Labor Supply

COURSE INSTRUCTOR : USAMA TAHIR ( usamatahir1993@gmail.com )

E C O N O M I C S D E PA R T M E N T | G P G C J H E L U M
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It’s true hard work never killed anybody,

but I figure, why take the chance?
—Ronald Reagan

Economics Department | GPGC Jhelum

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Labor Force - Pakistan

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Introduction to Labor Supply

PARTICIPATION RATE:
(32.3%) LFS 2014-15 is equivalent to that of LFS 2013-14 (32.3%).

 Rate for males (48.0%, 48.1%) ↑

 Rate for female (15.8%, 15.8%) ≈

 Rural areas(33.8%, 34.0%) ↑

 Urban areas (29.4%, 29.0%) ↓

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Introduction to Labor Supply

Employment by Major Industries indicates marginal changes in the employment

shares.

 MANUFACTURING (14.2%, 15.3%) ↑

 AGRICULTURE/FORESTRY/HUNTING & FISHING (43.5%, 42.3%) ↓

 OTHER INDUSTRIAL CATEGORIES fare approximately at the same level

during the comparative period.

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Introduction to Labor Supply
EMPLOYMENT STATUS:
comprises followed by
 own account workers (36.1%),
 employers (1.4%).
 employees (38.7%)
 contributing family workers (23.8%)
and
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As far change during the comparative
periods,
 own account workers (35.4%, 36.1%)
 employers (1.1%, 1.4%) trend up,
 employees (39.1%, 38.7)
 contributing family workers (24.4%,
23.8%) scale down.
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Introduction to Labor Supply

UNEMPLOYMENT RATE:
(5.9%) fares in proximity of the previous survey (6.0%).
Similar configuration obtains in the case of

 Males (5.1%, 5.0%)

 Females (8.7%, 9.0%)

 Urban Areas (8.0%, 8.0%)

 Rural Areas (5.0%, 5.0%)

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Introduction to Labor Supply

ACTIVITY STATUS: comprises formal and informal sectors.

INFORMAL SECTOR (73.6%, 72.6%) ↓

accounts for more than seven-tenth (72.6%) of non-agricultural employment,
more in rural (76.1%) than in urban areas (69.2%).

FORMAL SECTOR (26.4%, 27.4%) ↑

activities are concentrated more in urban areas (30.8%) than in rural areas
(23.9%).

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Introduction to Labor Supply

UNDEREMPLOYMENT RATE:
recedes from 1.2% in 2013-14 to 1.1% in 2014-15 equivalently for

 Females (1.9%, 1.8%)

 Males (1.0%, 0.9%)

 Rural (1.4%, 1.3%)

 Urban areas (0.8%, 0.7%)

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Measuring the Labor Force

 Labor Force = Employed + Unemployed

 LF = E + U
NOTE: Size of LF does not tell us about “intensity” of work

 Labor Force Participation Rate

 LFPR = LF/P
 P = civilian adult population 18 years or older not in institutions

 Employment Population Ratio (percent of population that is employed)

 EPR = E/P

 Unemployment Rate
 UR = U/LF
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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, giving up in their search
for work

 EPR is a better measure of fluctuations in economic activity

than the UR

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Worker Performance

 Framework used to analyze labor supply behavior is the

“Neo-Classical 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, L)
where;
 U is an index
 Higher U means happier person
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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)

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Indifference Curves

Consumption ($)

500

450

400

40,000 Utils

25,000 Utils
Hours of
100+ 125 150 Leisure
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Indifference Curves Do Not Intersect

Consumption ($)

Y
Z
U 1

U 0

0 Leisure

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Differences in Preferences across Workers

Steep and flat indifference curves:

Consumption ($) Consumption ($)

U 1

U
1

U U 0
0

Hours of Hours of
Leisure Leisure

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The Budget Constraint

 C = wh + V

 Consumption equals labor earning (wages × hours) plus nonlabor income (V)

 Because of time, rewrite as

 C = w(T – L) + V

 Budget constraint sets boundaries on the worker’s opportunity set of all the
consumption baskets the worker can afford

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Depicting the Budget Constraint

Consumption ($)

wT+V

Budget Line

E
V

Hours of
0 Leisure
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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

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Optimal Consumption and Leisure

$1200
A Y
$1100

P
$500
U 1

U*

$100 E
U
0 Hours of
0 70 110 Leisure
Hours of
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TWO EFFECTS

 Increase in nonlabor income allows worker to “jump” to higher indifference

curve, indicating the Income Effect
 Leisure can be treated as a normal good or as an inferior good

 As wages change holding real income constant, changes in consumption-leisure

bundle indicate the Substitution Effect

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The Effect of a Change in Non labor Income on Hours of Work

Consumption ($)
F
 INCOME EFFECT
1

 NORMAL GOOD
F 0

P
1

U
1

P0

$200 E
U
1
0

$100 E 0

70 80 110 Hours of
Leisure

An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the
worker from point P0 to point P1. If leisure is a NORMAL GOOD, hours of work fall.
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The Effect of a Change in Non labor Income on Hours of Work

Consumption ($)

F
 INCOME EFFECT
1

P 1
 INFERIOR GOOD
F0

U
1

$200 P 0 E 1
U
0

$100
E 0

60 70 110

An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the
worker from point P0 to point P1. If leisure is an INFERIOR GOOD, hours of work increase.
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Ambiguous Relationship: Hours Worked and Wage Rates

 If the Substitution Effect is greater than the Income Effect, 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.

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More Leisure at a Higher Wage (When the Income Effect dominates)

 If the Income Effect is greater than the Substitution Effect,

then hours of work decreases when the wage rate rises.
Consumption ($)

U
1

R
D Q
U 0

D
F P

V
E
Hours of
Leisure
Economics Department | GPGC Jhelum 0 70 75 85 110
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More Work at a Higher Wage (When the Substitution Effect dominates)

 If the Substitution Effect is greater than the Income Effect, then hours of work increase when the wage rate
rises

Consumption ($)
U 1

R
D
Q
U 0
D

F P
V
E

0 65 70 80 110 Hours of
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Leisure
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To Work or Not to Work?
N O O N E WA N T T O W O R K I F H E C AT C H E S A H A N D S O M E PA C K A G E O F
SALARY WITHOUT WORK… BUT JUST FORGET IT… ITS NOT GOING TO
HAPPEN ;P

 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 1: if the market wage is less than the reservation wage, then the person will not
work

 Rule 2: the reservation wage increases as nonlabor income increases

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The Reservation Wage

Consumption
($)
H
Has Slope -whigh

G
X
U H

E
U 0

Has Slope -w

0 T Hours of
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Leisure
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Labor Supply Curve

 Relationship between hours worked and the wage rate

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

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Estimates of Labor Supply Elasticity

 When estimates are negative the income effect dominates

 Labor supply tends to be inelastic

 As time period increases, labor supply becomes more elastic [initially]

 Measurement error tends to overemphasize the importance of the income

effect

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Labor Supply Curve

 Example of backward bending labor supply:

Wage Rate ($)

25

20

10

0 20 30 40
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Hours
of Work
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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, substitution effects dominate income effects

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Derivation of the Market Labor Supply Curve from the Supply Curves of
Individual Workers

Wage Rate ($) Wage Rate ($) Wage Rate ($)

hB
hA ~ hA + hB
~ wB
wB
~ ~ hA
wA wA
Hours of
0 0 (b) Brenda 0 (c) Market Work
(a) Alice

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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

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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, and encourages the worker to leave the labor force.

Consumption
($)
F

P
G
500 U 1

U 0

Hours
0 70 110 of
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Effect of a Welfare Program on Hours of Work

Consumption ($)
U
0
U 1

F
slope = -$10

H
D

slope = -$5
Q

R
P

$500
D G

E
Hours of
0 70 100 110
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REFERENCE:

 Borjas, G. J. (2016). Labor economics. Boston [etc.]: McGraw-Hill Education

 Labor Force Survey Pakistan LFS 2014-15

Economics Department | GPGC Jhelum