3.

3 Labour Supply

3.3.1 Assumptions of the Model

3.3.2 Deriving the Budget Constraint
3.3.3 Labour Supply Decision
3.3.4 Summary
 3.3.1 Assumptions of the Model

People have a choice: to work or not to work

If not working, they will remain at home or engage

in leisure

Supply labour if Price (wage) > reservation wage

Reservation wage is the minimum wage needed to

attract a person away from leisure and into work
Represents the opportunity cost of labour
Can we model this decision making?

Can analyse using indifference curve analysis

Simplify the analysis to a choice between work
and leisure

Assume seven days of 24 hours available

Assume labour is homogeneous and waged

Assume the wage rate is w

 3.3.2 Deriving the Budget Constraint
Income
If no work undertaken then 168 hours of
leisure taken and income is zero (a)
If worker then decides to work one hour
then leisure decline and income rises to w
One more hour gives income of 2 w

2w c
b
w
a
Leisure Hours 168
Work Hours
Income
Maximum income is 168 w

Slope = - w

Leisure Hours 168

 Indifference curve for income-leisure trade off
Income

U3

U2
U1
Leisure Hours
Work Hours
 3.3.3 Labour Supply Decision

Once someone is working how do they respond to a

change in the wage rate?

Two key elements:

Substitution effect – as wages rise, person works more
and substitutes work for leisure as the opportunity cost
of leisure rises
Income effect – as wages rise, person works less as
his/her income has risen thus allowing him/her to spend
more time in leisure activities
 Substitution: a to c (wage up, work up)
Income Income: c to b (income up, work down)
Y2

b
Y1 c
U2
a
U1

Leisure Hours 168

For most workers, SUBSTITUTION > INCOME
effects but…...
(no I curves shown)

Y5
Price consumption curve
Y4
Y3
Y2
Y1
Wage

W1

H1 Hours worked

BACKWARD BENDING SUPPLY CURVE FOR

LABOUR
 3.3.4 Summary

• Reservation wages determine the point of entry into

the labour market
• Need to trade-off between leisure and income
• Can analyse using indifference curve approach
• Income effects can outweigh substitution effects to
give a backward bending supply curve
• Implications for tax/benefit policy