Topic 1 : Human Capital

1. Education in human capital is an investment producing earnings in the future BUT

a. Education can only be a source of future earnings if wages reflect differences
in productivity

2. Wage differential is partly due to difference in the stock of human capital

a. Good stock or bad stock ; taste based differences

3. Human capital : set of skills or characteristics that increase a workers productivity

4. Views of human capital :

a. Becker : human capital is stock of knowledge or skills that is directly useful in
the production process
b. Gardner : human capital is not unidimensional ; mental vs physical ability
c. Schultz/Nelson-Phelps : human capital is the capacity to adapt in the dealing
with disequilibrium or new environment
d. Bowles-Gintis : capacity to work in organization ; adapt to life in hierarchal or
capitalist
e. Spence : signaling model view ; human capital is the signal of ability in the
production process

5. Sources of human capital :

a. Innate ability : source of heterogeneity, empirical applications
b. Schooling
c. School quality and non-schooling investments
d. On the job training
e. Pre-labour market influences or peer effects (encouraging to invests in
themselves to invest in software, learn a new language etc.)

Becker :
- Education can only be a source of future earnings if wages reflect differences in
productivity  influenced by investments made in education/training
o Must compare ‘education/training costs to investments’ that will be sources
of future earnings
- It is not self-evident that improved productivity lead systematically to an increase in
wages (even in perfectly competitive labour market  perfect knowledge and free
mobility)
- Types of training :
o General training : enhances productivity for ALL types of jobs ; No incentive
to finance
o Specific training : enhances productivity for one type of job ; Employers have
incentive to invest
- In perfectly competitive economy, individual choices regarding training are socially
efficient
o Mechanism of competition give individuals an incentive to become educated
to acquire knowledge/skills which the market sets a premium
 - If wages are lower than productivity bc firms dispose of monopsony power 
investment in human capital is less than socially optimum
o Monopsony : singular buyer in the market
o Monopsony is unlikely but if it exists then we’re not investing enough for the
premium on additional investments
 Externalities are mostly positive  education
 Better educated individuals transmit part of their knowledge which
boost productivity of those around them
 Education reduces criminality  spillover effects

- Collective return to education is greater than individual return because of spillover

effects
- Educational effort is generally insufficient in the absence of any intervention from a
third party  compulsory education laws
- Mincerian human capital earnings :
o Y = Individual earnings
o S = Years of completed educations
o X = experience ; X = A – S ; A = age

Basic Human Capital Model

- Implies that people finish their formal schooling before entering the labour market
- Effect of schooling is separable from effect of experience
- Model : individual chooses to maximise utility function U(y,S) where y is annual
average earnings  Utility = Earnings – Cost
o FOC : Marginal rate of return = marginal cost

1. How to determine optimal years of schooling ?

a. When individuals have different discount rate but the same MRR/ability
i. Individuals with higher discount rate of the future tend to invest less
in education and are likely to receive less earnings
ii. As years of schooling increases, rate of interest decreases (MRR
negatively sloped)
iii. Wage to years of schooling (concave function)
b. When individuals have the same discount rate but different abilities
i. Individuals with tend to invest more in schooling and are likely to
receive higher returns compared to those with lower abilities
ii. Same r but different MRR curves

2. Two sources of individual heterogeneity in optimal schooling choice :

a. MRR
b. Cost of schooling
Optimal level of schooling : S* = (b – r) / k where k = k1 +k2

3. Model gives a distribution of marginal returns across the population unless either :
a. Equality of ability (k1 = 0 and bi = average b)
b. Equality of opportunity (k2 = 0 and ri = average r)

Human Capital Signaling Model

Spence signaling model :

- Premise of theory : individuals who perform most effectively in active life are also
the ones who perform best while studying  education is a signal for agent’s
efficiency
- More efficient individuals have higher earnings

1. In signaling theory, overinvesting in education has no benefits to increase productive

capacity  only sends out a signal to employers
a. Productive capacity  intrinsic quality (unobservable)

2. Efficiency of investments in education

a. Education is socially efficient but there are overeducation tendencies

3. In the model, workers tend to over-invest in education to signal their abilities

4. Assumptions :
a. Individuals have different productivities
b. Education does not improve individual productivity, it can serve only to signal
abilities when it is not observed by employers

5. Preferences of worker : u(R,s,H) = R – (s/h)

 6. Worker decisions :

a. Workers choose their level of education s

b. Firms enter the labour market freely, observe the signals s, and make
simultaneous wage offers to worker
c. Workers accept or refuse the offers made to them

Free entry assumption implies w(h) = h for h ∈ {h+,h−} 

- Implies that the wage is equal to their level of ability or productivity

- This equality between wages and ability holds for both the high-ability and low-
ability group

7. When ability are unobservable :

a. Signal becomes a way for most efficient workers to bring themselves to the
attention of firms
b. It is sufficient for workers to choose a level of education that is costly enough
for inefficient workers
i. Efficient workers want to differentiate themselves from low efficiency
workers

8. Signal :
a. Low efficiency workers : send signal s = 0 ; positive signal brings them no gain
i. They would get less utility associated with higher costs of the claimed
education if give signal s+
ii. Workers can identify later on their lack of ability

9. For equilibrium to be SEPARATING : no type h- worker should deviate and choose s+

signal, identical to an efficient worker

10. Workers of type h+ have an interest in sending the weakest signal possible, which
workers of type h- have no interest in imitating  s* = h- (h+ - h-)

11. Efficient workers prefer s = s* to s = 0 ; since workers of type h- whose signaling costs
are greater, are indifferent between these 2 values of education s

Separating eq :
- Workers of low efficiency do not see education and obtain a wage w(h-)
- Efficient workers become educated to a level s* > 0 and obtain a wage w(h+)

The inefficiency of education as a signaling device

Compare allocations obtained with and without education :

1. When education is absent :

 a. Workers are indistinguishable
b. Opportunity cost of labour = 0 ; everyone participates in labour market
c. Identical wages
d. Total production = E(h)

2. When education is present :

a. Production = gross production E(h) – cost of education
3. Low efficient individuals obtain :
a. In absence of education : E(h)
b. In presence of education : h-
c. SYSTEMATICALLY DISADVANTAGES by education

4. Efficient individuals obtain :

a. In absence of education : E(h)
b. In presence of education : equation from slides
c. AMBIGUOUS EFFECT

Therefore, efficient workers only benefit from education when their proportion is
sufficiently small with respect to the efficiency gap between them and less productive
workers

BUT by assuming that opportunity cost of labour is different from zero, education becomes
and efficient signaling device

- Change in Utility of workers : u(R, s, d, h) = R +d – (s/h)

- D : indicator amounting to 0 if employed and 1 if not employed

5. When abilities are not observable with no signaling activity, nobody enters the
labour market
a. Wage is less than opportunity cost of labour
b. Happens when proportion of workers with productivity h that is less than the
opportunity cost of labour is large

Workers with low productivity will stay out of the market and send a 0 signal

- This separating eq dominates the equilibrium without signaling since

o Low-ability workers receive the same level in 2 equilibria  1

On the Job training

1. Most rapid increase in earnings occur early  rise steeply early on then flatten
a. Individuals tend to invest in human capital at younger age because they have
a longer time span to enjoy their investment

b. Concave shape to age/earnings profile

2. Concavity explained by on-the-job training

 a. Presence of training is hard to observe because
i. Informal
ii. Not publicly recorded

3. Forms of on-the-job training

a. Learning by doing (skills improving with practice)
b. Formal training programs at/away from the workplace
c. Informally working under a mentor (experienced worker)

4. Training reduces productivity among trainees and trainers during learning process 
dedicate time to training rather than working
a. Cost of training is partially paid by workers one way or another
b. Cost of training is a unique friction in labour market

- During training period  employer bears cost on behalf of new hired worker >
worker’s marginal product ; employer bears net costs of training period if they
believe that the workers’ post training revenue is worth it
o To do so, employer keeps partial amount of added post training revenue by
not giving all of it to the worker in the form of a wage increase

5. Conditions for a firm to invest in training :

a. Training employees receive must increase marginal revenue productivity
more than it increases wages
b. Employees must stay with employer long enough for the employer to receive
required returns

- Firms invest in general training  If employees are deterred from quitting by high
mobility costs

Scenarios
 If employees pay part of costs, post-training wage can be increased MORE if
employers beers all training costs
 Increased post training wage protects firms’ investments by reducing probability
of quitting
 Training costs borne by employers must be recouped by not raising post-training
wage very much

In recession
- Average labour productivity falls in the early stages of recession and rises during
early stages of recovery
- In beginning of recession, reducing labour decreases production and in early stages
of recovery, workers who are most skilled have higher productivity over time
- Returns are generally larger when post investment period is longer
- With each succeeding year, actual earnings become closer to potential earnings
- Gap between Ea and Ep  total investment costs of training
- Over time, gap becomes smaller because workers become less willing to invest in
human capital

- For those who invest on-the-job training  actual earnings start below Es then
approach it near age A* then continue to rise above it afterwards

o As they choose to train more implies less wage

o Age A*  OVERTAKING AGE
 Age at which workers with same level of schooling have equivalent
earnings regardless of whether they have invested in on-the-job
training
  Actual earnings is less than Es at A0 because they are investing in
training so  lower earnings than someone who is not currently
training
 Correlation between earnings and education will be strongest at A*
where Ea = Es 
 Correlation between schooling and earnings weakened before
and after A* because of presence of on-the-job training

Education and training investmentsho

- Investments in human capital more likely when :

o Expected earnings differentials are greater
o Initial investment costs are lower
o Investor has a longer time to recoup the returns
o Investor has a lower discount rate  values future rewards compared to
immediate

SAME FOR PEOPLE WITH THE ABILITY TO LEARN MORE QUICKLY

WHY ?
- Ability to learn rapidly helps to :
o Shorten training period
o Experience lower psychic costs (lower levels of frustration) during training
- Thus, workers who invested more in schooling also invest more in post-schooling job
training  reap the benefits from formal schooling the best
- Employers tend to want to seek out fast learners

How does this affect age/earnings profile ?

- Tendency of better-educated workers to invest more in job training explains why
age/earnings profile start low then rise quickly and keep rising after the profiles of
less-educated counterparts have levelled off
- People with ability to learn quickly select high-paying jobs where :
o More learning is required
o Abilities put to a greater advantage

Women in Human capital

- Age/earnings profile of men tend to be more concave and to fan out more than
those for women BECAUSE :
o Length of work life over investment can be recouped is historically shorter for
women
 Women are childbearing
 Females lose continuity of experience compared to men
 Women expect a discontinuity in labour force participation freeand
avoid certain job markets
 Employers avoid hiring women for jobs that require a lot of on-the-job
training
Concave and flat age earnings profile :
- Flat : because of lower levels of training
Live Lecture

- When we allow opportunity cost of labour not equal to 0 :

o Inefficient workers receive utility of u = 1 and do no enter labour market
o Efficient workers provide signal s*  gives a utility that pays off for giving off
that signal

Separating equilibrium :
- Tendency of too much education ; overeducation
o In order to avoid this : propose cross subsidisation
 Helps reduce gap between education levels of inefficient and efficient
individuals
- Cross subsidization model :

If not cross-subsidisation :
- Efficient individual obtain wage h+ and chooses education signal s*
- Inefficient individuals gives 0 signal and gain d = 1  this worker did not enter the
labour market
o Situation A (separating equilibrium) : 0 signal for inefficient and s* for
efficient

Cross-subsidisation
- Subsidy entails : Allow individual who are signaling a lower education than s* but
non 0
- Cross subsidisation : puts them on a higher indifference curve
 o Those who signal s1 get w1
o Those who get 0 signal get 1 + subsidy s  higher utility level
 Increase returns by signaling positive education level + subsidy and
reduce gap between 2 levels of workers

In comparison :
- B with subsidization is better than A without subsidisation
- B allows firms to distinguish between the 2 types of workers since the inefficient
type has no interest in imitating the efficient by getting an education
o They have no reason to imitate s* because they have utility 1 + subsidy if
they don’t signal education(at higher indifference curve)
o Subsidisation : Allow ineifficient indivuals to give a positive signal

Inefficient workers either get :

- 1 + x  0 signal
- Signal positive value and get w1
- Since efficient individuals have the choice to signal s1 which is below s*

Conditions that need to be satisfied for separating equilibrium : FOR B TO HAPPEN

- Inefficient workers : If utility they are getting what they are getting from subsidy
- Efficient workers : utility is greater than what inefficient workers get
- So must assign the subsidy that allows these 2 conditions

- Cross subsidisation allows limiting incentive to overeducation

- Happens when s tends to 0
- Curb the incentives by causing spending ton education to remain positive but tend to
0
HOWEVER this model relies on the assumption : limitations
- Education is nothing but a signaling device
- The most efficient workers are getting overeducated  this is UNREALISTIC

OVEREDUCATION ASSUMPTION REST ON THAT :

- Employers don’t hire individuals while they are still in school  satisfied in Spence’s
model but criticized by Weiss
- In pooling eq : workers get remuneration equal to productivity
o Allow workers and employers to interact based on how productive you are
o BUT Swinkels (1999) says that inefficient individuals tend to overeducate
themselves which is COSTLY

Critique
- Education is not just a signaling device but it increases productivity

Social returns
1. Those who have higher education tend to have less risky behavior, less divorce, less
likely to exhibit risky behavior (better lifestyle)  more benefits to education rather
to higher income (non-financial returns)

2. Examples : positive externality and its social returns are superior to private returns:
a. Social engagement : Helliwell and Putnam
b. Criminality and violence : Lochner and Moretti
c. Labour mobility : Machin et al
d. Spillover on children : Currie and Moretti
e. Knowledge externalities : Rauch

Live Lecture Week 2

1. Mincer (1974) : estimates the internal rate of return for investing in human capital
a. IRR = discount rate at which the net present value of the costs of education =
net present benefit of investment  rate of return of investment
b. Because education is strongly related to experience, equation focused on
schooling experience
c. Selection bias (ability bias) exists as a problem  to fix this, use instrument
variable method by including ability variable
d. RESULTS :
i. Negative interaction term with experience
ii. OLS estimator of p (row) is unbiased if S and epsilon are independent
iii. In the main findings : OLS estimate is biased
1. This is because of the selection bias (effect of schooling on
wages but did not control for ability)  measurement error so
endogeneity is present
2. Lochner and Monge-Naranjo 2011
a. Examine effect of ability and schooling on students  is ability the only
determinant on schooling decisions in the US ?
b. Stimulated responses to increase costs of and returns to college  examine
govt loan program to students and how student’s access to loans could affect
their investment behaviour
c. Relationship between borrowing and schooling behaviour/ability
d. KEY FINDINGS :
i. Eliminating the govt student loan programme severely restricted
investment among the poorest and least able
ii. Effects are fairly large, for all poor youth regardless of ability
iii. Students changed their behaviour and investment decreased by 80%
iv. If the limit of borrowing was expanded : investment increased
especially for those least able and least paid
v. If repayment period reduced : adds constraints to individuals ; but
does increase investment of least paid high able students
vi. Availability of loans and credit does allow people to invest more
regardless of level of ability with more results positively affecting the
least able
vii. College attendance increases with ability  family income is strongly
related to college attendance
viii. Students with high ability tend to invest more in education

3. Angrist and Krueger (1991) or Card (1995)

a. Instrumental variable ; use birth date and compulsory schooling law as
variable
b. KEY FINDINGS of Angrist & Krueger : Use IV method to examine
i. The later you’re born in the year, the higher your returns
ii. People that have done more than 12 years of education  not much
difference
iii. IV results : people born early in the year have shorter durations of
schooling compared to those born later
iv. For college grad rates : those born in 1st quarter do worse compared
to those born in 4th quarter
c. KEY FINDINGS OF CARD :
i. Used college proximity as an exogenous determinant of schooling
ii. Survey indicates whether a 4-year college is located close by and
whether that affects people attending college
iii. Results : students who have more access to colleges (proximity) tend
to invest more and have higher returns to such investments
iv. Those who are not able to send children due to income constraints
are most affected ; especially if you live far away
v. Availability and access to institutions helps reduce the low-income
barrier  higher returns to education
 4. Oreopoulos and Salvanes (2011)
a. Used data of siblings and twins  effect on schooling
b. KEY FINDINGS :
i. More education will increase your returns (even if you are a twin)
ii. Siblings with one more year or schooling, on average, have more
annual income than their less educated siblings

TOPIC 2 : LABOUR SUPPLY

- Working hours overtime has had a downward trend

o European countries tend to have lower working hours compared to OECD
and United States
o WHY ? 
 Labour supply : substitution and income effect
 Technology
 Better living standards

Example :
In US, they have more working hours so that means :
- Substitution effect dominates income effect  results to more working hours
- The way the workers react differ despite similar productivity levels

Participation increase over time :

- Increasing female labour participation
- Female are able to increase working hours by reducing home production hours
- Males then increase home production hours

Neoclassical theory of labour supply

- Basic model : based on trade off between consumption and leisure
- Labour supply is not necessarily monotonic function of wages
- Supply of labour does not necessarily increase proportionally with wages
- Consumer derives utility from :
o Quantity of consumed goods ; C
o Time of leisure ; L
- Total time available : L0
- Labour supply : h = L0 – L
- Non-wage income : R (investment income, transfer income or benefits)

1. Budget constraint : C <= wh + R or C + wL <= R0

2. Consumer decision : max U(C,L) subject to C + wL <= R0

3. Optimality condition : lies on budget constraint where the slope of indifference curve
= slope of budget constraint
Reservation wage
- How can we guarantee the interior solution ?
- When market wage is high enough to provide a profit incentive to give up some
leisure and opportunity cost of leisure would increase with market wage
- Marginal rate of substitution is decreasing along the indifference curve

1. Worker would supply hours of work if and only if :

a. When MRS (utility of substituting leisure for consumption) is less than the
wage
b. When reservation wage is less than wage offered  Wa

Reservation wage : Leaves individual indifferent between working and not working
- Determined labour supply

Substitution and income effects :

1. Examine the impact on leisure of :

a. A non-wage increase (R ) on labour supply
b. A wage increase (w) on labour supply

*totally different FOC*

2. Comparatives statics : non-wage impact (R)

a. We must fix the change in the dW = 0
b. Hence FOC shows that :
i. Unambiguous effect : Leisure is a normal good if its demand rises with
R
Graphically : if R increases, leisure increases
- If R increases : budget line moves to a higher one
- Optimality condition : E’  higher indifference curve and higher budget constraint
- The amount of leisure has increased while the working hours have decreased

3. Comparative statics : effect of a wage increase

a. Assume dR = 0
b. Influence of a wage increase on the labour supply can be ambiguous
i. Which is stronger ? Substitution effect or income effect ?
ii. Substitution effect is always negative  if wage increase, leisure
decreases and working hours increase
iii. Income effect is positive because better off financially  if wage
increases, leisure increases and working hours decrease
 - Originally at E ;
o But with increase in wage :
 Substitution effect : with more work and less leisure, we operate at E’
 Income effect : higher indifference curve at E’’ with less work compare
to E’ and more leisure but less compared to point E
o Final effect is generally ambiguous
o In diagram : substitution effect is bigger

Compensated and non-compensated elasticity of labour supply :

- Marshallian or non-compensated labour supply : h*  system 1  depends on wage
and non-earned income
o Change in h* with respect to w
- Hicksian or compensated labour supply  depends on wage and level of utility 
corresponds to value of labour after substitution effect
o Solution to problem minimising constraint subject to level of utility
o Change in w with respect h hat
- Marshallian elasticity is sum of substitution effect of Hicksian + income effect of
Slutsky
- Marshallian = substitution effect + income effect
- Slutsky  holding utility constant over time (substitution and income effect)
o Substitution effect  opportunity of leisure increases, work more, increase
labour supply
o Income effect  makes leisure more desirable because lifetime income
increases  work less  reduces labour supply

Slutsky’s equation in the dynamic model of labour supply shows a positive substitution effect of a
wage increase on labour supply, with a constant intertemporal utility.

Backward bending labour supply

- If wage rate increases, supply of labour increases from h1 to h2 but a further
increase in the wage rate reduces supply of labour back to h1
o Because substitution effect and income effect work in opposite directions
o Creates backward bending labour supply
o Slutsky equation says this effect is more likely to occur the larger the supply
of labour is

1. Look at overtime vs ordinary wage increase :

a. Individual gets higher wage for extra hours of working
b. 2 possibilities :
i. If overtime wage increases  increase supply of labour (substitution
effect with higher utility curve and pivoted budget constraint)
 ii. If ordinary wage increases  ambiguous effect on labour supply
(Substitution and income effect so one will be stronger than the
other)

Labour supply with household production

1. Consumption : market goods + domestic household goods

a. Consumption is increasing at a decreasing rate

2. L0 = paid working time, hM + household working time, hD + leisure, L

3. Budget constraint shows that : total income = sum of potential income, R0 + profit
from household activities  f(HD) – wHD  production – cost of being in household
(possible forgone earnings)

a. hD*  production that maximises the profit

b. f’(hD) = w
i. shows that allocation of working time between household and wage
activities is determined by relative productivities of both types of
activities
c. Wage reflects individual productivity of wage to labour

- Implication to elasticity of labour supply ?

o Possibility to make a trade off as household activity should increase the
higher the wage elasticity of labour supply
o You can choose on whether trade off leisure to work but also trade leisure to
household time or work, either or
 Becomes more responsive to wage rate
 Increase in W decreases home production

- Implication for elasticity of labour supply for men and women

o Studies show that female elasticity of labour supply is higher than males
o For men, trade-off between household and wage activity is marginal because
productivity of household activity is far below current wage
 Therefore, majority of men would trade off leisure against wage
labour ONLY
 For women, who have high household productivity compared to wage
rates, they would trade off among leisure, household activity and
wage labour
Family choices :
1. Unitary Model
a. Family can be linked as a sole agent having its own utility function
b. Assumes that the satisfaction obtained from the consumption of goods
depends on its TOTAL amount and not on how its shares amongst
members
c. Optimal choice is maximising utility under 1 single budget constraint
 i. MEANING : distribution of non-earned incomes has no importance
but sum matters
ii. INCOME POOLING : it is not necessary to know who is the
beneficiary of non-earned income
iii. Empirically rejected except for couples with no pre-school children
2. Collective Model
a. Household choices arise out of individual preferences ; not just sole agent
b. Assume that decisions within a household is pareto efficient  mutually
advantages allocation does not occur
c. Model is represented by maximisation of utility subject to utility of other
individual >= particular level of utility and budget constraint
i. Chiappori solution shows that efficient allocations  solutions of
individual programs in which each person is endowed with specific
non-wage income and which would depend on overall income of
household
ii. Optimality depends on overall income of that household
iii. To determine the sharing rule, we have to determine the sharing
rules in the household
iv. NOT INCOME POOLING
v. Eg : giving allowance to women  result to more expenditure on
women’s clothing or child items which bring them utility but not
the collective family so cannot pool income hypothesis

KEY DIFFERENCES OF UNITARY VS COLLECTIVE MODEL

1. Unitary model assumes a single set of preferences for the household vs Collective
model recognises individual preferences and potential for conflict/negotiation

2. In collective model ; individual income and bargaining power significantly influence

household decision making unlike Unitary model where income is pooled and
decisions are made to maximise overall household utility

Life Cycle Model

- Consider different time periods where consumer makes choices over a life cycle
represented by a succession of periods

Limitations of dynamic model of labour supply

1. Very restrictive representation of preferences : past behaviour and training decisions
a. Representation does not allow to take into account inertia of habits of
consumption and habits persistence
b. Have to take into account influence of past consumption on utility on current
consumption preferences ; look into history of past consumption

2. Absence of decisions about training

a. Training increases human capital and raises wage-earning prospects

Frischian, Hicksian and Marshallian Elasticities of Labour Supply

 1. Frischian elasticity  represents the impact of a modification of the wage at date t
on the supply of labour on the same date, assuming that marginal utility of wealth
remains constant
a. Change in marginal wage assuming marginal utility of wealth in constant
b. Measures intertemporal substitution
c. How much we are willing to alter the amount of time worked today when
today’s wage varies knowing that utility is unchanged
d. Useful to measure impact of transitory wage variation (negligible impact on
wealth)

2. Marshallian elasticity  measures total impact of a wage variation in labour supply ;

takes into account variability in the marginal utility of wealth
a. Take into account change in wealth
b. Substitution + Income effect

3. Hicksian elasticity  measures variation in the labour supply ; assumption that level
of intertemporal utility is constant
a. Fix utility
b. Substitution effect

4. Marshallian = Hicksian + Slutsky

- In this case, potential income R0, in the static model is replaced by present
intertemporal wealth  omega
o Omega = total income from wage + yield on saving + any other income from
wage all being adjusted to the interest rate between 2 successive periods of
time
o If ONLY the current-period wage varies, then this relation is identical to the
static model
o Marshallian = Hicksian + wealth effect  dynamic model

- Marshallian impact of a wage variation on labour supply

o Positive substitution effect on labour supply with a constant intertemporal
utility (hicksian)
o Negative wealth effect higher non-wage income leads to negative labour
supply and more leisure demand
o Therefore  Hicksian > Marshallian (larger)

How are the elasticities in the Frischian, Hicksian and Marshallian linked

1. When wage variation concerns on current period :

 - Frischian : elasticity of labour supply for current period with respect to current wage
(intertemporal substitution effect)
- Omega elasticity : elasticity of labour supply for current period with respect to total
present wealth (wealth effect)

2. Wealth effect can be broken town into 2 terms :

a. Variation in wealth
b. Variation in the price of leisure which modifies marginal utility of wealth

3. Frischian = Hicksian + Wealth effect

4. Marshallian = Frischian + Wealth effect * ( 1 – gamma* omega elasticity)

Relation demonstrates that Frischian elasticity > Hicksian elasticity > Marshallian elasticity

5. Impact of transitory and permanent wage changes on labour supply

a. Permanent positive shock  multiplication of all wages by a single positive
quantity
i. Therefore, optimal level of leisure and hours worked  remains
unchanged
b. Therefore, permanent shock has no influence on labour supply since
substitution and income effect cancel out

6. Transitory shock only causes the wage to change

a. This leads to leisure at date t diminishing, while leisure at all other dates to
remain unchanged

7. Overall, permanent wage changes have no effect on labour supply whereas

transitory affects the level of supply immediately through optimal response of agents
who adjust supply of labour to temporary changes in wage

Main results of Literature

1. Blundell et al (1992) – forms of labour supply

a. Individual’s supply takes the form of a hump shaped curve
b. As R (non-wage income) increases, leisure demand increases
c. Labour supply for those above median wage is less than those below median
wage
i. Labour supply curve could have a local maximum
ii. For low hourly wages, the substitution effect prevails as for higher
wage at lower wage levels, labour supply tends to increase
iii. For those above median wage, there is a reduction in labour supply
and hours worked  labour supply tends to decrease after high hours
of working

2. Differentiation between extensive and intensive margin elasticities

 a. Extensive margin  how many people work
b. Intensive margin  how much a given number of people work (how many
hours)

- Result : extensive margin elasticity tends to be larger than intensive margin elasticity
o Because :
 Existence of indivisibilities in labour supply  cannot divide labour
supply across individuals :
 Changes in tax/wage rates are compatible with large extensive
margin responses even if they have little effect on hours
condition on employment  higher wages lead to higher
participation rates even with 0 effect on individual supply
 Optimisation frictions :
 Make adjustment of hours costly
 Create the cost of finding another job that is more compatible
with worker’s desired timetable

3. Difference between labour supply elasticity between men and women (Bloom et al
2009)
a. Impact of children on working women tend to be negative
b. Removing legal restriction on abortion significantly reduces fertility
c. Ability to control birth timing strengthens female participation
d. Availability of childcare
e. Labour supply of elasticity for men are insignificant
f. Fiscal reforms affect the participation decisions of men ; women have lower
wages and have comparative advantage for household production
i. Women labour are more substitutable for domestic production

4. Cost of leisure and productivity of home production

a. Gonzales-Chapela (2007)
b. Cost of leisure  opportunity cost/forgone wages
c. Exogenous source of variation  weather affects decision to work and utility
i. Agriculture work (Connolly)
ii. Men tend to reduce investments in leisure time on rainy days so that
they can work longer

Live Lecture Week 4

1. What is the percentage of earnings lost to either higher taxes or lower benefits when
a job-seeker returns to work after 2 months of unemployment on average in the
OECD ?
- Financial disincentive to work : almost 70% get lost when you re-join the market
- If earning minimum wage : almost 73% earnings lost
 - Substitution effect : positive relation between wage and labour supply because the -
opportunity cost of leisure increases, so people are willing to work less hours and
substitute it for leisure  quantity of labour supplied decreases

OLS method is flawed

- Endogeneity of wages

2. Studies examining exogenous changes

a. Blundell (1998)
i. Married and cohabiting women in the UK during a period of tax
reforms
ii. See how the changes in taxes could affect female employment 
need exogenous variation that affects the wage and labour supply
iii. Use group estimators  group mean for wages and hours ; calculate
period mean (over each period, what is the group mean ?) then look
at mean difference of period and groups
iv. Any residual variation is attributed to changes in the treatment
v. After this operation, time invariant factors could influence wage levels
and that could also be related to hour levels that have been
eliminated
vi. Unobserved time variant factors common to all groups that could
have both influence wage levels and related to hour levels have also
been eliminated
vii. KEY FINDINGS :
1. Wage elasticities are positive and highest for women with
children at pre-school age  increase in wage will increase
labour supply
2. The compensate wage effects are all positive and significant 
substitution effect : increase labour supply if wage goes up
3. Income elasticities are negative  leisure is a normal good, if
other income increases as long it is non-labour income, labour
supply tends to decrease
4. Therefore  Positive elasticity of labour supply for wages and
negative effect on labour supply for increase in non-labour
income

b. Camerer (1997)
i. Examines the trip sheets of new York cab drivers
ii. Face wages that are highly correlated within days but only weakly
correlated between days (transitory wages)
iii. Instrumental variable : Use distribution of hourly wages of other
drivers that drove the same day and shift
iv. KEY FINDINGS :
1. Wage elasticities are significantly negative  if wage of taxi
driver increase, they won’t increase working hours
2. Elasticities of inexperienced driver are on average : -1 and are
less than 0
 3. WHY ? 
a. Drivers make labour supply decision within the date
instead of intertemporally substituting labour and
leisure across multiple days
b. Drivers set a loose daily income target and quit working
once they reach that target
4. RESULTS GO IN OPPOSITE DIRECTION TO THEORETICAL MODEL
 NEGATIVE ELASTICITY OF LABOUR SUPPLY
5. Argue that there is an income effect on a labour supply of a
transitory wage change (transitory should be purely
substitutional)

c. Farber (2005)
i. OLS results consistent with Camerer et al (1997)
ii. OLS is flawed  very difficult to find a good instrument for wage
iii. Use probit stopping model  probability of you stopping working
hours instead of calculating average working hours
iv. KEY FINDINGS :
1. Probability of stopping work after a particular trip is strongly
related to hours worked to that point and not significantly
related to cumulative income earned
2. Can very theoretical model of transitory wages but did not
estimate wage elasticity of labour supply
3. Proved the life-cycle model of labour supply validity 
positive relation between transitory change in wage and
labour supply

d. Fehr & Goette (2007)  life cycle model

i. Examine bicycle messengers
ii. Split employees from one firm who are willing to participate in group
A and B
1. Group A : higher pay in September
2. Group B : higher pay in November
iii. Look at revenues and number of shifts per 4 week period (proxy for
labour supply)
iv. Everyone received commission in December even though treated in
different months

v. KEY FINDINGS :
1. Before the treatment, not much difference in revenues
generated
2. Treatment period 1 : when group A receives treatment of
receiving 25% increase in commission  group A significantly
increase revenues compared to group B
a. Same for group B for their treatment period
3. A lot of differences in mean deviation during treatment
periods
4. Elasticity of labour supply  treatment effect / average
revenue as a ratio to total revenue
a. Elasticity is positive in period 1 and 2  if transitory
wage increase, labour supply increases