Supply of Labor

1. Supply of Labor

2. Labor Supply • Different questions to be asked: • Work or don’t work • Number of hours of work effort • Occupational choice • Locational choice • Individuals can work at home or work for pay, initially we will ignore household production or treat it the same as work for pay with the “payment” to household as an implicit wage contributing to “total” household income.

3. Labor Force Participation and Hours Worked • The most startling change has been the increased participation rate of women in work for pay. • The participation rate for younger and older men have fallen. • Hours worked in the short-run may be largely determined on the demand-side (pro-cyclical with the business cycle), but labor supply decision also impact them, particularly in the longer-run). • Over the last 100 years, the average work week in manufacturing has fallen.

4. The Decision to Work • Household supply labor in the resource markets and demand goods and services in the goods and services markets. • The goal of a rational household is to maximize their satisfaction or utility. • Utility flows from goods and services but most individuals need to generate income to purchase the goods and services. The primary source of income in the U.S. (70%) is labor income. • The demand for products comes from utility maximization • QD= F (P, Y or W, PR, T, E)

5. Individuals also value leisure so economist look at the supply decision as a household trying to maximize utility from income (which is a proxy for command over goods and services) and leisure. • Wealth is the stock of all financial and non-financial assets owned by and individual and income is the flow of purchasing power a household receives in a given time period. • In the simple case of no wealth or the stock of wealth remaining constant, income flows from the supply of labor. • The opportunity cost of leisure is the the command over goods and services sacrificed by not working or the wage rate.

6. Income and Substitution Effects • Similar to the scale and substitution effects in labor demand, a household has an income and a substitution effect when decided between income and leisure. • Following the books convention, since leisure and work are inversely related one can define these effects either between income and leisure or income and hours worked. The only difference is the sign.

7. The income effect – the relationship between hours worked and the hours worked, holding wages constant. • ΔH/ΔY|Ŵ<0 (ΔO/ΔY|Ŵ>0, where 0 is leisure (ocio in Spanish). • In words, as income increases, ceteris paribus, household will take more leisure and work fewer hours. • The substitution effect – the relationship between hours worked and wages, holding income constant. • ΔH/ΔW|Ŷ>0 (ΔO/ΔW| Ŷ <0, where 0 is leisure (ocio in Spanish) • In words, as the wage increases (or the opportunity cost of leisure), ceteris paribus, households will work more.

8. An increase in wages can be broken down into two effects: • IE: W↑, holding hours of work constant, Y↑, so households wish to H↓ • SE: W↑, holding income constant, the opportunity cost of leisure↑, so households wish to H↑ • Increases in wages produce ambiguous change in H. • If SE>IE → W↑ → H↑ a positively sloped labor supply curve • IF IE>SE → W↑→ H↓ a negatively sloped labor or back-ward bending supply curve • Pigeon example and Anderson gas taxes versus social security taxes

9. Figure 6.1An Individual Labor Supply Curve Can Bend Backward

10. Indifference Curve Analysis • Assume individuals are rational and try to set H and O and Y at levels that maximize their utility. • An “easy” way to analyze consumer choices is graphically with indifference curves. • Maximize utility = F( Y, O) subject to the constraint that Y = W x (Max hours – hours worked). • The problem is that, while possible, it is challenging to graph U, Y and O all at the same time. Indifference curves resolve that problem by holding U constant and observing the combination of Y and O that produce that level of utility.

11. Figure 6.2 Two Indifference Curves for the Same Person

12. Rules of Indifference Curves • Higher indifference curves (IC’s) → higher levels of utility (like topographical maps and altitude). • IC’s do not intersect • IC’s are negatively sloped and convex • Both income and leisure is valued • At high levels of income more income is needed to offset any declines in leisure and vice versa. • Different individuals have different preferences and different IC maps. • Steeper IC’s imply more income is needed in return for loss of leisure at any given level of leisure (leisure preferrer). • Flatter IC’s imply less income is needed in return for loss of leisure at any given level of leisure (income preferrer).

13. Figure 6.3 An Indifference Curve

14. Figure 6.4 Indifference Curves for Two Different People

15. Income and Wage Constraints • The map on which IC’s are depicted can also represent the income constraint that households face. • Assume that workers can work or take leisure a maximum of 16 hours per day (the rest is sleep). Then Y = W x H Y = W x (16- O) And ΔY/ΔH = W • The income possibilities of an individual can be easily graphed. • Parallel shifts in the constraint represent pure income effects, such as non-wage income. • Rotation of changes in the slope reflect changes in wages

16. Figure 6.5Indifference Curves and Budget Constraint

17. Graphical Depiction of Income and Substitution Effects • Pure income effect: is a parallel shift of the income constraint. • Change in wages generate an ambiguous observed change in leisure taken or hours worked, but the observed change can br broken into two parts: IE and SE • IE: the change in H when income changes wages constant (slope of the income constraint remains the same) • SE: the change in H when wages changes and income (read utility) remains constant.

18. Figure 6.8 Wage Increase with Substitution Effect Dominating

19. Figure 6.7 Indifference Curves and Budget Constraint (with an increase in nonlabor income)

20. Figure 6.9Wage Increase with Income Effect Dominating

21. Figure 6.10Wage Increase with Substitution Effect Dominating: Isolating Income and Substitution Effects

22. Employing the Model of Labor Supply • Which effect will be greater? • The flatter the IC’s the greater the substitution effect. Since IC’s are convex they are flatter the more leisure and the less work that any given person takes. • Change in wages will affect income the more that a person works and the less leisure they take. Therefore, the more a person works the greater the income effect. • Corner solution and the decision to participate or not participate in the labor force is dominated by the substitution effect. • If the IC is very steep one may end up with a corner solution • Reservation wage is the wage below which a person will not work or the minimum wage that is needed to participate in the labor force. • Reservation wage and minimum number of hours needed to work. Illustrated assuming a two hour commute.

23. Figure 6.11The Size of the Income Effect Is Affected by the Initial Hours of Work

24. Figure 6.6 The Decision Not to Work Is a “Corner Solution”

25. Welfare Policies • Negative net wage programs (workers compensation) • Income/wage constraint has a spike reflecting that if workers return to work they lose all benefits • Creates a significant disincentive to work • Zero net wage programs • Paying people the difference between a person’s earnings and society’s assessment of their needs. • Guaranteed income with a dollar reduction in welfare benefits for each dollar of earning, thus a zero net wage. • Welfare reform of 1996 • Five years of lifetime eligibility • After 2 years, 30 hours of work required to maintain benefits • Benefits are reduced a dollar for each dollar earned

26. Figure 6.13 Budget Constraint with a “Spike”

27. Figure 6.14 Income and Substitution Effects for the Basic Welfare System

28. Positive net wage programs • The reduction in welfare benefits are reduced less than one dollar for each dollar of work. • Negative income tax and the Earned Income Tax Credit (EITC) • Negative income tax • Guaranteed income level is $8,000 each dollar of earnings reduces benefits by $.50 (tax rate of 50%) • New income wage constraint is: • If Y <= $16,000 Y=$8,000 + .5WxH • If Y > $16,000 Y= WxH • EITC • Government reduces your tax obligation by the amount of the EITC and if EITC > income tax mails you a check. • If Y < = $6,900, tax credit = .34 of income and thus Y = $6,900 + .34xWxH • If 6,900< Y <= $12,900, the maximum tax credit is reached and Y = WxH + $2,353 ($2,353 is approximately equal to .34x$6,900) • If Y > $12,900, the EITC is phased out by tax benefits by 16% so by Y=$27,400 no benefits are received. ($2353/.16 = $14,706 and $14,706+$12,700 = $27,400)

29. Figure 6.15The Basic Welfare System: A Person Not Choosing Welfare

30. Figure 6.16The Welfare System with a Work Requirement

31. Figure 6.17Earned Income Tax Credit (One Child), 2000