ELM Part 2- Economic models
Manuela Samek
References
• Adnett N. (1996) European Labour Markets,
chapter 2.1,2.2; 4.2, 4.3;5.5,5.6;7.2,7.3,7.4
• Blanchard O. (2006) European Unemployment,
Economic Policy no.45 Jan.2006
Some questions looking for an answer
The labour market performance of EU countries presents
some problems which need to be addressed:
• Why the EU is not able to create enough jobs for its active
population? What factors influence labour demand?
• Why participation and employment rates in some
countries are very low especially for women and for the
less educated? What factors influence labour supply?
• Why unemployment is so persistent, especially among
some groups of the population?
• Why there are differences across countries? What is the
role of labour market institutions?
• What policies may be introduced to improve the labour
market performance of EU countries?
Economic models try to answer to these questions
Economic models
• Economic models of labour supply help to explain labour supply decisions
and differences in participation rates across different groups of the
population. They also help explaining the influence of working hours
regulation, the taxation and the welfare systems on labour supply
decisions;
• Economic models of labour demand explain how firms decide if and how
much labour to employ in the productive process. Models of labour
demand with adjusting costs consider the relation between employment
protection legislation and labour market performance;
• Search and matching models help the analysis of search behavior and the
matching of labour demand and supply, in order to derive what variables
affect unemployment duration and labour market mismatches;
• Wage determination models help to explain why wages are not flexible and
what variables affect wage bargaining and its effects on the wage
dynamics and structure.
• Human capital models help to explain why individuals invest in education
and training an what are the individual and social returns of this
investment.
THE ECONOMIC APPROACH TO THE LABOUR
MARKET
Main assumptions of the baseline neoclassical model (1)
• In the labour market buyers (firms, labour
demand) and sellers (individuals, labour supply)
of labour exchange labour services for pay.
Wages are the price of labour services.
• Agents (buyers and sellers) are rational: on
the basis of their tastes and constraints they try to
maximise their objective function. The objective
of buyers (firms) is to maximise profits; the
objective of sellers (individuals) is to maximise
utility.
Main assumptions of the baseline neoclassical
model (2)
• Markets are competitive. There are many sellers and
buyers which are price takers: they cannot affect wages
or prices which are completely flexible and are set only
by the movements of demand and supply. The
equilibrium wage and price are those determined by
the equality of demand and supply.
• Individuals and firms are homogenous
• Individuals and firms have a complete information
on labour market conditions
• There are no constraints to labour and firms’
mobility
Labour supply
At the aggregate/macroeconomic level, labour supply is the results of
the aggregation of individuals’ decisions relative to:
 Labour market participation
 Fertility decisions and migration flows which define the size of the
working age population
The labour force (LF) function/curve represents the size of the labour
force at different levels of the real wage (W/P).
We assume that aggregate participation increases with the real wage.
At the microeconomic /individual level, labour supply is the result of the
individual choice between work (which determines consumption
possibilities) and leisure (which increases the well being of the
individual).
We assume that the individual may freely choose the amount of work
to supply in the labour market.
LABOUR SUPPLY at the individual level
(1)
The labour supply function (Ls) represents
the behaviour of the sellers of labour.
It indicates the amount of work that
individuals or households are willing to supply
at each wage rate. Labour supply depends on:

Individual tastes and preferences

The real wage rate

Non labour income (which reflects the
system of welfare support such as subsidies or
unemployment benefits).
LABOUR SUPPLY at the individual level (2)
The individual maximise her/his utility function
(which depends on her/his preferences in relation
to consumption and leisure and is represented by
utility or indifference curves) under an income
and time constraint (which depends on the
income she/he may get either working or not and
the time available)
max
U (C , T )
C ,T
s.t .
W
X
C 
L 
P
P
Tmax  T  L
LABOUR SUPPLY (3)
• On this basis decision to participate to the labour markets
depends on the comparison between the (net of taxes) market
real wage and the reservation wage. The individual participate
only if the market wage is greater then the reservation wage.
• The reservation wage is the wage below which individuals do
not wish to work. The reservation wage depends on non labour
income and preferences.
• Changes in non-labour income and tastes shift the position of
the supply curve, while changes in the real wage result in
movements along the supply curve
Labour supply at the individual level
LABOUR SUPPLY (3)
• Any rise in the real wage (W/P) generates two opposite
effects:
a) the increase in the opportunity cost of leisure and home
production generates a subsitution of work for leisure, so
labour supply increases (substtituion effect)
b) the increase in income will consent to “buy” more leisure
and reduces labour supply (income effect)
• In the short run we assume that, given individuals’
preferences and non-labour income, the quantity of labour
supplied is a positive function of the real wage (we assume
that the substitution effect is higher than the income effect
for a relevant range of wages)
Effect of an increase in real wage
income effect > substitution effect
Effect of an increase in real wage
income effect < substitution effect
LABOUR SUPPLY (4)
•
A rise in non labour income (such as unemployment
benefits) reduces labour supply, by increasing the reservation
wage
• All factors which affect the reservation wage and the market
wage affect labour supply: family composition, welfare
subsidies, taxes. But also employment and working time
regulations affect labour supply, especially in the case of
secondary workers (such as married women) .
• In household labour supply models, the secondary worker
considers the primary worker’s wage as non labour income.
Hence changes in the wage of one component of the
household, affect not only his/her labour supply, but also the
labour supply of other components.
Effects of subsidies (non labour income) on labour
market participation
Individual labour supply curve
The effect of child care subsidies on labour market
participation
Estimations of labour supply
• Usually labour supply is estimated using the
following regression:
L=0+ 1W+ 2X+ε
• Empirical studies show that usually:
– men labour supply is not sensible to changes in real
wages (UNELASTIC) (the income effect compensate the
substituion effect)
– Women labour supply is usually sensible to changes in
real wages (ELASTIC) (the substituion effect is usually
prevalent)
Tab 3.4
Extensions of the basic model
Main extensions of the basic model:
– Household models to consider interactions
among households components in labour supply
decisions. These models are very useful to
explain women labour supply.
– Life cycle models to considier the possibility of
changes in preferences and market wages during
the life cycle of individuals. Very useful to
explain how labour supply changes with age
– Human capital models to consider the possibile
interactions among consumption choices,
investment in human capital and labour supply
Main predictions of economic models of
labour supply
– Labour supply decisions reflect individual and household
conditions, preferences, non labour income and market wages.
– The probability to participate to the labour market and hours
supplied usually increase when:
o the market wage increases, but over a certain level of hours
worked and market wage, further increases in wages may reduce
hours worked;
o Non labour income declines;
o The costs to be undertaken in order to work decline, especially
for secondary workers
– Restrictions on working hours oblige individuals to accept
second best solutions and may reduce the labour supply of
secondary workers,
– Taxation and welfare policies affect labour supply differently for
the different components of the household