Chapter 2
Labor Supply
“It’s true hard work never hurt
anybody, but I figure, why take
the chance?”
-Ronald Reagan
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Introduction to Labor Supply
Labor facts
• Men: labor force participation rates declined from 80% in
1900 to 71% in 2010.
• Women: labor force participation rates rose from 21% in
1900 to 60% in 2010.
• Hours worked fell from 40 to 34 per week during the same
time period.
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Measuring the Labor Force
Current population survey (CPS)
• Labor Force = Employed + Unemployed
• LF = E + U
• Size of LF does not tell us about “intensity” of work.
• Labor Force Participation Rate
• LFPR = LF/P
• P = civilian adult population 16 years or older not in institutions.
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Measuring the Labor Force
Current population survey (CPS)
• Employment: Population Ratio (percent of population that
is employed).
• EPR = E/P
• Unemployment Rate
• UR = U/LF
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Measuring the Labor Force
Labor force measurement relies on subjectivity and likely
understates the effects of a recession.
Hidden unemployed: persons who have given up in their search
for work and have therefore left the labor force.
The employment rate (E/P) can be a better measure of
fluctuations in economic activity than the unemployment rate.
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Labor Force Participation Facts
Labor force participation (LFP) is greatest for all groups during
the ages of 25 to 55.
LFP increases with education.
LFP has decreased for men over the age of 65 from 63% in 1900
to under 22% by 2010.
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Labor Force Participation Facts
More women than men work part-time.
More men who are high school drop outs work than women who
are high school drop outs.
White men have higher participation rates and hours of work
than black men.
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Average weekly hours of work of production workers,
1900-2013
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Neo-Classical Model of
Labor-Leisure ChoiceUtility Function
• Measure of satisfaction individuals receive from consumption (C) of
goods and leisure (L).
• U = f(C, L)
• U is an index.
• The higher is U, the happier is the person.
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Indifference Curves
Downward sloping, indicating the tradeoff between
consumption and leisure.
Higher curves = higher utility.
Do not intersect.
Convex to the origin, indicating that opportunity costs increase.
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Indifference Curves
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Indifference Curves Cannot Cross
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Differences in Preferences
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Workers with steeper indifference curves value
their leisure relatively more than workers with
shallower indifference curves.
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The Budget Constraint
The budget constraint defines the worker’s opportunity set,
indicating all of the consumption – leisure combinations the
worker can afford.
C = wh + V
• Consumption equals labor earning (wages × hours of work) plus
nonlabor income (V).
• As h = T – L, can rewrite C = w(T – L) + V.
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Graphing the Budget Constraint
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The Hours of Work Decision
Individuals choose consumption and leisure to
maximize utility.
Optimal consumption is given by the point where the
budget line is tangent to the indifference curve.
• At this point the marginal rate of substitution (MRS)
between consumption and leisure equals the wage.
• Any other consumption – leisure bundle on the budget
constraint would give the individual less utility.
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Optimal Consumption and Leisure
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The Effect of a Change in Nonlabor Income on Hours
of Work
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An increase in nonlabor income leads to a parallel, upward
shift in the budget line, moving the worker from point P0 to
point P1. If leisure is a normal good, hours of work fall.
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The Effect of a Change in Nonlabor
Income on Hours of Work
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An increase in nonlabor income leads to a parallel, upward
shift in the budget line, moving the worker from point P0 to
point P1. If leisure is inferior, hours of work increase.
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More Leisure at a Higher Wage
When the income effect dominates the substitution
effect, the worker increases hours of leisure in
response to an increase in the wage.
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More Work at a Higher Wage
When the substitution effect dominates the income
effect, the worker decreases hours of leisure in
response to an increase in the wage.
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To Work or Not to Work?
Are the “terms of trade” sufficiently attractive to
“bribe” a worker to enter the labor market?
Reservation wage: the lowest wage rate that would
make the person indifferent between working and not
working.
• Rule 1: if the market wage is less than the reservation
wage, then the person will not work.
• Rule 2: the reservation wage increases as nonlabor
income increases
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The Reservation Wage
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Labor Supply Curve
Relationship between hours worked and the wage rate.
• At wages slightly above the reservation wage, the labor supply curve
is positively sloped (the substitution effect dominates the income
effect).
• If the income effect begins to dominate the substitution, hours of
work decline as the wage rate increases (a negatively sloped labor
supply curve).
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The Backward Bending Labor Supply Curve
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Labor Supply Elasticity
The labor supply elasticity (σ) measures responsiveness
in hours worked to changes in the wage rate.
• σ = Percent change in hours worked divided by the
percent change in wage rate.
• Labor supply elasticity less than 1 is inelastic as hours of
work respond proportionally less than the change in
wages.
• Labor supply elasticity greater than 1 is elastic as hours of
work respond proportionally more than the change in
wages.
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Labor Supply of Women
Substantial cross-country differences in women’s labor force
participation rates.
Over time, women’s participation rates have increased.
In most studies on female labor supply, the substitution effect
dominates the income effect for women, implying an upward
sloped labor supply curve.
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Policy Application: Welfare Programs and Work
Incentives
Cash grants reduce wage incentives.
Welfare programs create work disincentives.
Welfare reduces supply of labor by increasing nonlabor income,
which raises the reservation wage.
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Effect of a Cash Grant on Work Incentives
A take-it-or-leave-it cash grant of $1,000 per week moves the worker from point P to
point G, and encourages the worker to leave the labor force.
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Effect of a Welfare Program on Hours of Work
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Policy Application:
The Earned-Income Tax Credit
The EITC should increase labor force participation of nonworkers
of targeted groups.
• The EITC encourages some non-workers to start working and never
encourages a worker to quit working.
The EITC produces an income effect.
• Hours worked should change.
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The EITC and the Budget Line
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Labor Supply over the Life Cycle
Wage rates change over the worker’s life (over the life cycle).
• Wages are low when young.
• Wages rise with time and peak around age 50.
• Wages decline or remain stable after age 50.
The changes in wages over the life cycle are “evolutionary” wage
changes that alter the price of leisure.
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Theoretical Issues of Evolutionary Wages
A person will work more hours when wages are higher (i.e., the
substitution effect tends to dominate the income effect).
The profile of hours of work over the life cycle will have the same
shape as the age-earnings profile.
Intertemporal substitution hypothesis: people substitute their
time over the life cycle to take advantages of changes in the
price of leisure.
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The Life Cycle Path of Wages and Hours for
a Typical Worker
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Hours of Work over the Life Cycle for Two Workers with
Different Wage Paths
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Joe’s wage exceeds Jack’s at every age. Although both Joe and Jack work more
hours when the wage is high, Joe works more hours than Jack if the substitution
effect dominates. If the income effect dominates, Joe works fewer hours than Jack.
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Labor Force Participation Rates over the
Life Cycle in 2013
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Hours of Work over the
Life Cycle in 2013
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Labor Supply Over the
Business Cycle
Added-worker effect.
• So-called “secondary” workers currently out of the labor market are
affected by a recession because the main breadwinner becomes
unemployed or faces a wage cut.
• A secondary worker may choose to enter the labor force during these
bad times
• The labor force participation rate of secondary workers (i.e., the
added worker effect) is counter-cyclical.
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Labor Supply Over the
Business Cycle
Discouraged worker effect.
• Unemployed workers find it very difficult to find jobs
during a recession, so they give up searching.
• Discouraged workers exit the labor force during bad times.
• The labor force participation rate of discouraged workers
is pro-cyclical.
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Labor Supply Over the
Business Cycle
The discouraged worker effect dominates the added-worker
effect, especially during recessions.
The Labor Force Participation Rate is pro-cyclical
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Retirement
Lifetime income is higher the longer a worker puts off
retirement.
If pension benefits are constant, wage increases have a
substitution and income effect, so lifetime income might not be
altered.
An increase in pension benefits reduces the price of retirement,
increasing the demand for leisure and encouraging the worker to
retire earlier.
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The Impact of the Social Security Earnings Test on
Hours of Work
The Social Security earnings test (which taxed retirees when they
earned more than $17,000 per year) generated the budget
“line” that affects behavior in varying ways.
The repeal of the earnings test moved retirees to another budget
line, as a result:
• One retiree would not change his hours of work.
• A second retiree would reduce his hours.
• A third retiree might increase or decrease his hours, depending on
whether substitution or income effects dominate.
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The Impact of the Social Security Earnings Test on
Hours of Work
Conclusions:
• (1) Overall, the theory suggests that elimination of the Social Security
earnings test is unlikely to substantially increase labor supply among
retirees.
• (2) The empirical evidence confirms the theoretical explanations: the
labor supply effects of the repeal tended to be small.
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