Chapter 6. Supply of Labor to the Economy Importance of Labor Supply 1) Any country ’ s well-being in the long run heavily depends on the willingness of its people to work, because labor is the most abundant factor of production. 2) Plays an equally important role with labor demand in determining  the unemployment (employment) rate  wages

Measuring labor supply  Amount of labor supplied in the economy depends on - how many people are willing to work - how long each person is willing to work -Total man-hours= labor force size  average hours Labor force participation rate  LFPR is a relatively pure measure of labor supply.  However, LFPR is influenced to some degree by forces on the demand side of the market. - Reduction of the number of jobs (or the wage rate) offered by firms is expected to reduce the number of people who want to work for pay.  Two competing hypotheses regarding LFPR in recessions.

1) Added-worker effect: LFPR  in a recession, i.e., when the labor demand weakens 2) Discouraged-worker effect: LS  in a recession - In reality, both effects exist. - In general, discouraged-worker effects dominate added-worker effects; the LFPR is weakly procyclical.  Hours of work  In contrast, weekly or yearly hours are often set up by employers especially in the short term.  Weekly hours are influenced to some degree by forces on the supply side of the market. - Employees “ choose ” work hours by choosing occupations and employers. Workers ’ preferences are also changed in the long term

Women’s Labor Force Participation Rate

Employment to population Ratio of Prime-Age Married Women

Theory of labor supply  Firms ’ profit max  labor demand curve Individuals ’ utility max  labor supply curve  Do firms want demand less labor with higher wages? Do people want to supply more labor with higher wages?  Basic concepts  Labor supply decision is ultimately a choice between leisure and working for pay.

 Allocation of time

 Supply of labor = mirror image of demand for leisure =16 – Demand for leisure  can apply the standard microeconomics analysis of the demand for any good to the demand for leisure.  Opportunity cost of leisure = wage rate  Income effect  If income increases, holding wages and preference constant, the demand for leisure (a normal good) increases.  Demand for Leisure   Supply of Labor   Substitution effect  If wages go up, holding income and preference constant, the opportunity cost of leisure goes up.  Demand for leisure   Supply of labor 

 Both effects occur when wages rise  If substitution effect  income effect, labor supply increases with wages  If income effect  substitution effect, labor supply decreases with wages.

 Backward-Bending Labor Supply Curve: Figure 6.1  In a reasonable rage of wages, labor supply is an upward-sloping function of wages

Graphical Derivation of Labor Supply Curve  Preferences and indifference curves (IC)  Two goods: U(leisure, money income)  Income represents all consumption goods  The two goods are substitutable to some degree. - Work less  more leisure  less income  Indifferences Curve - Combinations of income and leisure that give him/her the same level of satisfaction.  Characteristics of IC ’ s a. IC ’ s are negatively sloped. ; As either income or leisure is increased, the other is reduced in order to preserve the same level of satisfaction.

b. Any curve that lies to the northeast of another one is preferred to any curve to the southwest.(Figure 6- 2) c. IC ’ s do not intersect. d. IC ’ s are convex; diminishing marginal rate of substitution (Figure 6-3) e. Different people have different sets of IC ’ s (Figure 6.4).  Income and wage constraint (Figure 6.5)  An individual maximizes his/her utility subject to limited resources.  Assume only labor income  Suppose a person works H hours and receives $Y.  the slope of budget constraint= wage rate = Y/H

 How many hours will be supplied by the person in Figure 6.5 when W=$8/h?  9 hours (Point N). Why not L or M?  Different individuals supply different hours with the same budget.  Some individuals may choose not to supply any labor. (Figure 6.6)  Corner Solution (those who value leisure too much may stay out of labor force)

What happens to labor supply when nonlabor income increases? (Figure 6.7) What happens to labor supply when wages go up from $8/H to $12/H? (Figure 6.8) and (Figure 6.9)

Isolating Income and Substitution Effects: the case of upward- sloping Labor Supply curve (Try assignment 2 for numerical discussion of this issue) Restructuring (Figure 6.10) from a) through c)

The size of the income effect is affected by the initial hours of work (Figure 6.11)  Income effect is greater at A than at B.  At point C, no income effects. Only substitution effects exist.  Labor supply (LFPR) never decreases with wages.

Reservation wage (Figure 6.12) Reservation wage  Let us neglect the commuting time in Figure 6.12

-When the wage rate is relatively low (W 1 ), the person chooses not to work. -Let us assume that the budget constraint with a higher wage rate (W 2 ) is tangent to the IC at point A. -The wage offer should be at least as high as W 2 to make the person supply any labor. -W 2 is the person ’ s reservation wage. - Reservation wage with nonlabor income= slope of the line tangent to IC at l =16 (no labor supply) and Y=nonlabor income. Algebraically, Reservation wage=

Empirical Findings  Men: small income and substitution effects  Women: substitution > income  More elastic for women than for men.  Work hours are wage-inelastic for working women and men.  The greater labor supply elasticity for women is largely due to the great responsiveness of LFPR among married women  LFPR  as W  (Corner Solution)

Policy Application: The Effects of Welfare programs on Work-Incentive Almost all welfare programs affect the shape of the budget constraint. Basic Welfare Programs  takes the form of a guaranteed annual income.  The government determines the needed income  Actual earnings are subtracted from the needed income.  The person receives a check for the difference each month.  Disincentive to work (Figure 6-12)

-Budget constraint without the program=AD -Budget constraint after the program = ABCD -Slope of BC=0= net wage rate  For every dollar earned, dollar-to-dollar reduction in welfare benefits -Decision without any program = E = decide to work -Decision under the basic program = B = decide not to supply labor -Income effect: E  F Substitution effect: F  B, as wages go down.

A numerical example Suppose there are 16 hours that an individual can use either for leisure or work. The wage rate is $8 per hour and his/her utility function is given by, where l is the number of hours of leisure and Y is income. a.Find the utility maximizing bundle of l and Y. Ans: l*=8, Y*=64 b.If (s)he is not working, he receives a lump-sum payment of $16/day from the government. If (s)he works, (s)he does not receive the subsidy. Find the utility maximizing bundle of l and Y. Ans: l**=8, Y**=64 c.How are the answers to b) changed when the lump-sum transfer is raised to $62.5/day? Ans: l***=16, Y**=62.5 d.How are the answers to b) changed when a 50% tax is placed on labor income in addition to the $16/day of the lump-sum transfer? Ans: (S)he is indifferent between working 8 hours (l =8, Y=32) and living on the welfare (l=16, Y=16).

Budget constraint & work incentive under Earned Income Tax Credit (EITC) (Figure 6.17)

Why EITC?  Compared with the basic welfare program, overall labor supply reduction is modest.  Labor supply increases among the lowest income group, especially among single mothers.  Benefits are concentrated on the poor. Remember the major limitation of the MW.  Is EITC a replacement for MW?