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Chapter 2

Labor Supply

McGraw-Hill/Irwin Labor Economics, 4th edition

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

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Introduction to Labor Supply
• Labor facts
- Working men: decline in labor force participation from 90% in 1947 to 75% in 1990 - Working women: rise in labor force participation from 32% in 1947 to 60% in 1990

- Work hours fell from 40 to 35 per week during the same time period

2.Labor Force Participation Rate • LFPR = LF/P • P = civilian adult population 16 years or older not in institutions .4 Measuring the Labor Force • Current population survey (CPS) .Unemployment Rate • UR = U/LF .Employment: Population Ratio (percent of population that is employed) • EPR = E/P .Labor Force = Employed + Unemployed • LF = E + U • Size of LF does not tell us about “intensity” of work .

2. giving up in their search for work • EPR is a better measure of fluctuations in economic activity than the UR .5 Measurement Issues • Labor Force measurement relies on subjectivity and likely understates the effects of a recession • Hidden unemployed: persons who have left the labor force.

2.6 Facts of Labor Supply • More women than men work part-time • More men who are high school drop outs work than women who are high school drop outs • White men have higher participation rates and hours of work than black men .

7 Average hours worked/week.2. 1900-2005 60 55 50 45 40 35 30 1900 Weekly hours 1920 1940 1960 Year 1980 2000 2020 .

L). where .2.Higher U means happier person .U is an index .8 Worker Performance • Framework used to analyze labor supply behavior is the NeoClassical Model of Labor-Leisure Choice • Utility Function – measure of satisfaction that individuals receive from consumption of goods and leisure (a kind of good) • U = f(C.

9 Indifference Curves • Downward sloping (indicates the trade off between consumption and leisure) • Higher curves = higher utility • Do not intersect • Convex to the origin (indicating that opportunity costs increase) .2.

000 Utils Hours of 100+ 125 150 Leisure .10 Indifference Curves Consumption ($) 500 450 400 40.2.000 Utils 25.

2.11 Indifference Curves Do Not Intersect Consumption ($) Y Z U1 U0 0 Leisure .

12 Differences in Preferences across Workers Steep and flat indifference curves: Consumption ($) Consumption ($) U1 U1 U0 Hours of U0 Hours of Leisure Leisure .2.

2.C = w(T – L) + V • Budget constraint sets boundaries on the worker’s opportunity set of all the consumption baskets the worker can afford .13 The Budget Constraint • C = wh + V • Consumption equals labor earning (wages × hours) plus nonlabor income (V) • Because of time. rewrite as .

14 Depicting the Budget Constraint Consumption ($) wT+V Budget Line E V 0 T Hours of Leisure .2.

2.15 The Hours of Work Decision • Individual will choose consumption and leisure to maximize utility • Optimal consumption is given by the point where the budget line is tangent to the indifference curve • At this point the Marginal Rate of Substitution between consumption and leisure equals the wage rate • Any other bundle of consumption and leisure given the budget constraint would mean the individual has less utility .

16 Optimal Consumption and Leisure $1200 $1100 A Y $500 P U1 U* $100 0 110 70 40 110 0 E U0 Hours of Leisure Hours of Work .2.

Leisure can be treated as a normal good or as an inferior good • As wages change holding real income constant.17 Two Effects • Increase in nonlabor income allows worker to “jump” to higher indifference curve. changes in consumption-leisure bundle indicate the Substitution Effect .2. indicating the Income Effect .

2. upward shift in the budget line.18 The Effect of a Change in Nonlabor Income on Hours of Work Consumption ($) F1 F0 P0 P1 U1 E1 $200 U0 $100 E0 70 80 110 Hours of Leisure An increase in nonlabor income leads to a parallel. moving the worker from point P0 to point P1. hours of work fall. If leisure is a normal good. .

moving the worker from point P0 to point P1.19 The Effect of a Change in Nonlabor Income on Hours of Work Consumption ($) F1 P1 U1 $200 P0 E1 F0 U0 $100 E0 60 70 110 An increase in nonlabor income leads to a parallel. upward shift in the budget line.2. . hours of work increase. If leisure is an inferior good.

then hours of work increase when the wage rate rises • If the Income Effect is greater than the Substitution Effect. then hours of work decreases when the wage rate rises.2. .20 Ambiguous Relationship: Hours Worked and Wage Rates • If the Substitution Effect is greater than the Income Effect.

21 More Leisure at a Higher Wage • When the Income Effect dominates: Consumption ($) G U1 R D U0 F V E D P Q 0 70 75 85 110 Hours of Leisure .2.

2.22 More Work at a Higher Wage • When the Substitution Effect dominates: Consumption ($) U1 G R D U0 Q D P E F V 0 65 70 80 110 Hours of Leisure .

23 To Work or Not to Work? • Are the “terms of trade” sufficiently attractive to bribe a worker to enter the labor market? • Reservation wage: the minimum increase in income that would make the person indifferent between working and not working .Rule 2: the reservation wage increases as nonlabor income increases .2. then the person will not work .Rule 1: if the market wage is less than the reservation wage.

2.24 The Reservation Wage Consumption ($) H Has Slope -whigh Y G X E U0 Has Slope -w UH 0 T Hours of Leisure .

25 Labor Supply Curve • Relationship between hours worked and the wage rate .If the income effect begins to dominate. the labor supply curve is positively sloped (the substitution effect dominates) .2. hours of work decline as wage rates increase (a negatively sloped labor supply curve) .At wages slightly above the reservation wage.Labor supply elasticity • % change in hours worked/% change in wage rate • Labor supply elasticity less than 1 means “inelastic” .

labor supply becomes more elastic • Measurement error tends to overemphasize the importance of the income effect .26 Estimates of Labor Supply Elasticity • When estimates are negative the income effect dominates • Labor supply tends to be inelastic • As time period increases.2.

2.27 Labor Supply Curve • Example of backward bending labor supply: Wage Rate ($) 25 20 10 0 20 30 40 Hours of Work .

2. substitution effects dominate income effects .28 Labor Supply of Women • Substantial cross-country differences in women’s labor force participation rates • Over time. women’s participation rates have increased • In most studies on women.

2.29 Derivation of the Market Labor Supply Curve from the Supply Curves of Individual Workers Wage Rate ($) Wage Rate ($) Wage Rate ($) hB hA ~ wA ~ wB 0 (b) Brenda ~ wB hA 0 (c) Market hA + hB Hours of Work ~ wA 0 (a) Alice .

“Intercountry Comparisons of Labor Force Trends and of Related Developments: An Overview.2.30 Cross-Country Relationship: Growth in Female Labor Force and the Wage. Part 2): S2.” Journal of Labor Economics 3 (January 1985. S6. . 1960-1980 7 6 Netherlands Female Participation 5 Australia Growth Rate of 4 3 USSR Israel Britain France Germany Italy Sweden Japan Spain 2 1 United States 0 1 2 3 4 5 6 7 8 9 Percentage Change in Wage • Source: Jacob Mincer.

2.31 Policy Application: Welfare Programs and Work Incentives • Cash grants reduce wage incentives • Welfare programs create work disincentives • Welfare reduces supply of labor by granting nonlabor income. which raises reservation wage .

and encourages the worker to leave the labor force.32 Effect of a Cash Grant on Work Incentives • A take-it-or-leave-it cash grant of $500 per week moves the worker from point P to point G. Consumption ($) F P G 500 U1 U0 0 70 110 Hours of Leisure .2.

2.33 Effect of a Welfare Program on Hours of Work Consumption ($) F U0 U1 slope = -$10 H D slope = -$5 Q P $500 R D G E 0 70 100 110 Hours of Work .

34 Policy Application: The Earned-Income Tax Credit • EITC should increase labor force participation of nonworkers of targeted groups • EITC produces an income effect .2.Hours worked should change .

The EITC grants the worker a credit of 40 percent on labor earnings as long she earns less than $10.350 and $13. • This is shown in the next slide.520. (not drawn to scale).140. the budget line is given by FE. The worker’s “net” wage is 21. The worker receives this maximum amount as long as she earns between $10. .35 EITC and Labor Supply • In the absence of the tax credit. The tax credit is then phased out gradually. The credit is capped at $4.350.520 and $33.178.06 cents below her actual wage whenever she earns between $13.2.

350 E 110 Hours of Leisure .660 H Net wage equals the actual wage J 14.2.520 Net wage is 40% above the actual wage 10.36 The EITC and the Budget Line Consumption ($) F G 33.06% below the actual wage 17.178 Net wage is 21.490 13.

In the shifts illustrated in (b) and (c). The impact of the EITC on the labor supply of persons already in the labor market is less clear.2. . and will draw new workers into the labor market.37 The Impact of the EITC on Labor Supply The EITC shifts the budget line. the person enters the labor market by moving from point P to point R. the worker reduced hours of work. In (a).

38 End of Chapter 2 .2.