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Labor Supply

Labor Supply. 7/8/09. 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

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Labor Supply

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  1. Labor Supply 7/8/09

  2. 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

  3. 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

  4. 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

  5. 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

  6. Average hours worked/week, 1900-2005

  7. Worker Performance • Framework used to analyze labor supply behavior is the Neo-Classical 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

  8. 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)

  9. Indifference Curves Consumption ($) 500 450 400 40,000 Utils 25,000 Utils Hours of Leisure 100+ 125 150

  10. Consumption ($) Y Z U1 U0 Leisure 0 Indifference Curves Do Not Intersect

  11. Consumption ($) Consumption ($) U1 U1 U0 U0 Hours of Leisure Hours of Leisure Differences in Preferences across Workers Steep and flat indifference curves:

  12. 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

  13. Consumption ($) wT+V Budget Line E V Hours of Leisure 0 T Depicting the Budget Constraint

  14. 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

  15. Optimal Consumption and Leisure $1200 Y A $1100 P $500 U1 U* E $100 U0 Hours of Leisure 0 70 110 Hours of Work 0 110 40

  16. 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

  17. Consumption ($) F1 F0 P1 U1 P0 $200 E1 U0 $100 E0 110 Hours of Leisure 70 80 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.

  18. Consumption ($) F1 P1 F0 U1 P0 $200 E1 U0 $100 E0 110 70 60 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 an inferior good, hours of work increase.

  19. 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.

  20. More Leisure at a Higher Wage • When the Income Effect dominates: Consumption ($) G U1 R D Q U0 D F P V E Hours of Leisure 110 0 70 75 85

  21. Consumption ($) U1 G R D Q U0 D F P V E 110 0 Hours ofLeisure 65 80 70 More Work at a Higher Wage • When the Substitution Effect dominates:

  22. 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

  23. The Reservation Wage Consumption ($) H Has Slope -whigh Y G X UH E U0 Has Slope -w T 0 Hours of Leisure

  24. 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”

  25. 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

  26. Wage Rate ($) 25 20 10 0 40 20 30 Labor Supply Curve • Example of backward bending labor supply: Hours of Work

  27. 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

  28. Derivation of the MarketLabor Supply Curve from the Supply Curves of Individual Workers

  29. Cross-Country Relationship: Growth in Female Labor Force and the Wage, 1960-1980 • 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.

  30. 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

  31. Consumption ($) F G U1 500 U0 Hours of Leisure 70 0 110 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. P

  32. Consumption ($) U0 U1 F slope = -$10 H D slope = -$5 Q R P $500 G D E Hours of Leisure 0 100 70 110 Effect of a Welfare Program on Hours of Work

  33. 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

  34. 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).

  35. Consumption ($) F G Net wage is 21.06% below the actual wage 33,178 H 17,660 Net wage equals the actual wage J 14,490 13,520 Net wage is 40% above the actual wage 10,350 E Hours of Leisure 110 The EITC and the Budget Line

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