Chapter 2

The Theory of
Individual Labor
Supply

Next
page
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
2-2

The Work-Leisure
Decision: Basic Model

Jump to first page

2-3

Assumptions
 Each individual has a fixed amount of
time.
 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

Jump to first page

2-4

Optimal decision
To make your optimal decision, you need
2 sets of information:
 Subjective information (your work-
leisure preferences) shown on
indifference curves
 Objective information (labor market
information) shown on a budget
constraint

Jump to first page

 2-5
Indifference Curve
Income/day

• The indifference curve shows

work and leisure combinations
that yield the same amount of
total utility.
• Having more hours of leisure
implies fewer hours of work.

0 24 Leisure Hours
24 0 Work Hours

Jump to first page

2-6
Indifference Curve
Properties
 Negative slope
 To keep the level of utility the same, if one gets
more leisure, some of income must be given up.
 Convex to origin
 With little hours of leisure, individuals are
willing to give up a large amount of income to
get 1 more leisure hour.
 With too many hours of leisure, individuals are
willing to give up an hour of leisure to get a
small amount of income.
“Scarcity rationale”
Jump to first page
 2-7 Marginal Rate
• The slope of the IC is the
marginal rate of substitution
of Substitution
(MRS) of leisure for income.
Income/day
• The marginal rate of
substitution (MRS) is the amount
of income one must give up to
compensate for 1 more hour of 4
leisure.
• At 3 hours of leisure (21 hours
of work), one must give up 4
units of income to
compensate for 1more 1
• hour of leisure.
At 16 hours of leisure (8 hours
of work), one must give up 1
unit of income to compensate
for 1 more hour of leisure.
• The MRS falls as one moves 0 34 16 17 24 Leisure
southeast along an
indifference curve. 24 0 Work
“scarcity rationale”
Jump to first page
 2-8
Work-Leisure Preferences
Shape of Indifference curves
Income/day
People have different work-
leisure preferences

• “Leisure lovers” place a high IB

value on leisure. They have IA
a steep indifference curve.
They are willing to
sacrifice a large amount of
income to get a small increase
in leisure. I1 I2
• “Workaholics” place a low
value on leisure. They have
a flat indifference curve. They
must be given a large
increase in leisure to 0 24 Leisure
compensate for a small
decrease in income.
Jump to first page
 2-9
Indifference Map
• Income/day
Curves further from the origin
indicate higher utility.
• Combination L2Y2 is preferred
to combination L1Y1 since
one gets both more income and
more leisure. Y2
Y1 I3
• Indifference curve an never I2
intersect. I1

• A person will maximize utility

by getting to the highest
attainable indifference curve.

0 L1 L2 24 Leisure

Jump to first page

 2-10

Budget Constraint
• Income/day
The budget constraint shows
the combinations of income
and leisure that a worker
could get given a wage
rate. $360
• The slope of the budget
constraint is – wage rate.
$240
• At a wage rate of $5, a worker
could get a maximum income
of $120 per day ($5/hour * $120
24 ).
• At a wage rate of $10, a
worker could get a maximum
income of $240 per day.
• At a wage rate of $15, a 0 24 Leisure
worker could get a maximum
income of $360 per day.
Jump to first page
 2-11

Utility Maximization
• Income/day
The optimal or utility
maximizing point is where the
budget constraint is tangent to
the highest attainable
indifference curve (U on I2).
• At U, the MRS (slope of the
indifference curve) is equal
to the wage rate (slope of the $240
budget constraint) B
• At B, the MRS is greater U
than the wage rate. The $80 I3
individual values I2
leisure more than the A I1
• wage rate.
At A, the MRS is less than
the wage rate. The individual
values leisure less than the 0 16 24 Leisure
wage rate.

Jump to first page

2-12
Backward-Bending Individual Labor
Y/ day
Supply Curve
w5

w4 I5
I4
I3
w3
u5
u4
I2
w2 u3
I1
w1 u2
u1

0 Hours of leisure Hours of work 24

Jump to first page
 2-13
An Individual Labor Supply Curve

• For a given person, hours of

work may increase as the wage Wage Rate
rate rises. SL
• If the wage rate rises from $10
to $25 per hour, hours of
work rise from 8 to 10
hours per day. $25
• Above $25 per hour, hours of
work fall.
• A wage increase, increases your
income for any given hours of $10
work (Y effect), and increases
the opportunity cost of your
leisure time (substitution effect).
• The backward bending labor
supply curve is the result of 0 8 10 24 Hours of
the income and substitution Work
effects of a wage change.
Jump to first page
2-14

Income Effect
 Income Effect
 The change in desired hours of work
resulting from a change in income,
holding the wage constant.
 Assuming 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.

Jump to first page

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 (opportunity cost) of leisure.
 Assuming leisure is a normal good,
then you buy less of it i.e. more hours
of work.
 For a wage increase, the substitution
effect raises desired work hours.

Jump to first page

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.

Jump to first page

 2-17
Income and Substitution
• At a wage rate of $10/hour,
the optimal hours of
Effects
leisure are 16 (8 hours of Income/day
• work)
If theatwage
pointrate
U1. rises to
$30/hour, the optimal hours of
leisure are 15 at point U2.
$720
• The income effect (YE) is
measured through a parallel
shift of the old budget U2
constraint. The YE is from U1 to $240
U2’ (from 16 to 17 hours of U2’
leisure). I2
• U1
The substitution effect (SE)
is measured by Net effect I1
movement along I2. The SE is
S -effect
from U2’ to U2 Y-effect
(from 17 to 15 hours of
• leisure).
The net effect is an increase 0 15 16 17 24 Leisure
of hours of work by 1
hour.

Jump to first page

Backward-bending
2-18
Labor supply curve

u5

u4
Y-effect > Substitution
Wage rate

u31

Substitution > Y-effect

u2

u1

0 Hours of work
24 Jump to first page
2-19
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.

Jump to first page

2-20

Elasticity of Labor Supply

 Elasticity of labor supply measures the responsiveness of
desired hours of work to Δs in the wage rate.

% Change in
Elasticity quantity of labor supplied
of Labor Supply =
% Change in the wage rate

Es = Δ in quantity ÷ Δ in Wage .
Sum of quantities / 2 Sum of wages / 2

• Es depends on the relative strength of the Y &

S effects.
• This causes movement along the individual
labor supply curve.
Jump to first page
2-21

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.

Jump to first page

2-22

Elasticity of Labor Supply

• Shifts in the labor supply curve entail
releasing either of the 2 factors we held
constant:
 ∆s in non-labor Y
 ∆s in work-leisure preferences

Jump to first page

2-23

Applying and Extending

the Model

Jump to first page

2-24
Factors conducive to Non-
participation in the labor market
Factors conducive to non-participating in the labor
force:
 A high evaluation of leisure implies a steep
indifference curve.
 Availability of non-labor income e.g. an intra-
household transfer to the young student. Budget line
starts from a point above the right origin.
 Low earning ability (a relatively flat budget line).

Jump to first page

 2-25

Non-Labor Income
• At a wage rate of $10/hour Income/day
with no other income, the
optimal hours of leisure are 16
(8 hours of work) at point U1.
• If the person gets an
inheritance that generates $300
$60 a day of non- labor income,
the budget constraint has a $240
parallel shift. U2
• The optimal hours of leisure
U1
rise to 17 at point U2 . I2
• With an increase in non-labor I1
income, only the income
effect occurs and so hours of
work must fall. 0 16 17 24 Leisure

Jump to first page

 2-26
Non-Labor Income + Low Earning Ability
+ high evaluation of Leisure
• If a person has a low wage rate Income/day
(WN is flat), higher non-labor W ’
income (NH), or steep
indifference curves (I1), he is I2
less likely to participate in the I1
labor force (U1). W
• If a person has a high wage U2
rate (HW’), low non-labor
income (zero), or flat
indifference curves (I2), he is
more likely to participate (U2).
• College students are less U1
likely to participate in the N
labor force than other
persons. Why? H
0 10 24 Leisure

Jump to first page

2-27
Non-participation – the college
student
The case of an individual who decides not to
participate in the LF (a 20-year-old who attends
college).

• The reservation wage is the lowest wage necessary to

induce someone to work.

Jump to first page

2-28
Non-participation – the college student

I2 I3 I4 If the market wage

w ’
w’’ rate was above the
reservation wage
I1
u2 Reservation wage:
is the lowest wage
W u rate at which the
individual would
decide to work.

H
0 16 18 24
Hours of leisure Hours of work

Jump to first page

2-29
Non-participation – Pensions
& the Elderly
Budget
constraint
W
I2
I3
HW before
I1 accepting
the pension

Budget
u constraint
HNN’ after
N’ N
receiving
the pension

0 H1 H
24
Leisure Work
Jump to first page
 2-30

Over-Employment
• Income/day
If an individual is free to
choose the number of hours of
work, she would choose
point U1, with 18 hours of
leisure and 6 hours of work. W
• If the individual is
constrained to work a
standard workday of 8
hours or not at all, she will
U2 U1
• be at point U2.
At U2, her MRS is more than
the wage rate and so she feels
overemployed. N
• What is a potential solution
to her overemployment H
situation? 0 16 18 24 Leisure
• Higher absence rate
• Higher labor turnover rate
• More shirking Jump to first page
 2-31

Under-Employment
• If an individual is free to choose
the number of hours of work, she Income/day
would choose point U1, with 10
hours of leisure and 14 hours of
work.
• If the individual is constrained W
to work a standard workday of U1
8 hours or not all, she has to be
at point U2.
• At U2, her MRS is less than
the wage rate and so she U2
feels underemployed.
• What is a potential solution N
to her underemployment
situation?
H
Moonlighting or second job. 0 10 16 24 Leisure

Jump to first page

2-32
Standard workday
(Over-employment & Under-employment)

Ij3
Ij2

W
Ij1
uj
Is2 Is3
P

Is1 us

0 H
hj D hs
Leisure Work

Jump to first page

2-33 Premium pay versus straight time
Premium pay is overtime pay e.g. 1.5 times your normal
pay if you work above the standard work hours (8
hours/day).

Example:
Case of premium pay:
$6/hour for the 1st 8 hours, and
$9/hour for the additional 2 hours
Income/day = ($6 x 8) + ($9 x 2) = $66/day
Case of straight time equivalent pay yielding same
income per day
$6.6/hour for each of the 10 hours = $66/day

Jump to first page

2-34
Premium Pay vs. Straight-time Wage
 W1=$6 per hour for the 1st 8 hours (Hh1)
 u1P = $9 per hour for additional hours above standard work hours
 W2= $6.6 per hour for each of the 10 hours = $66/day

W2

Hh1 = 8 hours
u2 of work
u3 Hh2 = 10 hours
W1
of work
I3 Hh3 = 9 hours
u1
I2 of work
I1

0 h2 h3 h1 H
Jump to first page
2-35

Income & substitution effects of a premium pay

u2
W1

ui
u1
I2
S-effect I1
Y-effect

0 h2 h1 h H
i
Jump to first page
2-36

Income & substitution effects of a

straight-time pay

W2

W1
u3
ui
u1 I3

I1
S-effect
Y-effect

0 h3 h1 h H
i
Jump to first page
2-37 Income Maintenance programs
 Y-maintenance programs are directed to
the needy.

 They are not the same as social insurance

programs.

 An efficient Y-maintenance program

should :
 Effectively eliminate poverty
 Maintain incentives to work
 Achieve this at a reasonable cost.

Jump to first page

2-38 Income Maintenance programs
The amount actually received (S) depends on 3 main
elements:
 Y guarantee or basic benefit (B) = amount received in
case of no earned Y.
 Benefit reduction rate (t) = rate at which B is reduced as
earned Y ↑.
 Breakeven level of Y (Yb) = level of earned Y at which
actual subsidy payment (S) becomes zero i.e. dropped
from the Y maintenance program.
S = B – tY
If B = 2000
t = 0.50 Yb = B/t
Y = 2000 Yb = 2000 / 0.50
Then S = 2000 – 0.50*2000
= 2000 – 1000 = $1000 = 4000
S = 2000 – 0.5 * 4000 = 0
Jump to first page
2-39
Income Maintenance Programs
Y/year & Incentives to Work
W’ I2

Wn = (1- 0.5)w
W’ I1 I2
W
$4000 W
I1

Yb
$4000 u3 u3
Yb
u1 u2 u2
$2000 $2000 B (2000) B (2000)
u1
H’

0
Y effect
S effect
H
H’

0 h3 h2 H
h1
Leisure Work
Jump to first page