Nonparticipation and other examples in the labor market

C The flat budget line implies the amount of con. received when Nonparticipation - not in the labor market C The flat budget line implies the amount of con. received when a unit of leisure is given up is low. Note: 1)nonlabor income is available 2) Wage is relativiely low I1 I2 I3 I4 A leisure 24 Starting at point A, the amount of consumption the person would like to get back and have utility I3 when giving up a unit of leisure is way more than what the market will give back as reflected in the budget line slope. The person stays at A

Starting at A the person has utility I3 Starting at A the person has utility I3. They would give up a unit of leisure and be as happy if they get back the consumption amount ac . But they only get back bc. The person won’t do it. Nonparticipation - not in the labor market C I1 I2 I3 I4 a A b c leisure 24 Analogy time: say you are truly willing to give up $10 for something. But you have to give up, say $15. You don’t do it.

So, for the person on the previous slide, the wage in the market is so low that the individual is not willing to give up leisure because the consumption given back it too low! Another point to make here is that we are no longer at an interior solution.

Reservation Wage C Note here I have three budget lines. The flattest has the lowest wage and I show two more budgets with progressively higher wages. Leisure

Reservation wage On the previous slide where I have three budgets I also have three indifference curves. Given these three budgets the person will never end up on the lowest indifference curve. At the lowest budget the person will take all leisure. Even at the second budget show the person will spend all their time in leisure. With the third budget the person actually gives up some leisure for labor and we are back to an interior solution. When we are not at an interior solution and we end up at the endowment point we could have two general scenarios.

Reservation wage If at the endowment point the budget line “cuts through” the indifference curve the individual will take all leisure and have no labor supply. The wage could be increased but the budget still cuts through the indifference curve and there would be no labor supply. As the wage rises the budget line may still have the person take all leisure, but at some point if the wage becomes any higher the person will start to give up some leisure. The last wage at which the person does not supply any labor is called the reservation wage.

Reservation Wage The solid budget line from last graph has a tangency with the second indifference curve at the endowment. The wage associated with this budget is the reservation wage. At wages below this no labor will be supplied. At wages above this some labor will be supplied. Since we have a tangency, the slope of the budget and the slope of the indifference curves are equal. The slope of the budget, in absolute value, is the wage. The slope of the indifference curve, in absolute value, is the MRS. The two are equal!

Problem 2-4 Note the endowment point is L = 168, C = 630. AT that point the MRS = C / L = 630/168 = 3.75 We know that the reservation wage is the wage at the endowment where MRS = w. SO if MRS = 3.75 reservation wage must be 3.75. Let’s play with this example some. U = C times L. At the endowment U = 630 times 168 = 105840. If the wage is 3.75, then if L = 167 C = 633.75 and U = 105836.25. So, you see it doesn’t make sense to give up leisure at the reservation wage because with the C given back U is lowered.

Prob - continued If wage = 4, then if L = 167, C = 634 and U = 105878 and so now this is better than staying at endowment. Note, I am not saying this is the best point for the consumer, just that it is better than the endowment point and thus the worker begins to supply labor.