Chapter 2

Labor Supply

Measurement and Definition

• Labor force (LF) is given by participant either employed (E) and unemployed (U), so LF = E + U.

• Labor force participation rate (LFPR) = LF/P

• Employment Rate (ER) = E/P

• Unemployment Rate (UR) = U/LF

• See attachment A.

Decision• Individual may make a decision about

– Work or not work (binary decision)– If they work, how many working hours?– Occupation and Industry– How long to work at this job? Migration?

• Simple Model– Trade off between leisure (time to rest) and consumption – leisure = total hour – working hour – work more can generate more income and can consume more

• So, we need– Indifferent curve (IC)– Budget Line– Maximization of Satisfaction (utility)

Preferences

• Presented by IC between leisure and consumption

• Properties– Indifferent curve has negative slope – The higher IC indicates to higher level of

utility.. – Individual ICs cannot cross. – ICs are convex to origin. Law of diminishing

marginal utility

Leisure

Consumption

IC1

IC2

Leisure

Consumption

IC1

IC2

Superior

Inferior

Inconclusive

Inconclusive

Slope of IC

• Slope of IC

• The shape of IC can show the worker’s preference about the degree of loving to work or take leisure.

• This show by the slope of IC or MRS, the higher MRS (without considering the negative sign) implies to prefer leisure than consumption whereas the steeper slope of IC means to prefer consumption than leisure.

• So, we can classify individual into two groups which are “workaholic” and “leisure lover”.

• Important factors to determine the decision are personality, occupation, and individual circumstances.

llC

C

MUCMRS

l MU

Budget Constraint

• Decision may have limit on time and income

• income = working hour x wage crate + nonlabor income

• Select the best combination that maximize the utility subject to budget constraint (optimal work – leisure combination)

• Slope of IC = Slope of Budget line

( )C w T l V

Leisure

Consumption

wT+V

V

T0

E

Solutions

• There are two type of solutions– Interior solution – decision between

consumption and leisure are neither zero unit– Corner solution – either consumption or

leisure are zero unit

• Explanation for zero working hour– High Reservation wage rate– Very high non-labor income– Preference

Leisure

Consumption

wT+V

V

T0 l

w(T- l)+V

E

P

Leisure

Consumption

wT+V

V

T0

E

Leisure

Consumption

196

100

T0 l = 9.8

156.8

E

P

U = 3.956

U = 3.860

Slope is - 4

Change in Non-labor Income• Change in non-labor income when wage rate still

constant Change in leisure hour at wage rate constant “Income effect”

• The increasing/decreasing of non-labor income extends the possible set.

• Shift the budget line (slope of budget line constant)

• Some government’s program is shifting non-labor income such as pension for older, 2000Bt at April 2009

• There are two possibilities– Leisure is normal good (increasing leisure, work less)– Leisure is an inferior good (reducing leisure, work

more)

Leisure

Consumption

T0 l1

C1

E

P

QC2

l2

Leisure is normal good

Leisure

Consumption

T0 l1

C1

E

P

Q

l2

C2

Leisure is inferior good

Change in Wage rate

• Chang in wage rate change in working hour change in working hour when maintain income constant substitution effect

• We need to decompose effect of changing in wage rate into substitution effect and income effect

• total effect = substitution effect + income effect

• Increasing of wage rate implies to increasing cost of leisure

• If you rest more, you may have more opportunity cost due to wage rate increases.

• Leisure = loss of time to work = opportunity cost • If the price of leisure increases, we have to buy less

leisure.• In general, price increases less leisure (work

more)• However, if the price if extremely increases, there

are possible that income effect may dominate substitution effect.

Leisure

Consumption

T0 l1

C1

E

P

QC2

l2

Decomposing

• Draw before and after price change situation

• Keep wage rate constant (same slope) at the same level of new satisfaction (shift income to new IC)

• l1 l2 is total effect

• l2 l3 is substitution effect

• l1 l3 is income effect

Leisure

Consumption

T0 l1

C1

E

P

QC2

l2 l3

R

Substitution Effect Dominates

Leisure

Consumption

T0 l1

C1

E

PQ

C2

l2l3

R

Income Effect Dominates

Effect Dominates

• There are two possible outcomes

• Substitution Effect dominates Income Effect Work More (Less Leisure) because income effect is not high enough to induce individual to rest more

• Income Effect dominates Substitution Effect Work Less (More Leisure)

Reservation wage rate

• Theoretically, there are such a wage rate that individual is indifferent between work and rest.

• We call this rate as “reservation wage”, if

• Offered wage rate > reservation rate work

• Offered wage rate < reservation rate Not

• From figure, reservation wage is w2

Leisure

Consumption

T0

w1

E

P

w3

w2

F

IC1IC2

IC3

Individual Supply of Labor

• Note Supply is a component of willing to work at specific wage rate

• Utility Maximization means that willing to do at optimal point

• In some case, we may find the backward shape due to the income effect dominant

• Depends on MRS at each point of IC

Leisure

Consumption

T0

w1

E

P

w3

w2

F

IC1IC2

IC3

w4

Q

Working Hours

Wage rate

0

w1

E

Pw3

w2

F

w4Q

Substitution effect > Income Effect

Substitution effect < Income Effect

Fact about Labor Supply

• Male Income Effect > Sub Effect , then when wage increase Take more leisure

• Female Sub Effect > Income Effect Labor supply curve is steep

• Because, men already work of 90% of their time, no housework, then elasticity is low

• Leisure are not perfectly substituted product to work

• Female LFPR is lower than male because the housework

• Married women has elastic (highly substitutable) for leisure and work work for money use money for house service full time work

• They may have three choices, work in labor market, work in house, leisure

• How about high education women?

• Female reservation wage decrease more LFP because – Fertility Number of children and cost of

children – Household production-technology change– Demand for female labor– Attitude about female work– Marital status and Stability

• Children is normal good– Increasing in income more children

• Rural and Urban– Rural families have more children than urban

families– Differential female wage rate between rural

and urban– Government policy about fertility– Socioeconomic

• Read – Becker, Gary S. 1965. “A Theory of the

Allocation of Time,” The Economic Journal, September, pp. 493-517.

Estimation of Elasticity

• Elasticity of Supply

• The estimation equation

%

%

h h w

w w h

i i i ih w v X

Problem of Estimation

• What’s happen if there are individuals who didn’t work for long time?, so and doesn’t exist.

• For this group, how do you take care of the wage rate?

• How do you correctly collect the data about non-labor income?

• The unit of hour of work, should it be weekly, monthly, or yearly?

• Technical problem– Measurement Error– Exogeneity– Sample Selection Heckman Selection Method

Policy Implication

• Policy in Text book (Please read your text book)

• a) Labor supply of woman• b) Cash Grant • c) The Earned Income tax Credit• d) Transfer 2000 Bt.**• e) Limit working hour • f) Overtime (OT)

Transfer 2000 Bt.**

Note that both cases increase consumption that is an objective of government transfer program

Leisure

Consumption

wT+V

V

T0

E

Limit working hour

wH*+V

l =T-H*

H*

F

Leisure

Consumption

w**T+V

V

T0

E

Overtime

w*(T-H*)+wH*+V

l =T-H*

FwT+V

G

Retirement Decision

• In case of there is no mandatory retirement age

• Age at retirement depends on– Wage rate and Pension– Wage rate increase substitution effect– Pension increase income and substitution

effects