Chapter 2 Labor Supply Mc GrawHillIrwin Labor Economics

2 - 3 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

2 - 4 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

2 - 5 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

2 - 6 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

2 - 7 Average hours worked/week, 1900 -2005

2 - 8 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

2 - 9 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)

2 - 10 Indifference Curves Consumption ($) 500 450 40, 000 Utils 25, 000 Utils 100+ 125 150 Hours of Leisure

2 - 11 Indifference Curves Do Not Intersect Consumption ($) Y Z U 1 U 0 0 Leisure

2 - 12 Differences in Preferences across Workers Steep and flat indifference curves: Consumption ($) U 1 U 0 Hours of Leisure

2 - 13 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

2 - 14 Depicting the Budget Constraint Consumption ($) w. T+V Budget Line E V 0 T Hours of Leisure

2 - 15 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

2 - 16 Optimal Consumption and Leisure $1200 Y A $1100 P $500 U 1 U* E $100 U 0 0 110 70 40 110 Hours of Leisure 0 Hours of Work

2 - 17 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

2 - 18 The Effect of a Change in Nonlabor Income on Hours of Work Consumption ($) F 1 F 0 $200 P 1 U 1 P 0 U 0 $100 E 1 E 0 70 80 110 Hours of Leisure An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P 0 to point P 1. If leisure is a normal good, hours of work fall.

2 - 19 The Effect of a Change in Nonlabor Income on Hours of Work Consumption ($) F 1 F 0 P 1 U 1 P 0 $200 $100 U 0 E 1 E 0 60 70 110 An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P 0 to point P 1. If leisure is an inferior good, hours of work increase.

2 - 20 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.

2 - 21 More Leisure at a Higher Wage • When the Income Effect dominates: Consumption ($) G U 1 R D Q U 0 F D P V E 0 70 75 85 110 Hours of Leisure

2 - 22 More Work at a Higher Wage • When the Substitution Effect dominates: Consumption ($) U 1 G R D Q U 0 F D P V E 0 65 70 80 110 Hours of Leisure

2 - 23 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

2 - 24 The Reservation Wage Consumption ($) H Has Slope -whigh Y G X UH E U 0 Has Slope -w 0 T Hours of Leisure

2 - 25 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”

2 - 26 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

2 - 27 Labor Supply Curve • Example of backward bending labor supply: Wage Rate ($) 25 20 10 0 20 30 40 Hours of Work

2 - 28 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

2 - 29 Derivation of the Market Labor Supply Curve from the Supply Curves of Individual Workers

2 - 30 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): S 2, S 6.

2 - 31 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

2 - 32 Effect of a Cash Grant on Work Incentives • A take-it-or-leave-it cash grant of $500 per week moves the worker from point P to point G, and encourages the worker to leave the labor force. Consumption ($) F P G 500 U 1 U 0 0 70 110 Hours of Leisure

2 - 33 Effect of a Welfare Program on Hours of Work Consumption ($) F U 0 U 1 slope = -$10 H D slope = -$5 Q R P $500 D G E 0 70 100 110 Hours of Work

2 - 34 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

2 - 35 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).

2 - 36 The EITC and the Budget Line Consumption ($) F G 33, 178 17, 660 14, 490 Net wage is 21. 06% below the actual wage H Net wage equals the actual wage J 13, 520 Net wage is 40% above the actual wage 10, 350 E 110 Hours of Leisure

2 - 37 The Impact of the EITC on Labor Supply The EITC shifts the budget line, and will draw new workers into the labor market. In (a), the person enters the labor market by moving from point P to point R. The impact of the EITC on the labor supply of persons already in the labor market is less clear. In the shifts illustrated in (b) and (c), the worker reduced hours of work.

2 - 38 End of Chapter 2