Scribd
Upload
16 views48 pages

Labour Supply

The document discusses labour supply theory including preferences over consumption and leisure, budget constraints, income and substitution effects, and the labour supply curve. It outlines how individuals allocate their time between leisure and labour based on preferences and wages, and how their optimal choice is determined by the tangency of indifference curves and budget constraints.

Uploaded by

rtchuidjangnana
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
16 views48 pages

Labour Supply

The document discusses labour supply theory including preferences over consumption and leisure, budget constraints, income and substitution effects, and the labour supply curve. It outlines how individuals allocate their time between leisure and labour based on preferences and wages, and how their optimal choice is determined by the tangency of indifference curves and budget constraints.

Uploaded by

rtchuidjangnana
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 48

Labour Supply

Outline

 Introduction and motivation


 The theory of labour supply
 preferences
 budget constraint
 optimal choice
 Income and substitution effects
 The labour supply curve
 The reservation wage
Labour Supply: Introduction and
motivation
Labour supply over time

 Two very important secular trends

1. Gigantic increase of the labour supply of women

2. Shortening working lives of men


Activity rates of women
Activity rates men 60-64
The theory of labour supply
Theory of labour supply

 24 hours in a day
 Time endowment = 16 hours? (we must sleep!)
 How do we allocate this time between
 leisure
 labour
 at home (we ignore it for now)
 in the market
The theory of labour supply
 Time endowment = leisure (L) + labour supply (H)
 Labour supply = time endowment - leisure
 Labour supply = demand of leisure
 We will treat leisure just like a normal good and we
will apply standard consumption theory:
 preferences
 price of consumption good (wage, opportunity cost)
 wealth (financial and real wealth)
The choice between labour and leisure
 Two goods:
1. leisure
2. consumption goods
 Budget constraint
 consumption goods are bought with the revenues
obtained from selling leisure
 the more you work the more you can consume but
the less leisure you can enjoy
Preferences over consumption and leisure

 Individuals have preferences over consumption and


leisure

 Preferences are described by “maps” of indifference


curves:
 combinations of leisure and consumption associated to the
same level of utility (indifferent)
Indifference curves of an individual
Properties of the indifference curves

 4 properties:
 curves closer to the origin are associated with lower
levels of utility (B>A)
 the are negatively sloped
 they are convex (scarce goods are valued more)
 they are parallel (never cross)
Convexity of indifference curves

 (Y4-Y3)=(Y2-Y1)
 but (H4-H3)<(H2-H1)
The slope of the indifference curves
 Moving along one indifference curve consumption
and leisure change but, by definition, utility remains
constant
 Hence the sum of the effect on utility of the changes
in consumption and leisure along one indifference
curve must be zero
 What is the effect on utility of a variation in Y?
∆UY = MUY x ∆Y
 What is the effect on utility of a variation in L?
∆UL = MUL x ∆L
The slope of the indifference curves
 Along the same indifference curve, the sum of
these variations must be zero:
∆U = ∆UY + ∆UL = (MUY x ∆Y) + (MUL x ∆L) = 0
 From this expression we can easily derive the slope
of the indifference curves:
(MUY x ∆Y) + (MUL x ∆L) = 0
∆Y/∆L = - MUL / MUY
 The slope of the indifference curves equal (minus)
the ratio of the marginal utility of leisure and
income/consumption.
Indifference curves of different
individuals
The budget constraint
 Budget set: set of all combinations of consumption
and leisure that are affordable for the individual
 Example:
 V= wealth/non-labour income
 T hours in the time endowment
 w hourly wage
 C = consumption (= income (Y), no savings)
 all and only the consumption-leisure combinations
satisfying the following constraint can be bought:
The budget constraint
 An alternative way to write the budget constraint is
the following
 Recall that L=T-H
The budget constraint
 Example:
 T = 16; w = 8; V = 0; p=1
 if the agent works 16 hours (H=0) she can consume
16x8=128 (point E)
 if she works 0 hours (H=16) she can consume zero (point D)

 On the consumption-leisure plane the budget set is:


The budget constraint
The optimal choice
 Which is the consumption-leisure combination that
guarantees the highest utility compatibly with the
budget constraint?
 It is the combination at the tangency point between
the budget constraint and the map of indifference
curves
 Agents with different preferences choose different
consumption-leisure combinations even if they face
the same budget constraint
Optimal consumption-leisure choice

slope of the budget


constraint = -w
The optimal choice
 In the tangency point, by definition, the budget
constraint and the indifference curves have the same
slope
 the slope of the budget constraint is – w/p (real wage)
 the slope of the indifference curves is the ratio of the
marginal utilities of the two goods (consumption and leisure)
- MUL / MUC

 Optimality condition:
The choice not to work is a “corner” solution
Income and substitution effects
Pure income effect
 What is the effect of an increase in non-labour
income (V) holding all other things fixed?
 the intercept of the budget constraint increases but the
slope does not change
 the budget constraint shifts parallel upward

C 𝒘 ·𝑳 𝒘·𝑻 𝑽
𝒔𝒍𝒐𝒑𝒆 𝒊𝒏𝒕𝒆𝒓𝒄𝒆𝒑𝒕

 The agent eventually chooses to consume more


leisure and to offer less labour (leisure is a normal
good)
Pure income effect
Income and substitution effects
 What is the effect of a wage increase, holding all
other things fixed?
 the (opportunity) cost of leisure increases
 this increases both the revenues from selling leisure to
the market AND the value of the time endowment

 the budget constraint shifts upward (the value of


the endowment increases) AND becomes steeper
(the cost of leisure increases)
Income and substitution effects
 An increase in the wage generates both an income
and a substitution effect

 Intuitively:
 with a higher wage the agent can consume the same and
work less (income effect)
 each hour of work is now remunerated more so there is
an incentive to work more (substitution effect)

 The overall effect is ambiguous...


Wage change where the substitution effect
dominates
Wage change where the income effect
dominates
Detecting the effects graphically
Income and substitution effects
Which effect prevails?

 The income effect is stronger when the agent


already works a lot:
 if the agent works many hours an increase in the wage
increases disposable income by a lot (the hourly wage is
multiplied by many hours), even holding working hours
fixed
 to the extreme, if the agent does not work at all the wage
increase does not generate any income effect
Income effect and hours worked
The labour supply curve
 Now we can draw the labour supply curve on the wage-
hours plane
The labour supply curve

 It is usually convex because the income effect


becomes stronger and stronger as the number of
hours of work increases

 The labour supply curve may actually bend


backward if the income effect is particularly strong
Backward bending labour supply
 When supplying many hours of work, the income effect
may dominate and the labour supply curve may bend
backward.
The reservation wage
The reservation wage

 Reservation wage = minimum wage at which the


agent is willing to supply a positive number of
hours of work

 At the reservation wage the agent is indifferent


between working and not working
Every map of indifference curves has
a reservation wage
Wage

w
w*
 Hours of leisure
 Hours of work
Formal derivation of labour
supply
Utility maximisation

 Consider a generic utility function, continuous and


concave in leisure L and in consumption C, U(C,L).

 Agents maximise it with respect to C and L subject


to the budget constraint:
Max{C,L} U(C,L) subject to pC=w(T-L)+V
Utility maximisation
 Replace the constraint into the utility function:

 Take first order condition with respect to l:


∗ ∗

∗ ∗

 The optimum is at the tangency of the budget line


and the indifference curves.
Labour supply and welfare
programmes
Labour supply with non-employment subsidies
Labour supply with a basic income

You might also like