low tastes for work: high

 Differences in Preferences across Workers 𝑀𝑅𝑆 =

𝑀𝑅𝑆 𝐶𝑖𝑛𝑑𝑦 > 𝑀𝑅𝑆 𝑀𝑖𝑛𝑑𝑦

 Differences in Preferences across Workers

Time and Income

 Total Income: Labor and Non-Labor income 

 Graph the budget constraint (w=constant):

 Different examples of budget constraints: The slope of the budget constraint is

 Different examples of budget constraints: Tax on wage income (t=tax-rate)

 Different examples of budget constraints: Labour Costs (e.g. Daycare,

Time is needed for “D”

 Different examples of budget constraints: Fixed hours of work

 Different examples of budget constraints: wage rates might depend on the

Kinks Overtime: non constant wage

70 110 Hours of Leisure 44

 1) Exercise 1 (Borjas 1-3). (Cont.)

Maximing the utility function subjet to Budget

 Labour Supply Decision

 Maximization: Combining preferences with budget constraints:

Max U(C, L) Max U(C, L)

 First order condition solution {since we have simplified to single variable

 Maximization: Combining preferences with budget constraints:

In point A: 𝑅𝑀𝑆 𝐶, 𝐿 > w. The

To the right of point P: 𝑅𝑀𝑆 𝐶, 𝐿 <

 Maximization: Combining preferences with budget constraints:

Changes in Non-labor income {holding constant the wage}

 ¿What Happens to Hours of Work When……?

 Meyer, Viscusi, and Durban (1990): What is the effect of Worker’s

 What is the effect of Worker’s Compensation benefit generosity on return to