EC306 Labour Economics

• Chapter 2#•  Labour Supply

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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

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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.

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7

8

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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

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Example

Review: consumer choice theory

• Substitution effects - changes in relative prices

•  Income effects - overall ability to purchase goods

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•  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

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• Two “goods” – consumption –  leisure

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

Preferences

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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

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•  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

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Relationship between Wages, Earnings, Compensation, and Income

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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

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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

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Equilibrium of a participant

Leisure 0 T

Income

W0T+YN

YN

Interior solution: market wage exceeds reservation wage

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Equilibrium of a non-participant

Leisure 0 T

Income

W0T+YN

YN

Corner solution: reservation wage exceeds market wage

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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

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Example

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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)

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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

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

Consume more leisure Consume less

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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

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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

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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

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Deriving the individual supply curve

Deriving the individual supply curve

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Extensions and Applications of the Model

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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?

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Fixed hours constraints

Leisure 0 T

Income

W0T+YN

YN

Fixed hours constraints lead to moonlighting (B)

A

B

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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

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Overtime

Leisure 0 T

Income

W0T+YN

YN

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Overtime Premium

•  Substitution effect is larger than the income effect

•  Price of leisure is higher for overtime hours

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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

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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

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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

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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 )#

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