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Chapter 2

Labor Supply

Note: 본강의자료는 The McGraw Hill Companies에서제공한 Slides와 ‘Personal Economics in Practice (E. Lazear & M. Gibbs)’의일부를활용하여편집되었음.

2

Introduction to Labor Supply• Ch. 2 (Labor Supply) focus on issues of

worker behavior (worker’s decision)

– Whether to seek employment (whether to work or not)

– If so, how long to work

3

In this chapter, look for the answers to these questions:

• Measuring LF

• Model of Labor-Leisure Choice

• Why women’s work propensities rose and hours of work declined

• Do welfare programs reduce incentives to work?

• Does a cut in the income tax rate increase hours of work?

• What factors explain the rapid growth of women’s LFPR?

3

4

Introduction to Labor Supply• Ch. 2 (Labor Supply) focus on issues of

worker behavior (worker’s decision)

– Whether to seek employment (whether to work or not)

– If so, how long to work

5

Introduction to Labor Supply• Labor force participation (LFP) rate

66

20

30

40

50

60

70

80

90

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

LFPR by Gender, 1950-2007

Men

Women

Note: PowerPoint Slides by Ron Cronovich의자료를참조함.

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Why?

• women• New technologies (washer, refrigerator, dish

washer, etc.)• Improved birth control• Etc.

• men• Stay longer at school• Retire earlier and live longer

8


9


10


11

30

35

40

45

50

55

60

1900 1920 1940 1960 1980 2000 2020

Year

Wee

kly ho

urs

• Trends in Hours of Work (1900-2007)

Introduction to Labor Supply

12

Measuring the Labor Force• LF statistics produced by Statistics

Korea (KOSTAT) in Korea and – the Bureau of Labor Statistics (BLS) in the

U.S. Dept. of Labor in U.S. • Based on regular survey of 32,000

households in Korea– Based on regular survey of 60,000

households in U.S.• Based on “adult population” (15/16 yrs

or older)

13

Measuring the Labor ForceKOSTAT/BLS divides population into 3 groups:– Employed: paid employees, self-employed,

and unpaid workers in a family business

– Unemployed: people not working who have looked for work during previous 4 weeks

– Not in the labor force: everyone else

The labor force is the total # of workers, including the employed and unemployed.

14

Measuring the Labor Force

• as of Aug. of 2013(1,000 people), 15+pop: 42,168, LF: 26,074,• Employed: 25,291; unemployed: 783

15

Measuring the Labor Force

labor force participation rate

labor forceadult population

= 100 x

Labor force participation rate: % of the adult population that is in the labor force

Unemployment rate (“u-rate”): % of the labor force that is unemployed

u-rate # of unemployedlabor force

= 100 x

16

Measuring the Labor ForceEmployment rate : % of adult population that is employed

Emp-rate # of employedAdult population

= 100 x

Calculate labor force statistics

17

Compute the labor force, u-rate, adult population, and labor force participation rate using this data:

Adult population by group

# of employed 145.9 million

# of unemployed 8.5 million

not in labor force 79.2 million

Labor force = employed + unemployed

= 145.9 + 8.5

= 154.4 million

U-rate = 100 x (unemployed)/(labor force)

= 100 x 8.5/154.4

= 5.5%

Answers

18

Adult Population = labor force + not in labor force

= 154.4 + 79.2

= 233.6

LF partic. rate = 100 x (labor force)/(population)

= 100 x 154.4/233.6

= 66.1%

Answers

19

20

Limitations of the U-rateIn each of the following, what happens to the u-rate? Does the u-rate give an accurate impression of what’s happening in the labor market?

A. Sue lost her job and begins looking for a new one.

B. Jon, a steelworker who has been out of work since his mill closed last year, becomes discouraged and gives up looking for work.

C. Sam, the sole earner in his family of 5, just lost his $80,000 job as a research scientist. Immediately, he takes a part-time job at McDonald’s until he can find another job in his field.

Answers

21

A. Sue lost her job and begins looking for a new one.

u-rate rises. A rising u-rate gives the impression that the labor market is worsening, and it is.

B. Jon has been out of work since last year, becomes discouraged, stops looking for work.

Discouraged workers would like to work but have given up looking for jobs classified as “not in the labor force” rather than

“unemployed”

U-rate falls because Jon is no longer counted as unemployed. A falling u-rate gives the impression that the labor market is improving, but it is not.

Answers

22

C. Sam lost his $80,000 job, and takes a part-time job at McDonald’s until he finds a better one.

U-rate unchanged because a person is “employed” whether they work full or part time.

Things are worse, but the u-rate fails to show it.

23

What Does the U-Rate Really Measure?

• The u-rate is not a perfect indicator of joblessness or the health of the labor market:– It excludes discouraged workers.– It does not distinguish between full-time and

part-time work, or people working part time because full-time jobs not available.

– Some people misreport their work status in the KOSTAT/BLS survey.

• Despite these issues, the u-rate is still a very useful barometer of the labor market & economy.

24

Employment Rate

• The employment rate (Emp/15+Pop) can be a better measure of fluctuations in economic activity than the unemployment rate.

25

LFP Stylized Facts(2-2. Basic Facts about LF)

• LFP has decreased for men over the age of 65 from 63% in 1900 to under 20% by 2000. (table 2-1)

• LFP increases with education. (table 2-3)

26

• More women than men work part-time. (table 2-3)

• More men who are high school drop outs work than women who are high school drop outs. (table 2-3)

• White men have higher participation rates and hours of work than black men. (table 2-3)

LFP Stylized Facts(2-2. Basic Facts about LF)

27

Main question (theme) of this chapter

• In supplying Labor, human beings are a diverse lot. (Adam, Anderson, Brown…)

• How are these diverse labor supply decisions made? How do individuals decide on the # of hours of work

• Our main goal is to develop and apply a basic theory of ind. LS that will help answer these question.

• Are you going to work? If so, How many hours work? • To answer, we will use “Neo-Classical Model of

Labor(work)-Leisure Choice”

28

Neo-Classical Model ofLabor-Leisure Choice

Need basic microeconomics concepts (consumption choice model/theory)

• Utility function & Indifference curve• Budget constraint• Optimization• Income and substitution effects

29

Neo-Classical Model ofLabor-Leisure Choice

1. Utility Function

– Measure of satisfaction that individuals receive from consumption (C) of goods and leisure (L).

– U = f(C, L), (ex: U(C, L) = C3L2)

• U is an index.• Higher U means happier person.

30

2. Indifference Curves: Combination points of C & L that generate (yield) a

particular level of Utility/satisfaction (same utility)

31

2. Indifference Curves: properties

• Downward sloping, indicating the tradeoff between consumption and leisure.

• Higher curves = higher utility.

• Do not intersect.

• Convex to the origin, indicating that MRS diminish.

32

2. Indifference Curves: slope

C

L

MUMU

LC

- (need to know “total derivative”)- Marginal rate of substitution (MRS) of

leisure for consumptionMRSLC: maximum amount of C that a

person is willing to give up in order to obtain one additional unit of L, while holding U constant.

33

2. Indifference curve: Differences in Preferences

- Who is “workaholic”/ “leisure lover”?

34

3. The Budget Constraint / Budget line

• The limit on the consumption bundles (C, L) that a consumer (a worker) can afford.

• The boundary of the worker’s opportunity set of all the consumption baskets the worker can afford.

• Derivation- C = wh + V– Consumption equals labor earning (wages ×

hours of work) plus non-labor income (V).– As h = T – L, can rewrite C = w(T – L) + V.

35

Graphing the Budget Constraintdepicting the BC

T

EV

wT+V

0

Hours ofLeisure

Consumption ($)

Budget Line

36

1st question: The Hours of Work Decision• Individuals 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 (MRS)

between consumption and leisure equals the wage. (MRS = wage)

– Any other consumption – leisure bundle on the budget constraint would give the individual less utility.

37

Optimal Consumption and Leisure

$1100

$1200A Y

$500 P

U1

$100U0

U*

E

110

110

40

70

0

0Hours of Work

Hours of Leisure

38

Policy Implications

1. What happens to h (hours of work) when NON-LABOR INCOME changes?

- if leisure is normal good

- if leisure is an inferior good (IC flat)

2. What happens to h (hours of work) when WAGE changes?

- when the Income effect dominates

- when the Substitution effect dominates

39

The Effect of a Change in Nonlabor Income on Hours of Work

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.

F1

P1

$200

U1

U0

E1

E0

P0

70 80 110

F0

$100

Consumption ($)

Hours of Leisure

40

The Effect of a Change in NonlaborIncome on Hours of Work

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 inferior, hours of work increase.

F1

P1

$200

U1

U0

E1

E0

P0

7060 110

F0

$100

Consumption ($)

41

500

350

The Effects of a Price Change

Quantity of Fish

Quantity of Mangos

1200

600

300150 600

initial optimum

new optimum

Initially,PF = $4PM = $1Total budget: $1,200

PF falls to $2budget constraint rotates outward,Hurley buys more fish and fewer mangos.

42

A fall in the price of fish has two effects on Hurley’s optimal consumption of both goods. Income effect

A fall in PF boosts the purchasing power of Hurley’s income, allows him to buy more mangos and more fish.

Substitution effect A fall in PF makes mangos more expensive relative to fish, causes Hurley to buy fewer mangos & more fish.

Notice: The net effect on mangos is ambiguous.

The Income and Substitution Effects

43

The Income and Substitution Effects

Initial optimum at A.

PF falls.

Substitution effect:from A to B, buy more fish and fewer mangos.

Income effect:from B to C, buy more of both goods. Quantity

of Fish

Quantity of Mangos

A

B

C

In this example, the net effect on mangos is negative.

In this example, the net effect on mangos is negative.

44

More Leisure at a Higher WageWhen the income effect dominates the substitutioneffect, the worker increases hours of leisure inresponse to an increase in the wage.

G

U1

QD

D

R

P

U0

V

F

E

8575 1100 70 Hours of Leisure

Consumption ($)

45

More Work at a Higher WageWhen the substitution effect dominates the incomeeffect, the worker decreases hours of leisure inresponse to an increase in the wage.

G

D

D

F

E

U1

Q

R

P

U0

V

8070 1100 65

Consumption ($)

Hours of Leisure

46

• Are the “terms of trade” sufficiently attractive to “bribe” a worker to enter the labor market?

• Reservation wage: the lowest wage rate 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

2nd question: To Work of Not to Work?

47

The Reservation Wage

H

Y

GX

UH

E

U0

Hours of LeisureT0

Has Slope -whigh

Has Slope -w

Consumption ($)

48

• Prove the following statement using Figure 2-6. “the reservation wage increases as nonlabor income

increases”

49

2-7. Labor Supply Curve(deriving a LSC)

• 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 the income effect).

– If the income effect begins to dominate the substitution, hours of work decline as the wage rate increases (a negatively sloped labor supply curve).

51

The Backward Bending Labor Supply Curve

Hours of Work0

Wage Rate ($)

4020 30

10

20

25

52

Labor Supply Elasticity• The labor supply elasticity (σ) measures

responsiveness in hours worked to changes in the wage rate.

– Labor supply elasticity less than 1 is inelastic as hours of work respond proportionally less than the change in wages.

– Labor supply elasticity greater than 1 is elastic as hours of work respond proportionally more than the change in wages.

hw

wh

ww

hh

winchangehinchange

%%

Example: Calculate labor supply elasticity

53

1. When the wage was $10 per hour, she works 1,900 hours of work per year. The wage then increased to $20 per hour, and she decided to work 2,090 hours of work per year. What is the wage elasticity of labor supply?

2. When the wage was $10 per hour, a group of workers supplied 30 hours of work per week on average. The wage then increased to $12 per hour, and the same group of workers supplied 33 hours of work per week on average. What is the elasticity of labor supply for this group of workers?

54

Empirical results of σ• The labor supply elasticity (σ) of men is

roughly around -0.1– 10% in wage increase leads 1% decrease in

working hours for men.– 1% increase (substitution effect)– 2% decrease (income effect)– Income effect dominates

• Differs greatly b/t men and women and b/t younger and older workers

55

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 (upward sloped labor supply curve).

56

Growth in Female Labor Force Participation Rates and the Wage, Cross Countries 1960-80

• 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.

1 2 3 4 5 6 7 8 9

Percentage Change in Wage

0

1

2

3

4

5

6

7

Fem

ale

Par

ticip

atio

nG

row

th R

ate

of

USSR

United States

Israel Britain

France

Sweden

Germany

Italy

Australia

Spain

Japan

Netherlands

57

Derivation of the Market Labor Supply Curve from Individual Supply Curves

0 0 0

w~B

w~A

w~B

w~A

hA

hA + hB

(a) Alice (b) Brenda (c) Market

Wage Rate ($) Wage Rate ($) Wage Rate ($)

Hours of Work

hA

hB

58

2-10. Policy Application: Welfare Programs and Work Incentives

• Cash grants (take-it-or-leave-it) reduce wage incentives.

• Welfare programs create work disincentives.

• Welfare reduces supply of labor by increasing nonlabor income, which raises the reservation wage.

59

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.

F

Consumption($)

500

Hours of Leisure

0 11070

GU1

U0

P

60

Effect of a Welfare Program on Hours of Work

Hours ofWork

$500

U0 U1

G

E

P

F

R

Q

H

D

D

0 11010070

slope = -$5

slope = -$10

Consumption ($)

• cash grant of $500 and imposes a 50% tax on labor earnings. - reduces work incentives

• In the absence of welfare, the worker is at P.

• the income effect resulting from the program moves the worker to Q;

• the substitution effect moves the worker to R.

• Both income and substitution effects reduces h.

61

Policy Application:The Earned-Income Tax Credit

• The EITC should increase labor force participation of nonworkers of targeted groups.– The EITC encourages some non-workers to

start working and never encourages a worker to quit working.

• The EITC produces an income effect.– Hours worked should change.

62

The EITC and the Budget Line

Hours of Leisure

Consumption($)

110

10,350

13,520

14,490

17,660

33,178

E

J

H

G

F

Net wage is 40% above the actual wage

Net wage equals the actual wage

Net wage is 21.06% below the actual wage

63

How does the EITC affect labor supply?

• Graphical illustration [figure 2-17]• Evidence- Nada Eissa and Jeffree B. Liebman, “Labor supply response to the Earned Income Tax Credit,” QJE 111(May 1996) - Marianne Bertrand, Esther Duflo, and Sendhil Mullainathan, “How Much Should We Trust Difference-in-Difference Estimates?,” QJE 119(Feb. 2004)

64

Discouraged worker – unemployment statistics

• Open question? – page 72

65

2-12. Labor Supply over the Life Cycle

• Wage rates change over the worker’s life (over the life cycle).– Wages are low when young.– Wages rise with time and peak around age 50.– Wages decline or remain stable after age 50.

• The changes in wages over the life cycle are “evolutionary” wage changes that alter the price of leisure.

66

Theoretical Issues of Evolutionary Wages

• A person will work more hours when wages are higher (i.e., the substitution effect tends to dominate the income effect).

• The profile of hours of work over the life cycle will have the same shape as the age-earnings profile.

• Intertemporal substitution hypothesis: people substitute their time over the life cycle to take advantages of changes in the price of leisure.

67

The Life Cycle Path of Wages and Hours for a Typical Worker

Age

Wage Rate

50 Age

Hours of work

50

• A person will work few hours in those periods of the life cycle when the wage is low and will work many hours in those periods when the wage is high. (intertemporal substitution hypothesis)

68

Hours of Work over the Life Cycle for Two Workers with Different Wage Paths

Age

Jack

t* Aget *

Joe

Wage Rate Hours of

Work

Jack

Joe (if substitution effect dominates)

Joe (if income effectdominates)

Joe’s wage exceeds Jack’s at every age. Although both Joe and Jack work morehours when the wage is high, Joe works more hours than Jack if the substitutioneffect dominates. If the income effect dominates, Joe works fewer hours than Jack.

69

Labor Force Participation Rates over the Life Cycle in 2005

30

40

50

60

70

80

90

100

15 25 35 45 55 65

Age

Labo

r fo

rce

part

icip

atio

n ra

te

Male

Female

70

Hours of Work over the Life Cycle in 2005

500

1,000

1,500

2,000

2,500

15 25 35 45 55 65

Age

Ann

ual h

ours

of w

ork

Male

Female

The available evidence suggests that both LFPR and hours of work respond toevolutionary wage changes.Three exists “intertemporal substitution hypothesis”

71

Labor Supply in Recessions: The “Discouraged” vs. the “Added” worker. (Labor Supply Over the Business Cycle)

• Consider, for example, a “traditional” family in which market work is performed by the husband and in which the wife is employed full time in the home.

• What will happen if a recession causes the husband to become unemployed?

72

Labor Supply in Recessions: The “Discouraged” vs. the “Added” worker.

• Added-worker effect.– So-called “secondary” workers currently out of

the labor market are affected by a recession because the main breadwinner becomes unemployed or faces a wage cut.

– A secondary worker may choose to enter the labor force during these bad times

– The labor force participation rate of secondary workers (i.e., the added worker effect) is counter-cyclical.

73

• Discouraged worker effect.

– Unemployed workers find it very difficult to find jobs during a recession, so they give up searching.

– Discouraged workers exit the labor force during bad times.

– The labor force participation rate of discouraged workers is pro-cyclical.


74

• The discouraged worker effect dominates the added-worker effect, especially during recessions.– Unemployment insurance benefits– Confined– Substitution effect is relatively strong for

married women


75

Retirement• Lifetime income is higher the longer a worker

puts off retirement.

• If pension benefits are constant, wage increases have a substitution and income effect, so lifetime income might not be altered.

• An increase in pension benefits reduces the price of retirement, increasing the demand for leisure and encouraging the worker to retire earlier.

76

The Impact of the Social Security Earnings Test on Hours of Work

• The Social Security earnings test (which taxes retirees when they earn more than $17,000 per year) generates the budget “line” that affects behavior in varying ways.

• The repeal of the earnings test moves retirees to another budget line, as a result:– One retiree would not change his hours of work.– A second retiree would reduce his hours.– A third retiree might increase or decrease his hours,

depending on whether substitution or income effects dominate.

77

2-14. Fertility: LR LS

• Malthus Theory of Fertility: as incomes rise, families want more children (children are normal goods so the income effect is large).

• Malthusian model of fertility failed to predict what actually happened to fertility behavior. → as per-capita incomes rose, fertility rates did not rise, actually fallen.

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• Malthus Theory of Fertility explains the fertility by stressing that fertility depends only income.

• 50 years ago (1960), Gary Becker introduced PRICE also to explain the fertility and got the Nobel prize.

79


• An increase in the price of a person’s time (i.e., an increase in the wage) increases the opportunity cost of exiting the labor market to rear children.

80

The Fertility Decision

Goods

I/pX

Number of Children

P

Indifference Curve

3 I/pN

The household’s utility depends on the number of children and on the consumption of goods. A utility-maximizing household chooses point P and has three children.

81

The Impact of Income and Prices on the Household’s Fertility

U0

U0

U1

U1P

P

R

43 Number of Children

Goods

Goods

D

R

21 3 Number of Children

Q

I/PX

(a) Increase in Income

(b) Increase in the price of children

82

Summary• Reservation wage• Utility-maximizing worker• ↑ in non-labor income• ↑ in wage• Labor supply elasticity• Welfare program create work disincentives…

83

End of Chapter 2

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