EC306 Labour Economics - Tammy Schirle · – Intensive and extensive margins# ... • Slope of indifference curve ... • Utility-maximizing equilibrium – highest indifference

EC306 Labour Economics

• Chapter 2#•  Labour Supply

1

Chapter objectives •  Terminology/measurement#•  Review consumer choice theory#•  Basic model of labour supply (individuals)#

–  Intensive and extensive margins#•  Income and substitution effects#•  Extensions and applications

2

Labour Force •  LF (Labour Force)

–  Individuals in the eligible population (15 years and older) who participate in labour market activities, either employed or unemployed

•  LFPR – The fraction of the eligible population that

participates in the labour force – LFPR = LF/POP

3

4

5

0

10

20

30

40

50

60

70

80

90

100

1976 1980 1984 1988 1992 1996 2000 2004 2008

Part

icip

atio

n R

ate Men 25-54 Men 55+

Women 25-54 Women 55+

Source: Labour Force Survey, Cansim Table 282-0002, using estat.

6

7

8

9

Unemployment

•  To be considered unemployed, a person must be in one of the following three categories:

•  Without work but has made specific efforts to find a job within the previous four weeks

•  Waiting to be called back to a job from which he or she has been laid off

•  Waiting to start a new job within four weeks

Employment and unemployment rates

•  UR = U/LF

•  ER=E/POP. ( working age )

10

0

2

4

6

8

10

12

1976 1980 1984 1988 1992 1996 2000 2004 2008

Une

mpl

oym

ent R

ate

Men 25-54 Women 25-54

Source: Labour Force Survey, Cansim Table 282-0002, using estat.

Review: Consumer choice

12 X

Y M=PxX+PyY

Yes, you need to do the math...

Review:consumer choice theory

• Slope of budget constraint

• Slope of indifference curve

• Diminishing marginal rate of substitution

• Solve the utility maximization problem - review derivatives if necessary

13

Example

Review: consumer choice theory

• Substitution effects - changes in relative prices

•  Income effects - overall ability to purchase goods

15

16

•  The choice of hours worked given opportunities and value of non-market time – preferences and constraints –  individuals choose the feasible outcomes

which yield the highest level of satisfaction

Basic Income–Leisure Model

17

• Two “goods” – consumption –  leisure

• Represented by indifference curves (A person is indifferent between various combinations of consumption and leisure on an indifference curve)

Preferences

18

Indifference Curve

Leisure 0

Con

sum

ptio

n

Slope - Marginal Rate of Substitution

A. Willing to give up an abundance of consumption for leisure

B. Willing to give up an abundance of leisure for

consumption

19

•  Constrained are determined by the economic properties of the market, which, in turn, transform consumption-leisure to income-leisure by setting the price of consumption

Constraints

20

Relationship between Wages, Earnings, Compensation, and Income

21

Leisure

0 T

Income

W1 High wage

W0 Low wage

Linear Potential Income Constraint

W1T+YN

W0T+YN

YN

Slope depends on #the wage rate

22

The Consumer’s Optimum

•  Optimal amount of income and leisure •  Utility-maximizing equilibrium

– highest indifference curve given the income constraint •  Compare MRS with the Market Wage Rate

– MRS: measures the willingness to exchange leisure for consumption (or income)

– Market Wage Rate: measures the ability to exchange leisure for income

23

Equilibrium of a participant

Leisure 0 T

Income

W0T+YN

YN

Interior solution: market wage exceeds reservation wage

24

Equilibrium of a non-participant

Leisure 0 T

Income

W0T+YN

YN

Corner solution: reservation wage exceeds market wage

25

Reservation wage of a participant

Leisure 0 T

Income

W0T+YN

YN

Interior solution: market wage exceeds reservation wage

The utility maximization problem

• Given all prices (consumer goods and leisure), choose the feasible amount of consumption and leisure that maximizes your utility

• Yes, you need to do the math

26

Example

28

The Effect of an Increase in Non-Labour Income on Labour Supply (two effects)

1. Labour Participation Effect If Leisure is a normal good:

Increase in non-labour income leads to increase in consumption of leisure (some leave the labour market: decrease in labour supply, and non-participants continue to remain non-participants)

If Leisure is an inferior good: Increase in non-labour income leads to reduction of

consumption of leisure (increase in labour supply)

29

Effect of Non-Labour Income on Labour Supply

2. Hours of Work Effect #Increase in non-labour income results in a

parallel outward shift of the budget constraint – Leisure, Normal good:

•  more leisure will be consumed resulting in less work hours

– Leisure, Inferior good: •  less leisure will be consumed resulting in more

work hours

30

The Effect of an Increase in Non-Labour Income on Supply (hours of work)

Consume more leisure Consume less

31

Change in Wage Rate

Two effects: 1. Income effect

–  the worker has more income to buy more goods including leisure (reduces work hours)

2. Substitution effect –  individual may work more because the returns are

greater substituting away from leisure

32 Leisure

0 T

Income

Income and substitution effects for increase in wage.

W1T+YN

W0T+YN

YN

A B

C

Find substitution effects first

33

Effect of Wage Increase on Participation

•  The net effect depends on both substitution effect and income effect

•  If income effect dominates, hours of work may decline

•  For a non-participant an ↑ W may leave the equilibrium unchanged or induce the individual to participate

34

Individual Supply Curve

•  If substitution effect dominates, "– ↑ wage leads to ↑ labour supplied –  wages continue to ↑ until a point where

substitution effect and income effect offset each other#

•  Supply curve bends backward when income effect dominates substitution effect

Deriving the individual supply curve

35

Deriving the individual supply curve

Deriving the individual supply curve

38

Extensions and Applications of the Model

39

Moonlighting, Overtime, Flexible Work Hours

•  Why do some people moonlight at a second job at a wage less than their market wage on their first job?

•  Why do some people require an overtime premium to work more?

40

Fixed hours constraints

Leisure 0 T

Income

W0T+YN

YN

Fixed hours constraints lead to moonlighting (B)

A

B

41

Overtime and Overemployment

•  Workers prefer to work fewer hours at the going wage rate

•  Workers are induced to work more hours through an overtime premium

42

Overtime

Leisure 0 T

Income

W0T+YN

YN

43

Overtime Premium

•  Substitution effect is larger than the income effect

•  Price of leisure is higher for overtime hours

44

Is Overtime Premium preferred to Straight Line Equivalent? Why?

•  No! Because: •  Worker would not remain at overtime

equilibrium •  New (Straight Line) equilibrium on a higher

utility curve •  Income effect outweighs the substitution effect

causing the person to supply less work

45

Choice in Working Hours

•  Changing work force •  Different groups with different

preferences for work-time arrangements •  1985: two-thirds of the work force was

discontent with work-time arrangements

46

Gains from Alternative Work Schedules

Leisure 0 T

Income

W0T+YN

YN

A

B

C

C. Willing to accept lower wage for preferred work schedule

A.  Constrained B.  Preferred

47

Solution

•  No difference in utility between A and C even though C implies a lower wage rate

•  Allowing workers to work desired amount of hours saves on costs

•  Flex-time •  Compressed work week

Reading and references •  Required #

– BGLR Ch. 2#•  Suggested#

– Guide to the Labour Force Survey 2011(http://www.statcan.gc.ca/pub/71-543-g/71-543-g2011001-eng.htm )#

48