Chapter 2
Labor Supply
McGraw-Hill/Irwin
Labor Economics, 4th edition
Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.
2- 3
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
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Measuring the Labor Force
• Current population survey (CPS)
- Labor Force = Employed + Unemployed
• LF = E + U
• Size of LF does not tell us about “intensity” of work
- Labor Force Participation Rate
• LFPR = LF/P
• P = civilian adult population 16 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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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
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Average hours worked/week, 1900-2005
60
Weekly hours
55
50
45
40
35
30
1900
1920
1940
1960
Year
1980
2000
2020
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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, 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 ($)
500
450
400
40,000 Utils
25,000 Utils
Hours of
100+ 125
150
Leisure
2- 11
Indifference Curves Do Not Intersect
Consumption ($)
Y
Z
U1
U0
0
Leisure
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Differences in Preferences across Workers
Steep and flat indifference curves:
Consumption ($)
Consumption ($)
U1
U1
U0
U0
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
0
T
Hours of
Leisure
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
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Optimal Consumption and Leisure
$1200
$1100
Y
A
P
$500
U1
U*
E
$100
U0
0
110
70
40
110
0
Hours of
Leisure
Hours of
Work
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Two Effects
• Increase in nonlabor income allows worker to “jump” to higher
indifference curve, indicating the Income Effect
- Leisure can be treated as a normal good or as an inferior
good
• As wages change holding real income constant, changes in
consumption-leisure bundle indicate the Substitution Effect
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The Effect of a Change in Nonlabor Income on
Hours of Work
Consumption ($)
F1
F0
$200
P1
U1
P0
U0
$100
E1
E0
70 80
110
Hours of
Leisure
An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the
worker from point P0 to point P1. If leisure is a normal good, hours of work fall.
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The Effect of a Change in Nonlabor Income on Hours of
Work
Consumption ($)
F1
F0
P1
U1
P0
$200
$100
U0
E1
E0
60
70
110
An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the
worker from point P0 to point P1. If leisure is an inferior good, hours of work increase.
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Ambiguous Relationship: Hours Worked and Wage
Rates
• If the Substitution Effect is greater than the Income Effect, then
hours of work increase when the wage rate rises
• If the Income Effect is greater than the Substitution Effect, then
hours of work decreases when the wage rate rises.
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More Leisure at a Higher Wage
• When the Income Effect dominates:
Consumption ($)
G
U1
R
D
Q
U0
D
F
P
V
E
0
70 75
85
110
Hours of
Leisure
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More Work at a Higher Wage
• When the Substitution Effect dominates:
Consumption ($)
U1
G
R
D
Q
U0
F
D
P
V
E
0
65 70
80
110 Hours of
Leisure
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To Work or Not to Work?
• Are the “terms of trade” sufficiently attractive to bribe a worker
to enter the labor market?
• Reservation wage: the minimum increase in income that would
make the person indifferent between working and not working
- Rule 1: if the market wage is less than the reservation wage,
then the person will not work
- Rule 2: the reservation wage increases as nonlabor income
increases
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The Reservation Wage
Consumption
($)
H
Has Slope -whigh
Y
G
X
UH
E
U0
Has Slope -w
0
T
Hours of
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
• 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 ($)
25
20
10
0
20
30
40
Hours of
Work
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Labor Supply of Women
• Substantial cross-country differences in women’s labor force
participation rates
• Over time, women’s participation rates have increased
• In most studies on women, substitution effects dominate
income effects
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Derivation of the Market Labor Supply Curve from
the Supply Curves of Individual Workers
Wage Rate ($)
Wage Rate ($)
Wage Rate ($)
hB
hA
~
wA
0
(a) Alice
hA + hB
~
wB
~
wA
~
wB
0
(b) Brenda
hA
0
(c) Market
Hours of
Work
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Cross-Country Relationship: Growth in Female
Labor Force and the Wage, 1960-1980
7
Netherlands
Female Participation
Growth Rate of
6
5
A us tralia
J apan
4
Italy
3
S weden
USS R
Is rael
B ritain
S pain
2
Franc e
Germany
1
United States
0
1
2
3
4
5
6
7
Perc entage Change in Wage
•
Source: Jacob Mincer, “Intercountry Comparisons of Labor Force Trends and of Related Developments:
An Overview,” Journal of Labor Economics 3 (January 1985, Part 2): S2, S6.
8
9
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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
U1
500
U0
0
70
110
Hours
of
Leisure
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Effect of a Welfare Program on Hours of
Work
Consumption ($)
F
U0
U1
slope = -$10
H
D
slope = -$5
Q
R
P
$500
D
G
E
0
70
100
110
Hours of
Work
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Policy Application: The Earned-Income Tax
Credit
• EITC should increase labor force participation of nonworkers
of targeted groups
• EITC produces an income effect
- Hours worked should change
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EITC and Labor Supply
• In the absence of the tax credit, the budget line is given by FE.
The EITC grants the worker a credit of 40 percent on labor
earnings as long she earns less than $10,350. The credit is
capped at $4,140. The worker receives this maximum amount
as long as she earns between $10,350 and $13,520. The tax
credit is then phased out gradually. The worker’s “net” wage is
21.06 cents below her actual wage whenever she earns between
$13,520 and $33,178.
• This is shown in the next slide, (not drawn to scale).
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The EITC and the Budget Line
Consumption
($)
F
G
Net wage is 21.06% below the actual wage
33,178
17,660
H
Net wage equals the actual wage
J
14,490
13,520
Net wage is 40% above the actual wage
10,350
E
110
Hours
of
Leisure
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The Impact of the EITC on Labor Supply
The EITC shifts the budget line, and will draw new
workers into the labor market.
In (a), the person enters the labor market by
moving from point P to point R. The impact of the
EITC on the labor supply of persons already in the
labor market is less clear.
In the shifts illustrated in (b) and (c), the
worker reduced hours of work.
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End of Chapter 2