Chapter 2

The Theory of
Individual Labor
Supply
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
1. The Work-Leisure
Decision: Basic Model

2-2
 Assumptions
• Individuals choose between work
and leisure.
– Work is time spent on a paying job.
– Leisure includes activities where
one is not paid.
• Education
• Rest
• Work within the household

2-3
 Indifference Curve
Income/day

• The indifference curve

shows work and leisure
combinations that yield the
same amount of total utility.

• More hours of leisure

implies fewer hours of
work.

0 24 Leisure Hr
24 0 Work Hr
2-4
Indifference Curve Properties
• Negative slope
– To keep the level of utility the
same, if one get more leisure, some
of income must be given up.
• Convex to origin
– With low hours of leisure,
individuals are willing to give up a
large amount of income to get 1
more leisure hour.

2-5
Indifference Curve Properties

– With high hours of leisure,

individuals are willing to give up a
small amount of income to get 1
more leisure hour.

2-6
 Marginal Rate of Substitution
• The marginal rate of Income/day
substitution (MRS) is the
amount of income one
must give up to
compensate for 1 more 4
hour of leisure.
• At 3 hours of leisure (21
hours of work), one must
give up 4 units of income 1
to compensate for 1more
hour of leisure.
• At 8 hours of leisure (16
hours of work), one must
give up 1 unit of income to
compensate for 1 more
hour of leisure. 0 34 8 9 24 Leisure
• The MRS falls as one 24 0 Work
moves southeast along an
indifference curve. 2-7
 MRS
• The slope of the indifference curve at any
point defines MRS between consumption and
leisure. It represents the quantity of goods
that a consumer must give up in exchange for
1 hour of additional leisure to keep her utility
unchanged.
 Indifference Map
Income/day
• Curves further from the
origin indicate higher
utility.
• Combination L2Y2 is
preferred to combination
L1Y1 since one gets both Y2
more income and more Y1 I3
leisure. I2
• A person will maximize I1
utility by getting to the
highest attainable
indifference curve.

0 L1 L2 24 Leisure

2-9
 Work-Leisure Preferences
Income/day
• “Leisure lovers” place a
high value on leisure.
They have a steep
indifference curve. They
are willing to sacrifice a IB
large amount of income IA
to get a small increase
in leisure.
• “Workaholics” place a low
value on leisure. They
have a flat indifference I2
curve. They must be I1
given a large increase in
leisure to compensate for
a small decrease in
income.
0 24 Leisure

2-10
 Budget Constraint
• The budget constraint Income/day
shows the combinations
of income and leisure that
a worker could get given
a wage rate.
$360
• At a wage rate of $5, a
worker could get a
maximum income of $120
per day ($5/hour * 24 ). $240

• At a wage rate of $10, a

worker could get a $120
maximum income of $240
per day.
• At a wage rate of $15, a
worker could get a
maximum income of 0 24 Leisure
$360 per day.
• The slope of the budget
constraint is–wage rate. 2-11
 Utility Maximization
• The optimal or utility
maximizing point is where Income/day
the budget constraint is
tangent to the highest
attainable indifference curve
(U).
• At U, the MRS (slope of
the indifference curve) is
equal to the wage rate $240
(slope of the budget
constraint) B
U
• At B, the MRS is greater $80 I3
than the wage rate. The I2
individual values leisure A I1
more than the wage rate.
• At A, the MRS is less than 0 16 24 Leisure
the wage rate. The
individual values leisure
less than the wage rate.
2-12
Backward Bending Labor Supply Curve
Wage Rate
• For a given person,
hours of work may SL
increase as the wage
rate rises.
• If the wage rate rises
from $10 to $25 per $25
hour hours of work rises
from 8 to 10 hours per
day.
$10
• Above $25 per hour,
hours of work fall.
• The backward bending
labor supply curve is
the result of the income
and substitution effects 0 8 10 24 Hours of
of a wage change. Work

2-13
 Income Effect
• Income Effect
– The change in desired hours of
work resulting from a change in
income, holding the wage constant.
• Leisure is a normal good, so higher
income implies a desire for more
leisure (fewer hours of work).
• For a wage increase, income is raised
and so the income effect lowers
desired work hours.

2-15
 Substitution Effect
• Substitution Effect
– The change in desired hours of
work resulting from a change in the
wage rate, holding income
constant.
• A higher wage rate raises the relative
price of leisure.
• For a wage increase, the substitution
effect raises desired work hours.

2-16
 Net Effect
• For Wage Increases
– If substitution effect > income
effect, then hours of work rise.
– If income effect > substitution
effect, then hours of work fall.
• For Wage Decreases
– If substitution effect > income
effect, then hours of work fall.
– If income effect > substitution
effect, then hours of work rise.
2-17
 Income and Substitution Effects
• At a wage rate of $10/hour,
the optimal hours of leisure is
16 (8 hours of work) at point
Income/day
U1.
• If the wage rate rises to
$15/hour, the optimal $360
hours of leisure is 15 at
point U2.
• The income effect (IE) is U2
measured through a $240
parallel shift of the old U2 ’
budget constraint. The IE I2
U1
is from U1 to U2’ (from 16
to 17 hours of leisure).
I1
• The substitution effect
(SE) is measured by
movement along I2. The
SE is from U2’ to U2 (from 0 15 16 17 24 Leisure
17 to 15 hours of leisure).

• The net effect is an increase 2-18

of hours of work by 1 hour.
Backward Bending Labor Supply
Rationale
• The substitution effect dominates
at low wage rates.
– The MRS is low because income is
scarce relative to leisure.
• The income effect dominates at
higher wage rates.
– The MRS is high because leisure is
scarce relative to income.

2-19
 Empirical Evidence
• The labor supply curve is slightly
backward bending for men.
– The income effect is slightly greater
than the substitution effect.
– A 10 percent increase in male
wages is estimated to decrease hrs
worked by 1-2 percent. (Borjas and
Heckman, 1978)

2-20
 Empirical Evidence

• The labor supply curve’s slope is

positive for women.
– If substitution effect is greater than
the income effect.
• Women substitute between work at
home and market work more than
men.
• A 10 percent increase in female
wages is estimated to increase
hrs worked by about 10 percent.
(Keeley) 2-21
 Why do they show different
patterns?
– For what type of activities do men allocate their
time? Do they have any substitutes?

– For what type of activities do women allocate

their time? Do they have any substitutes?
 Time spent for child care
• Among all married couples with children, the husbands
provide 7.4 hours of child care per week on average, versus
13.3 hours for the wives (American Time Use Survey).
• Among the full time employed, with children, married men
provide 7.2 hours of child care per week versus 10.3 hours for
married women.
• Possible factors: relative income, relative bargaining power,
and the influence of traditional social norms and role models
(Schoonbroodt 2018)
Elasticity of Labor Supply
• The elasticity of labor supply
measures the responsiveness of
desired hours of work to the
wage rate.
= % Change in
Elasticity quantity of labor supplied
of Labor Supply % Change in the wage rate

2-26
 Elasticity of Labor Supply
• If the elasticity is zero, it is
perfectly inelastic.
• If the elasticity is negative, it is
backward bending.
• If the elasticity is positive and
less than 1, it is relatively
inelastic.
• If the elasticity is positive and
more than 1, it is relatively
elastic.

2-27
 Intensive & Extensive Elasticity
• Separate elasticity should be computed for
intensive and extensive margins.
• Intensive margin refers to the changes in hrs
worked as a response to wage change.
• Extensive margin refers to the decision to
participate (exit) labor force as a result of
wage increase (decrease).
• Why would elasticity matter for policy
makers?
 Estimated Wage Elasticity
• Women have elastic labor supply.
– Why? Substitutes, Necessity

• For Men, elasticity is almost zero.

Questions for Thought
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.

2-30
2. Applying and
Extending the Model

2-31
 Non-Labor Income
• At a wage rate of Income/day
$10/hour with no other
income, the optimal
hours of leisure is 16 (8
hours of work) at point
U1 .
$300
• If the person gets an
inheritance that generates $240
$60 a day of non-labor
income, the budget U2
constraint has a parallel U1
I2
shift.
I1
• The optimal hours of
leisure rises to 17 at point
U2 .
0 16 17 24 Leisure
• With an increase in non-
labor income, only the
income effect occurs and
2-32
so hours of work must fall.
 Non-Participants
• If a person has a low wage Income/day
rate (WN is flat), higher non- I2
labor income (NH), or steep W’
indifference curves (I1), he is
less likely to participate in
the labor force (U1). I1
W
• If a person has a high U2
wage rate (HW’), low non-
labor income (0), or flat
indifference curves (I2), she
is more likely to participate
(U2).
• The reservation wage is U1
the lowest wage N
necessary to induce
someone to work.
H
0 10 24 Leisure
• College students are less
likely to participate in the
labor force than other
persons. Why? 2-33
 Over-Employment
• If an individual is free to Income/day
choose the number of hours
of work, she would choose
point U1, with 18 hours of
leisure and 6 hours of work.

• If the individual is W
constrained to work a
standard workday of 8
hours or not all, she will
choose point U2.
U2 U1
• At U2, her MRS is more
than the wage rate and so N
she feels overemployed.

• What is a potential solution H

to her overemployment 0 16 18 24 Leisure
situation?

2-34
 Under-Employment
Income/day
• If an individual is free to
choose the number of hours
of work, she would choose
point U1, with 14 hours of
work and 10 hours of leisure.
W
• If the individual is U1
constrained to work a
standard workday of 8
hours or not all, she will
choose point U2.
U2
• At U2, her MRS is less than
the wage rate and so she N
feels underemployed.

• What is a potential solution H

to her underemployment 0 10 16 24 Leisure
situation?

2-35
 Premium Wages
• Suppose in a given industry, working 10 hrs a day has become
the practice.
• Does it make difference to pay:
– $6 per hr for the first 8 hrs and $9 per hour for an additional 2 hours of
overtime OR
– Pay $6.6 per hour for each 10 hrs?

• These two plans yield the same income at the same number
of hrs as the originally chosen by an individual paid the
overtime premium.
 Exercise
• A rather elderly person initally participating
the labor force by working 9 hrs a day at a $10
wage.
• As he reaches age 65, he is entitled to pension
income corresponing to $80 a day provided
that he retires fully from work .
• Show which one is preferable to him using
work-leisure model. Show the change in his
income. Show the change in his labor supply
curve.
Income Maintenance Program
Features

• Income Guarantee (B)

– Benefit received if individual/family
has no earned income.
• Benefit Reduction Rate (t)
– Rate by which the benefit is
reduced as income is increased.
• At t=.50, benefits are reduced by $.50
for every dollar earned.

2-40
Income Maintenance Program
Features

• Break-Even Level of Income (Yb)

– The level of earned income at
which the individual/family
receives no benefit.

2-41
 Benefit Example
The actual subsidy payment S
illustrates these concepts as
shown below.
S = B – tY

If B = $80, t = .5, earned income (Y) =

$60 then…
S = $80 - .5 * $60 =$50

2-42
 Benefit Example

The break-even level of income

formula is shown below:

Yb = B/t

If B = $80, t = .5, then Yb = $160

2-43
 Income Maintenance Program
• At a wage rate of
$10/hour, the optimal hours
of leisure is 16 (8 hours of
work) at point U1. Income/day
• If there is a welfare
program is started with a B
of $80 a day, t = .5, then
Yb= $160.
• The income effect (IE) is
measured through a parallel shift
of the old budget constraint. The
IE is from U1 to U2’ (from 16 to 18 $240
hours of leisure).
U2 ’
$160 U2
• The substitution effect (SE) is
measured by movement along
I2. The SE is from U2’ to U2 $80 I2
(from 18 to 22 hours of U1 I1
leisure). The tax lowers the
“price” of leisure.
• In contrast to a wage change,
both the IE and SE reduce 0 16 18 22 24 Leisure
desired hours of work.
• Compare this outcome with a
fixed benefit (80$ paid 2-44
regardles of the income)
 Welfare Reform
• There has been a large reduction
in caseloads since 1996.

2-45
Welfare Caseloads

2-46
 Why Did Caseloads Fall?
• The economic boom of the 1990s
helped the labor prospects of
welfare recipients.
• The expansion of tax subsidies for
working low income families
encouraged recipients to seek
jobs.

2-47
 Why Did Caseloads Fall?
• The benefit time limits
encouraged recipients to
conserve their benefits.
• Welfare benefit reductions, child
care expansions, and changes in
training programs also likely
played a role.

2-48
 Welfare Reform
• The main elements of the 1996 Welfare Reform Act are:
– Two-year time limit for receiving assistance.
– Five-year lifetime time limit for collecting assistance.
– Provisions to help enforce the collection of child
support payments from fathers.
– Limits led to a fall in welfare claims (partly due to
“banking” benefits for future use), a rise in
employment, and a decline in divorce rates. (Low et. Al,
2018).
– «Based on the model, which reproduces the reduced
form estimates, we show that among low educated
women, instead of relying on TANF, single mothers
work more, more mothers remain married, some move
to relying only on food stamps and, in ex-ante welfare
terms, women are worse off.»

2-49
 EITC
• The EITC grants the worker a credit of 40 percent on
labor earnings as long she earns less than $11,000.
• The credit is capped at $4,400. The worker receives
this maximum amount as long as she earns between
$11,000 and $14,370. The tax credit is then phased
out gradually.
• Each additional dollar earned reduces the credit by
21.06 cents. The worker’s net wage is 21.06 cents
below her actual wage whenever she earns between
$14,370 and $35,263.
 Earned Income Tax Credit
• Consider a household composed of a working mother with
two qualifying children.
 First: An easier example
• Suppose that, if the recipient does not work and goes on
welfare, her monthly income is $500
• Suppose that the government takes away 50 cents from the
cash grant for every dollar earned in the labor market.
• This means that, if the woman works one hour at a wage of
$10, her labor earnings increase by $10 but her grant is
reduced by $5. Her total income, therefore, is $505.
• Every additional hour of work increases income by only $5.
• Under the guise of reducing the size of the welfare grant, the
government is actually taxing the welfare recipient’s wage at a
50 percent rate.
Questions for Thought
1. One way of aiding low-income families is to
increase the minimum wage. An alternative is to
provide a direct grant of non-labor income.
Compare the impact of these two options on work
incentives.
2. How would you expect each of the following
factors to affect the probability someone
chooses not to participate in the labor force?
(a) Education
(b) Presence of preschool children
(c) Level of spouse’s income
(d) Marital status

2-54
 Marriage and Men
• We estimate marriage effects on hours worked (our proxy for work effort)
and on wage rates for ... men.
• The estimates reveal that entering marriage raises hours worked quickly
and substantially but that marriage's effect on wage rates takes place
more slowly while men continue in marriage. Together, the stimulus to
hours worked and wage rates generates an 18%-19% increase in earnings,
with about one-third to one-half of the marriage earnings premium
attributable to higher work effort.
• At the same time, higher wage rates and hours worked encourage men to
marry and to stay married.
• Thus, being married and having high earnings reinforce each other over
time. ( Ahituv and Lerman, 2007, Demography)