Chapter 6: Supply of labor to the Economy: The Decision to Work

Isolating Income and Sub effect

- As we recall an increase in wages can cause: 1. H to increase and L to decrease (Sub effect) 2. H to decrease and L to increase (income effect) - A hypothetical question would be: What would have been the change in labor supply if the worker reached a new (higher) indifference curve with a change in V (non labor income) instead of W (wages) 1. The budget constraint curve will move northeast parallel to the old budget constraint, holding W constant. 2. The worker will attain higher levels of utility with reduced work hours (associated with wealth) at the new point of tangency. 3. An increase in W (holding wealth constant) causes a worker to end on higher portion of the same indifferences with H increasing and Leisure decreasing. 6.10

A Theory of Decision to work

- Labor is high important factor of production, this is why the country's economic performance depends on the willingness of its people to work. - Peoples Discretionary Time (Time aside from eating and sleeping) is allocated to two factors: 1. Working for pay to derive income for consumption 2. Leisure.

In Set of preferences what happens when there is an income effect

- Non labor income (property, lottery) shift the budget constraint upward holding the wage rate constant. - income effect would be present if non labor increase and the hour supplied is 0 - The new source of income (wage rate constant) would cause the worker to work less. 6.7

Budget Constraints with "Spikes"

- The social insurance compensation programs compensate workers for work-related injuries - replaces most of the earnings/incomes lost by workers due to injuries. - Compensations are paid as long as the worker is off work and disabled, and payments cease even if the worker supplies only one hour of labor. - These programs affect the work-incentives of workers since the returns associated with the first hour of work are negative - reduced income for returning to work for 1 hour.

In Set of preferences what happens when there is a Sub Effect and an income effect

- if non labor is 0 (holding wealth constant) and the wage rate increased, this would cause both an income and sub effect. - Due by the W increase, the worker may increase their hour at work making the sub effect more stronger. - Due by the W increase, the worker may reduce their hours at work and this would be a stronger income effect. The difference between the income effect and the sub effect of a wage increase is that it solely depends on the shape of the indifference curve.

Looking at these two effect independently

- it is possible to look at situations that would only gear towards one effect. Example: Inheritance is an example of income effect which gears the person to demand more leisure time thus reducing the willingness to work.

What effect is stronger

- the extent on both effects depends on the slopes of the indifference and budget constraint. - if the difference curves was flat then the worker would have to work a lot of hours. - if the curves were steeper than the worker would have to work less hours. - With other things equal people who generally work longer hours will exhibit greater income effect when wages change.

What are the characteristics of the indifference curve?

1. Consumer preferences are usually northeast on the higher or highest indifference curve. 6.2 2. Indifference curves do not intersect. 3. Indifference curves are negatively sloped. 6.3 4. Indiffernce curves are convex (Steeper on the left then the right - when income is high leisure hours are low) 5. When moving down the curve it reflects value (When income is low, leisure time is high) 6.3 6. Indifference curve differs for everyone because everyones tastes/preferences or values are different. 6.4

What do Demand for good/service depend on?

1. The opportunity cost of the good (which can equal market price) 2. One's level of wealth 3. One's Set of preferences

Budget Constraints (Income and Wages Constraint)

Budget constraints show the combination of money income and the hours of leisure per day that are possible or attainable for the individual.

Income effect

If income increases, holding wages constant, desired hours work will go down (hours work supplied by worker will decrease) and demand for leisure would go up Income effect = (change in hours)/(change in income) while leaving wages constant.

Sub effect

If income is held constant, an increase in wage will raise the price (of goods?) and reduce the demand for leisure which would increase the workers incentive to work. Increase in OC of leisure reduces the demand for L Sub effect = (change in hour)/(change in wages) while leaving income constant.

Indifference curves

Indifference curves show the various combinations of money income (or goods and services) and the hours of leisure/work per day that will yield the same level of happiness.

Trends in the Labor Force Participation and Hours of Work

LFPR = (LF)/(WAP) x100 Labor Force Participation - Over the past ten decades this has more than doubled for women and this has decreased for men due to hat of factors - These trends have been seen in other countries Hours of Work - At first people here would work 55 hours per week but it has now declined to less than 40 hours.

Set of Preferences (Labor/Leisure choice)

Labor supply is easier to understand by using indifference curves and budget constraints. Preferences: U = f (Y, L) U = an index that measures the level of satisfaction or happiness. (utility) Y = is income (wage) L = Leisure

Looking at both effects at the same time

Simple both effects occur when wages increase. - Labor response to a wage increase involves both effects and these effects end up working in the opposite direction which creates ambiguity in prediction the overall labor supply response - So if income effect is stronger, then the person will decrease their supply and the supply curve will be negatively sloped ( W increase H decreases) - If the sub effect is stronger then the supply curve will be positive (W increase H increase)

Opportunity Cost of Leisure: The demand for leisure depends on

The opportunity cost of leisure, which is equal to one's wage rate or the extra earning a worker can take home from an extra hour of work.

The break down of the income and budget constraint

V = non labor income (property, inheritances) Line Dd in 6.7 H = # of hours allocated to the labor market w = hourly wage rate L = hours of leisure per day Y = total income defined as Y = wH + V Y = wH if V = 0 T = total discretionary time The slope constraint can be defined as: Wage Rate = (change in Y total income) / (change in H # of hours allocated to the labor market)

Empircal Findings n the Income and Sub effect

We know that the choices workers make with respect to the desired hours of work depends on: 1. Wealth 2. Wage rate 3. Leisure-income preferences I was should that in a study of men that the sub effect are more positive while the income effect effects are negative. Women have a higher responsiveness to wage changes than found among men.

Policy Application

We use labor supply theory to analyze the work-incentive effects of various social or income maintenance programs because they create budget constraints for their recipients. Since income maintenance programs create spikes and severe work disincentive problems: What can policymakers do to minimize the effects? 1. Set no-work benefits at some fraction of pre-injury earnings. 2. Set benefits at Ag (see Figure 6.13 ) so that a worker is on his or her pre-injury indifference but with earnings less than E0 or set benefits slightly less than Ag (about half the pre-injury earnings) so that a worker will be eager to return to work as soon as he or she is physically able to do so. 3. Set an upper limit on the weeks each unemployed worker can receive the no-work benefits. 4. If extensions are to be granted in some cases, set up a panel - medial or judicial board - to review such cases.

Wealth and Income

Wealth and income include: - Family's holding of bank accounts - Financial investments - Physical property or properties The effects of a increase in income and wages on leisure-work preferences of a person can be seen in two ways 1. Income effect 2. Sub effect

What do workers take into consideration

Worker takes into consideration some key factors in determining whether or not to work in the labor market: 1. Reservation wages and the earning possibilities 2. Commute time per day (fixed cost of working) 6.12

Reservation wage (Wr)

this represents the value placed on an hour of lost leisure time.