1. 3.3 Labour Supply
Assumptions of the Model
Deriving the Budget Constraint
Labour Supply Decision
Summary

2. 3.3.1 Assumptions of the Model
People have a choice: to work or not to work
If not working, they will remain at home or engage in leisure
Supply labour if Price (wage) > reservation wage
Reservation wage is the minimum wage needed to attract a person away from leisure and into work
Represents the opportunity cost of labour

3. Can we model this decision making?
Can analyse using indifference curve analysis
Simplify the analysis to a choice between work and leisure
Assume seven days of 24 hours available
Assume labour is homogeneous and waged
Assume the wage rate is

4. 3.3.2 Deriving the Budget Constraint
Income
If no work undertaken then 168 hours of leisure taken and income is zero (a)
If worker then decides to work one hour then leisure decline and income rises to
One more hour gives income of 2 c 2w b w a
Leisure Hours
168
Work Hours

5. Income
Maximum income is 168
Slope = - w 1
168
Leisure Hours

6. Indifference curve for income-leisure trade off
Leisure Hours
Work Hours

7. 3.3.3 Labour Supply Decision
Once someone is working how do they respond to a change in the wage rate?
Two key elements:
Substitution effect – as wages rise, person works more and substitutes work for leisure as the opportunity cost of leisure rises
Income effect – as wages rise, person works less as his/her income has risen thus allowing him/her to spend more time in leisure activities

8. Substitution: a to c (wage up, work up)
Income
Income: c to b (income up, work down) Y2 b Y1 c U2 a U1
168
Leisure Hours

9. For most workers, SUBSTITUTION > INCOME effects but…...
(no I curves shown) Y5
Price consumption curve Y4 Y3 Y2 Y1

10. BACKWARD BENDING SUPPLY CURVE FOR LABOUR
Wage W1 H1
Hours worked
BACKWARD BENDING SUPPLY CURVE FOR LABOUR

11. 3.3.4 Summary
Reservation wages determine the point of entry into the labour market
Need to trade-off between leisure and income
Can analyse using indifference curve approach
Income effects can outweigh substitution effects to give a backward bending supply curve
Implications for tax/benefit policy