ECON 370 - Lecture 3-5 - LabourEconomics

Maggie Jones

Labour Supply: IndividualAttachment to the Labour Market

Labour Supply

I Is supply upward sloping?

I Intuitively it makes sense that higher wages generate an

“incentive” e↵ect, wherein people are incentivized to work

more when the wage increases

I This may not always be the case (we will see why/where)

I Concept that people will work more when wages are higher is

still at the heart of the study of labour supply

I We will study how this a↵ects the decision to work (extensive

margin) and how much to work (intensive margin)

Extensive Margin: To Participate orNot

Labour Force Participation

I labour force participation decision: to participate in paid

labour market activities or not

I as opposed to: unpaid work in the home, volunteer work,education, retirement

I has implications for the size and composition of the labourforce

I a↵ects unemployment, economic growth, occupation andgender composition

I these, in turn, a↵ect relative wages, unionization, daycare,equal pay, etc.

The Labour Force

I potential labour force: consists of everyone who is eligiblewho participates in labour market activities

I eligible: civilian non-institutional population, 15 years old+,excluding the territories and Indian reserves

I labour force: those in the “potential labour force” who are

in the labour force

I employed: those in the labour force who did any work during

the survey period, or those in the labour force who were ill or

on strike, but otherwise would have been working, during the

survey period

I unemployed: those in the labour force who are not

employed, but are seeking work

Participation vs. Unemployment

I labour force participation rate: fraction of eligible

population who is in the labour force

I unemployment rate: fraction of those in the labour force

that is unemployed

Labour Force Participation Rate OverTime

Labour Force Participation RateAcross Countries

Labour Force Participation RateAcross Countries

LFPR vs.Per Capita Log GNI

Intensive Margin: How Much toParticipate

Hours Worked

I The “hours worked” decision encompasses more than just how

many hours to work

I hours per day, days per week, weeks per year

I In the short-run, hours of work are relatively fixed

I Occupation choice, flexible working hours, additional part-time

jobs, allow hours worked to be more variable than we may

assume

Distribution of Hours Worked

Basic Income-Leisure Model

Labour Supply Model

I We want to represent an individual’s choice of hours worked,

given their market opportunities and the value they place on

non-market activities

I We will assume that individuals do the best they can

(optimize) with the time they have (constraints) given their

individual preferences

I Our model is grounded in the canonical consumer theory

model

Preferences

I Starting point is to provide a framework for modelling

individual preferences

I We will assume there are two goods

I Consumption goods: things you can buy in the marketI Leisure: time spent doing all non-labour market activities

(household work, education, etc.)

I Preferences can be graphically represented by indi↵erencecurves which depict all the potential combinations of

consumption and leisure that yield the same utility

Consumption

Leisure

Consumption

Leisure

Consumption

Leisure

Constraints

I We assume that individuals want to reach the highest

indi↵erence curve subject to the constraints they face

I MoneyI Time (which e↵ectively equals money in this framework)

I Let price of consumption good be P so that the value of

consumption is P ⇥ C

I Ignore savings so that income equals the value of consumption

I This allows us to transfer our consumption-leisure framework

to an income-leisure framework

I Understanding the constraints agents face helps us to

determine the set of feasible income-leisure combinations from

which the consumer can choose

Income

Leisure

Income

Leisure

Income

Leisure

Consumer’s Optimum

I Putting together the individual’s budget constraint and

preferences (i.e. indi↵erence curves) yields the consumer’s

optimal allocation of labour/income-leisure

I in other words, the individual’s labour supply

Income

Leisure

Income

Leisure

I Let’s consider the individual’s decision to work when faced

with specific wage rates

I When MRS > wage the individual will not workI When MRS < wage the individual will increase hours until

MRS = wage

I E.g. Suppose you value one hour of leisure at $10. Someone

o↵er’s you $8 to complete a task that requires an hour of your

time. Would you complete this task?

Income

Leisure

Reservation Wage

I This analysis illustrates the idea at the core of the

reservation wageI The wage rate at which the individual is indi↵erent between

working and not working (labour and leisure)I It equals the slope of the individual’s indi↵erence curve at 0

hours worked (T)

Income

Leisure

Comparative Statics

Comparative Statics

I We are now equipped with the basic framework required to

analyze how individual’s will respond to changes in the

underlying economic environment

I changing non-labour incomeI changing the wage rate

I First we need to consider how the purchase of leisure will be

a↵ected by changes in income if leisure is a:

I normal good: " income ! " demand for leisureI inferior good: " income ! # demand for leisure

I Whether leisure is normal or inferior depends entirely on

preferences (most empirical evidence points to leisure being

normal)

Changing Non-Labour IncomeIncome

Leisure

Income

Leisure

Changing Wages

Increasing the wage rate has two opposing e↵ects:

I income e↵ect: for each hour of work the individual can buy

more goods including leisure. If leisure is a normal good this

means the “purchase” of more leisure and a decline in the

number of hours worked.

I substitution e↵ect: return to work is greater so the

individual may choose to work more in response to a wage

hike. The opportunity cost of leisure has increased, i.e. we

have a shift in the relative price of leisure (it is more

expensive). The individual will increase the number of hours

worked.

The overall e↵ect depends on whether the income or substitution

e↵ect dominates.

Income

Leisure

Changing Wages

Note that increasing the wage can never cause people to not

participate in the labour force. That is, LFP will not decrease

because of increases in the wage rate. Individuals can always reach

higher indi↵erence curves, and will not choose the lower IC that

will lead to no participation.

Increasing the wage could result in labour force participation

among people who otherwise would not participate.

In this sense, increases in the wage rate cannot decrease LFP, but

could potentially increase it.

Wage Elasticities of Supply

I uncompensated elasticity:

%�hours

%�wage

I compensated elasticity:

%�hours attributed to substitution e↵ect

%�wage

The Individual Labour Supply Curve

Individual Labour Supply

I Using our leisure-income model, we can examine how varyingthe wage rate will a↵ect individual’s optimal labour-leisurechoice in order to map out their labour supply.

I i.e., how much labour would the individual supply at eachvalue of the wage?

I0 hours until the wage = reservation wage

Isubstitution e↵ect dominates at low initial levels of the wage

Iincome e↵ect dominates as individual becomes wealthier

I At low wages the individual has an abundance of needs thathigher wages can help address. As wages rise and these needsare met, the individual does not need as much extra moneyand can begin to reduce labour supply.

Individual Labour Supply CurveIncome

Leisure

Income

Leisure

Barriers in the Labour Market

I Assumption underlying our model is that individuals canchoose any labour-leisure combination given their budgetconstraint and preferences.

I In practice this may not be realistic.I

e.g. suppose you wish to work 35 hours per week, but your

employer requires 40

Ie.g. suppose you wish to work 12 hours per day, but your

store is only open for 8

I It turns out that we can incorporate these barriers into ourbasic income-leisure model.

Moonlighting & Underemployment

Income

Leisure

Overemployment

Income

Leisure