Transcript Chapter 2

Chapter 2
Labor Supply
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction to Labor Supply
• Labor facts
– Men: labor force participation rates
declined from 90% in 1947 to 75% in 1990.
– Women: labor force participation rates rose
from 32% in 1947 to 60% in 1990.
– Hours worked fell from 40 to 35 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.
2-3
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
2-4
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
20% by 2000.
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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 hours worked/week
1900-2007
60
55
Weekly hours
50
45
40
35
30
1900
1920
1940
1960
1980
2000
2020
Year
2-8
Neo-Classical Model of
Labor-Leisure Choice
• Utility Function
– Measure of satisfaction that individuals
receive from consumption (C) of goods
and leisure (L).
– U = f(C, L)
• U is an index.
• Higher U means happier 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.
2-10
Indifference Curves
Consumption ($)
500
450
400
40,000 Utils
25,000 Utils
100+ 125
150
Hours of Leisure
2-11
Differences in Preferences
Consumption ($)
Consumption ($)
U1
U1
U0
U0
Hours of
Leisure
Hours of
Leisure
Workers with steeper indifference curves value their
leisure relatively more than workers with shallower
indifference curves.
2-12
The Budget Constraint
• The budget constraint defines the worker’s
opportunity set, indicating all of the
consumption – leisure baskets the worker
can afford.
• C = wh + V
– Consumption equals labor earning (wages ×
hours of work) plus nonlabor income (V).
– As h = T – L, can rewrite C = w(T – L) + V.
2-13
Graphing the Budget Constraint
Consumption ($)
wT+V
Budget Line
E
V
0
T
Hours of
Leisure
2-14
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.
2-15
Optimal Consumption and
Leisure
$1200
$1100
Y
A
P
$500
U1
U*
E
$100
U0
0
110
70
40
110
0
Hours of
Leisure
Hours of
Work
2-16
The Effect of a Change in Nonlabor
Income on Hours of Work
Consumption ($)
F1
F0
$200
P1
U1
P0
U0
$100
E1
E0
70 80
110
Hours of Leisure
An increase in nonlabor income leads to a parallel, upward
shift in the budget line, moving the worker from point P0 to
point P1. If leisure is a normal good, hours of work fall.
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The Effect of a Change in Nonlabor
Income on Hours of Work
Consumption ($)
F1
F0
P1
U1
P0
$200
$100
U0
E1
E0
60
70
110
An increase in nonlabor income leads to a parallel, upward
shift in the budget line, moving the worker from point P0 to
point P1. If leisure is inferior, hours of work increase.
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More Leisure at a Higher Wage
When the income effect dominates the substitution
effect, the worker increases hours of leisure in
response to an increase in the wage.
Consumption ($)
G
U1
R
D
Q
U0
D
F
P
V
E
0
70 75
85
110
Hours of Leisure
2-19
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.
Consumption ($)
U1
G
R
D
Q
U0
F
D
P
V
E
0
65 70
80
110
Hours of Leisure
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To Work or Not to Work?
• Are the “terms of trade” sufficiently attractive
to “bribe” a worker to enter the labor market?
• Reservation wage: the lowest wage rate that
would make the person indifferent between
working and not working.
– Rule 1: if the market wage is less than the
reservation wage, then the person will not work.
– Rule 2: the reservation wage increases as
nonlabor income increases
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The Reservation Wage
Consumption ($)
H
Has Slope -whigh
Y
G
X
UH
E
U0
Has Slope -w
0
T
Hours of Leisure
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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
Wage Rate ($)
25
20
10
0
20
30
40
Hours of Work
2-24
Labor Supply Elasticity
• The labor supply elasticity (σ) measures
responsiveness in hours worked to changes
in the wage rate.
– σ = Percent change in hours worked divided by
the percent change in wage rate.
– Labor supply elasticity less than 1 is inelastic as
hours of work respond proportionally less than the
change in wages.
– Labor supply elasticity greater than 1 is elastic as
hours of work respond proportionally more than
the change in wages.
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Labor Supply of Women
• Substantial cross-country differences in
women’s labor force participation rates.
• Over time, women’s participation rates
have increased.
• In most studies on women, substitution
effects dominate income effects (upward
sloped labor supply curve).
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Growth in Female Labor Force Participation
Rates and the Wage, Cross Countries 1960-80
7
Netherlands
Female Participation
Growth Rate of
6
5
A ustralia
Japan
4
Italy
3
S weden
USS R
Israel
B ritain
S pain
2
France
Germany
1
United States
0
1
2
3
4
5
6
7
8
9
Perc entage Change in Wage
•
Source: Jacob Mincer, “Intercountry Comparisons of Labor Force
Trends and of Related Developments: An Overview,” Journal of
Labor Economics 3 (January 1985, Part 2): S2, S6.
2-27
Derivation of the Market Labor Supply
Curve from Individual Supply Curves
Wage Rate ($)
Wage Rate ($)
Wage Rate ($)
hB
hA
~
wA
0
(a) Alice
hA + hB
~
wB
~
wA
~
wB
0
(b) Brenda
hA
0
(c) Market
Hours of
Work
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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 $500 per week
moves the worker from point P to point G, and
encourages the worker to leave the labor force.
Consumption
($)
F
P
G
U1
500
U0
0
70
110
Hours
of
Leisure
2-30
Effect of a Welfare Program on
Hours of Work
Consumption ($)
F
U0
U1
slope = -$10
H
D
slope = -$5
Q
R
P
$500
D
G
E
0
70
100
110
Hours of
Work
2-31
Policy Application:
The Earned-Income Tax Credit
• The EITC should increase labor force
participation of nonworkers of targeted
groups.
– The EITC encourages some non-workers to
start working and never encourages a worker
to quit working.
• The EITC produces an income effect.
– Hours worked should change.
2-32
The EITC and the Budget Line
Consumption
($)
F
G
Net wage is 21.06% below the actual wage
33,178
17,660
H
Net wage equals the actual wage
J
14,490
13,520
Net wage is 40% above the actual wage
10,350
E
110
Hours of Leisure
2-33
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.
2-34
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.
2-35
The Life Cycle Path of Wages and
Hours for a Typical Worker
Wage
Rate
Hours of
work
50
Age
50
Age
2-36
Hours of Work over the Life Cycle for Two
Workers with Different Wage Paths
Hours of
Work
Wage Rate
Joe (if substitution effect
dominates)
Joe
Jack
Jack
Joe (if income effect
dominates)
t*
Age
t*
Age
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.
2-37
Labor Force Participation Rates
over the Life Cycle in 2005
Labor force participation rate
100
90
Male
80
70
Female
60
50
40
30
15
25
35
45
55
65
Age
2-38
Hours of Work over the
Life Cycle in 2005
2,500
Annual hours of work
Male
2,000
Female
1,500
1,000
500
15
25
35
45
55
65
Age
2-39
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.
2-40
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.
2-41
Labor Supply Over the
Business Cycle
• The discouraged worker effect dominates
the added-worker effect, especially
during recessions.
2-42
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 taxes
retirees when they earn more than $17,000 per
year) generates the budget “line” that affects
behavior in varying ways.
• The repeal of the earnings test moves 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.
2-44
Fertility
• Malthus Theory of Fertility: as incomes
rise, families want more children (children
are normal goods so the income effect is
large).
• An increase in the price of a person’s time
(i.e., an increase in the wage) increases
the opportunity cost of exiting the labor
market to rear children.
2-45
The Fertility Decision
Goods
I/pX
P
Indifference Curve
3
I/pN
The household’s utility
depends on the
number of children and
on the consumption of
goods. A utilitymaximizing household
chooses point P and
has three children.
Number of
Children
2-46
The Impact of Income and Prices
on the Household’s Fertility
Good
s
I/PX
Good
s
P
R
U1
R
Q
U1
P
U0
U0
3
4
(a) Increase
in Income
D
Number
of
Children
1
2
3
Number
of
Children
(b) Increase
in the price of
children
2-47
End of Chapter 2
2-48