EC4307 - Lecture1 - Topic 2

EC4307 Lecture 1
Topic 1: Labor Supply, Labor Demand, General

Equilibrium and Applications
Dr. Huang Kui, Angela
National U of Singapore
January 9/11, 2023
Dr. Huang Kui, Angela (NUS) EC4307 Lecture 1 Topic 1 January 9/11, 2023 1 / 42
Outline
Labor Supply
Labor Demand
Competitive Equilibrium
Labor Supply: The Representative Household
Begin formal modeling by considering individual household behavior.

As an abstraction, we will think of one representative household as a
stand in for the whole economy.
Will define household preferences.
Then think about household constraints.
Finally, what will household do given preferences and constraints.
Labor Supply: Commodity Space
N↳
2 goods, consumption c and leisure l. upper
bound for
Total time of h hours, N s = labor ∆ N s = h ≠ l. leisure
Each good’s set: c. & l
c œ R+
l œ [0, h] leisure is bounded by h .
Then (c, l) œ R+ ◊ [0, h] solution

interior & corner
any the no .
Labor Supply: Preferences
Preferences: binary relation ≤ defined over pairs (c, l):
(ci , li ) 0
≤ (cj , lj )
at least as
good as
Working directly with binary relations is difficult.
Definition: a real-valued function u : R2 æ R is called a utility
function representing the binary relation ≤ defined over pairs (c, l) if
for ’(ci , li ) , (cj , lj ) œ R+ ◊ [0, h],
any
(ci , li ) ≤ (cj , lj ) … u (ci , li ) Ø u (cj , lj )
atheist
as good as ~
depicts
the binary relation
Labor Supply: Preferences
Theorem: if the binary relation is complete, reflexive, transitive,

strictly monotone and continuous, there exist a continuous real-valued
function u that represents ≤.
Indifference curves are level sets {(c, l) : u(c, l) =D-
ū}. same K utility
is
,
constant at ñ .
We’ll always assume u is continuous and differentiable.

u(c, l) is a function of two variables. To consider properties of u and
so optimal choices, we’ll need to consider how it varies separately with
c and l.
Labor Supply: Utility Function and Indifference Curves
-
more is
better
-
consumer
printers
diversity ? ?
Howl ?
2nd derivative
is - we
How ??
und !
'
Labor Supply: Budget Constraint
Leisure l ∆ labor supply N s = h ≠ l.

to write the BC
2 ways
Wage w . 1. Ito of labours NSW
Unearned income fi. 2. ito of leisure 4-Dw
A lump-sum tax T -
fixed amt
Then
⑤
① lab#
c = N s w + fi ≠ T = (h ≠ l) w + fi ≠ T
unemamtdme
dividend
income
Labor Supply: Household’s Problem
Problem for household is then:
max u (c, l) c- hw -
In in
-
-7
c,l
s.t. c = (h ≠ l) w + fi ≠ T
Form Lagrangian with multiplier ⁄ > 0 on constraint:
L = u (c, l) + ⁄ [(h ≠ l) w + fi ≠ T ≠ c]
a-
First order conditions:
-7
uc = ⁄
Uc
gc :
ul = ⁄w
Thus
ul
=w (1)
uc
marginal rate of substitution = relative price of leisure.
(1) can be solved to give the labor supply: N0 s (w )
Labor Supply: Consumer Optimization
Budget constraint :
Interior soln :
G-
tangent
-
w -
ltwhtz -
T
tornersoln :
slope : -
w
MRS > w
interrupt : whta -
☆ Indifference come
nlcsl )=ñ
Htwtogettheslpeof
1C ?
→ tatethetotal
derivative
vi. dctue.de
⇒
%; ¥ -
Figure: Consumer Optimization

.
= - MRS
Labor Supply: A Parametric Example
Suppose u (c, l) = log c + “ log l natural logarithm
From the first order conditions analyzed above, we have
MRS = uucl = w , where in this example:
ul “1 c
MRS = = 1l = “
uc c
l
So:
cú
“ =w
h ≠ Nú
Together with the Budget constraint:
c ú = N úw + fi ≠ T
Solve the two equations simultaneously, we have:

wh ≠ “ (fi ≠ T ) h “ (fi ≠ T )
Nú = = ≠
(1 + “) w 1+“ (1 + “) w
Labor Supply: Non-Participation
Previously we assumed an interior solution, l < h or N s > 0. But if
fi ≠ T > 0 there may be corner solutions of individuals who choose not to
quality constraint
work.
if its an
then
imply this
→
Impose additional constraint l Æ h via Kuhn-Tucker multiplier µ. µ = 0 if
" l < h, µ > 0 if l = h. mlh et -0 WHY ? ?
÷"
-
.#÷→€
L = u (c, l) + ⁄ [(h ≠ l) w + fi ≠ T ≠ c] + µ (h ≠ l)
First order conditions:
d. C : ite -7=0 ⇒
uc = ⁄
ul = ⁄w + µ
when
1- get
whereto
mm⑧
Thus how ?
ul µ
=w+ Øw
a.
.nu
.
uc
means you work ⁄
① sa
For participant, l < h, N > 0, µ = 0, uucl = w , marginal rate of substitution
= wage.
-
→ Interior solution
@ For non-participant, l = h, N s = 0, µ > 0, uucl > w , marginal rate of
substitution > wage. → corner solution
-
Labor Supply: Non-Participation
E:*
Witi
:
so
W
MRS >
is
steeper of
than slope
BC .
Rope of BC :
MRS .
Figure: The Representative Consumer Chooses Not to Work
Labor Supply: an Increase in fi ≠ T for the Consumer
New BL :
comparative
static Analysis
wltwht
⇐
?yo
-
11 shift
← new BC lnwmeeltat.
↳ income
pure
eltect .
C is normal goods ,
intuitively ,
c.
*↑
, eat Nsd
,
Figure: An Increase in fi ≠ T for the Consumer
Labor Supply: an Increase in the Real Wage Rate–Income
and Substitution Effects
Denom
posed to
imomelsubs
eltat :
New BC :
c- _
-
yl -11h -19--1
→ in interrupt .
F→o :
substitution
Orel .
slope → pure
✓
effect
wtf, leisure is more
expensive ,
0*4 ,
b*↓ ,
N*↑
0-74 :
a- T
- - - -
-
- - - -
-
I / shift : puremwmeeltect
/
should always gotoptis .
c*4 ,
1*9 ,N*↓
F→H :
Total elfect
0*9 ,
l*{ Tv same
,
Nˢ*{¥me
uncertain
Nˢ%oncs in
-
- - -
font tbsaysrlheraise
]
,
direction
"
' special
has cage
opp
see which eltwt of b*
→ .
dominates
Figure: An increase in the Real Wage Rate–Income and Substitution Effects

Labor Supply: Income and Substitution Effect
We will follow the Hicksian decomposition.

Income Effect: An increase in w induces a change in total income
even if l ú stays constant. Reduces work incentive: use more income to
“buy” leisure. N ↓ , 1*4 bmove in opp direction ]
*
Substitution Effect: An increase in w makes leisure change its relative

price with total utility constant. Increases work incentive.
f
revise
leisure more expensive
aisha :
Labor Supply: Income and Substitution Effects in the
Example
wh ≠ “ (fi ≠ T ) h “ (fi ≠ T )
Nú = = ≠
W (1 + “) w 1+“ (1 + “) w
①
Case 1: An increase in fi ≠ T for the household (Pure Income Effect)
-
oishift
ˆN ú ↳
{
to detect the “ howtouheok
with =≠ <0
change to
moped ˆ (fi ≠ T ) (1 + “) w theetteit ?
-
↳ take first
On : Dome need to know which one

•
denvatio .
ifdenvihiso
what 8571-7
,
move insane
direction
Labor Supply: Income and Substitution Effects in the
Example
wh ≠ “ (fi ≠ T ) h “ (fi ≠ T )
Nú =
(1 + “) w
=
1+“
≠
(1 + “) w 2%0
②
Case 2: An increase in the Real Wage Rate w (Income and Substitution
-
Effects)
- -
slope 8s
case 2.1:
Suppose fi ≠ T = 0, then means Nsf

labour
h ˆN ú doesn't nlopmd to
N =
ú
∆ =0 the wage ata⇒
1+“
.
ˆw
Labor supply does not respond to the wage at all! So income and
substitution effects completely offset. WHY ? ? ?
2.2:* Suppose fi ≠ T > 0, then
Cate
ˆN ú “ (fi ≠ T )
>
N*↑wl↑ñW
= >0 means
ˆw (1 + “) w 2 Crmbsubeltectcaise N*%o
means sub
Substitution effect dominates, and income effect only partly offsets elfeut
substitution effect.
-
FÉw? dominates)
Individual Labor Supply
Labor supply curve N s (w ) plots response of labor supplied by

households to a change in wage, holding fixed fi ≠ T (and
preferences).
For individual workers, the slope of labor supply is unclear. Depends
on income and substitution effects. For high enough wage, may be
backward bending. That is N s (w ) > 0 for low w but N s (w ) < 0 for
Õ Õ
c-
w high enough. "%
ang
May also be discontinuous if there are-
fixed costs of work (commuting
costs). Won’t work low number of hours.
-
>*
und ! !
÷ .
.
N
Aggregate Labor Supply
In the aggregate, labor supply curve embodies both intensive and

extensive margins, and is upward sloping.
Intensive margin: for those already working, increase in wage has
% income and substitution effects.

-
E-
Extensive margin: increases in wages may induce some who were not
in labor force to enter and supply labor. Always increasing in w .
-
Aggregate labor supply curve also smooths out kinks in individual

supply, for example due to fixed costs of work.
I t
Labor Supply Curve
Aggregate WI
Figure: Labor Supply Curve
Labor Supply Curve: Effect of an Increase in Dividend
Income fi or a Decrease in Taxes T
↑ in
pure income
etat
Cmb Nˢ*↓)
9%-171--04 or 7*-1-11-114
Figure: Effect of an Increase in Dividend Income or a Decrease in Taxes
Outline
Labor Supply
Next: Labor Demand
Labor Demand: What is a firm?
A firm uses capital K and labor N to produce output Y via a

level of technology gyp
production function F :
Y = zF (K , N) [
where z is the level of technology or total factor productivity (TFP).
The main example we’ll use is Cobb-Douglas production function,
with – œ (0, 1):
Y = zK – N 1≠–
We will start with a static model: K is constant.
Later will relax
↳
only 18
ing var . on we
this
assumption
.
Labor Demand: Properties of the Technology
We’ll make several assumptions on the technology F , all of which are
satisfied by Cobb-Douglas.
1 Inputs are essential.
zF (0, N) = zF (K , 0) = 0
2 Constant returns to scale:
zF (⁄K , ⁄N) = ⁄zF (K , N)
3 Marginal productivities of capital and labor are positive and decreasing.
MPK = zFK > 0, zFKK < 0
MPN = zFN > 0, zFNN < 0
4 Marginal productivity of each factor increases in the other.
ˆMPK ˆ
= zFK = zFKN > 0
ˆN ˆN
ˆMPN ˆ
= zFN = zFKN > 0
ˆK ˆK
Note one implies other since FKN = FNK .
Labor Demand: Total Factor Productivity Increases
29 ,
MPN =
MPN is bigger
than before
y
and .
Figure: Total Factor Productivity Increases
Labor Demand: Total Factor Productivity Increases
Figure: Effect of an Increase in Total Factor Productivity on the Marginal Product

of Labor
Labor Demand: Problem of the Firm
wstotcaiptal-rkcoh-oflabow-a.NL
Competitive firm rents capital at rate r , hires labor at wage w .
Profits: output minus costs fi = zF (K , N) ≠ rK ≠ wN. Here, we
8 0
ignore the depreciation rate ”.
Note everything in real terms – same as setting price of output to 1.
Firm maximizes profits by hiring labor and capital. We take first order
conditions for choice of K and N:
MPK
← marginal cost
ok -
_
MPK -7=0 → zFK (K , N) = r of labor
ON
:mpN-ws0⇒zFN (K , N) = w MPN
c- marginal cost (2)
of
capital
Factors are paid their marginal products.
(2) can be solved to give the labor demand: N d (w )
Labor Demand Curve
Figure: The Marginal Product of Labor Curve is the Labor Demand Curve of the
Profit-Maximizing Firm
Labor Demand: A Parametric Example
With Cobb-Douglas production, we have:
fi = zK – N 1≠– ≠rK ≠wN
We take first order conditions for K and N:
MPK 2 ✓ zFK (K , N) = z–K –≠1 N 1≠– = r (3)
-%ww
mp N w
-
zFN (K , N) = z (1 ≠ –) K – N ≠– = w (4)
(4) can be solved to give the labor demand: to go

dinard 3
z (1 ≠ –)
41
–
from here
Nd = K then
w
N d is decreasing in w . Increases in z and K shift the labor demand to
the right. BE -
Outline
Labor Supply
Labor Demand
Next: Competitive Equilibrium
Adding a Government
Operational definition: takes in taxes T and spends G.

We’ll assume a balanced budget. No debt in this static model.
G = T
Also assume household does not value government spending. Not

crucial here.
Putting Everything Together
We have a household that decides how much to work, N, and how

much to consume, c to maximize utility. It takes as given the wage,
w , and the interest rate, r .
We have a firm that decides how much to produce Y and how much
capital, K , and labor, N to hire. It takes as given the wage, w , and
the interest rate, r .
We have a government that raises taxes T , and spends G.
We are in a static world: we will assume K = K̄ constant.
Why do we put these together?

1 Consistency: we are sure that everyone is doing things that are
compatible.
2 To derive positive predictions from the model.
We will take as exogenous some objects: K = K̄ , G, and z. As well
as specifications of u and F .
We will derive endogenous objects: w , r , N, c, T . These imply Y , fi,
l.
A Competitive Equilibrium is an allocation {Y , N, K , c}, a price system

{w , r } and a government policy {T , G} such that:
1 Given the price system and the government policy, households choose
N s and c to maximize their utility.
2 Given the price system and the government policy, firms maximize
profits by choice of N d and K .
3 The government budget is balanced: G = T .
4 Markets clear:
Labor: N d = Ns = N
Capital: K = K̄
Goods: Y © zF (K , N) = c + G
Solving for an Equilibrium
Key here is find w to clear the labor market.

From consumer utility maximization:
ul (c, l)
MRS = =w
uc (c, l)
From firm profit maximization:
MPN = zFN (K , h ≠ l) = w
Equate and impose goods market clearing:

1 2
ul zF (K̄ , h ≠ l) ≠ G, l
1 2 = zFN (K , h ≠ l)
uc zF (K̄ , h ≠ l) ≠ G, l
Solve for l. Note MRS is decreasing in l, MPN is increasing in l.

Figure: The Production Function and the Production Possibilities Frontier
Figure: Competitive Equilibrium
Outline
Labor Supply
Labor Demand
Next Time: Pareto Optimality and Applications
Practice Question
1 Consider an individual with preferences over consumption c and
leisure l given by:
c 1≠“
u(c, l) = + al
1≠“
where “ > 0 and a > 0 are constants. She is endowed with h hours of
time to divide between working at wage w and leisure. She has no
unearned income and doesn’t need to pay taxes, thus uses all her
labor income for consumption. So the budget constraint is:
c = Nw = (h ≠ l) w
1 Solve for her optimal choices of consumption and leisure. (Consider the
interior solution for simplicity)
2 Under what conditions does her labor supply curve slope up or down?
Interpret your answer through the income and substitution
effects.
Related Material for Your Interest: Evaluations of recent
US tax reform by Tax Foundation and Tax Policy Center
“Preliminary Details and Analysis of the Tax Cuts and Jobs Act”
by Tax Foundation
https://taxfoundation.org/final-tax-cuts-and-jobs-act-details-
analysis/
“Macroeconomic Analysis of the Tax Cuts And Jobs Act” by Tax
Policy Center
http://www.taxpolicycenter.org/publications/macroeconomic-
analysis-tax-cuts-and-jobs-act
Related Article for Your Interest
“Why Do Americans Work So Much More Than Europeans?” by

Edward C. Prescott
https://www.nber.org/papers/w10316

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EC4307 Lecture 1

Topic 1: Labor Supply, Labor Demand, General

Dr. Huang Kui, Angela

January 9/11, 2023

Begin formal modeling by considering individual household behavior.

Then (c, l) œ R+ ◊ [0, h] solution

Preferences: binary relation ≤ defined over pairs (c, l):

Theorem: if the binary relation is complete, reflexive, transitive,

We’ll always assume u is continuous and differentiable.

Leisure l ∆ labor supply N s = h ≠ l.

Figure: Consumer Optimization

Solve the two equations simultaneously, we have:

Figure: The Representative Consumer Chooses Not to Work

Figure: An Increase in ﬁ ≠ T for the Consumer

Figure: An increase in the Real Wage Rate–Income and Substitution Effects

We will follow the Hicksian decomposition.

Substitution Effect: An increase in w makes leisure change its relative

On : Dome need to know which one

Suppose ﬁ ≠ T = 0, then means Nsf

Labor supply curve N s (w ) plots response of labor supplied by

In the aggregate, labor supply curve embodies both intensive and

% income and substitution effects.

Aggregate labor supply curve also smooths out kinks in individual

Figure: Labor Supply Curve

A firm uses capital K and labor N to produce output Y via a

Figure: Total Factor Productivity Increases

Figure: Effect of an Increase in Total Factor Productivity on the Marginal Product

With Cobb-Douglas production, we have:

ﬁ = zK – N 1≠– ≠rK ≠wN

We take first order conditions for K and N:

MPK 2 ✓ zFK (K , N) = z–K –≠1 N 1≠– = r (3)

(4) can be solved to give the labor demand: to go

Operational definition: takes in taxes T and spends G.

Also assume household does not value government spending. Not

We have a household that decides how much to work, N, and how

Why do we put these together?

A Competitive Equilibrium is an allocation {Y , N, K , c}, a price system

Key here is find w to clear the labor market.

From firm profit maximization:

Equate and impose goods market clearing:

Solve for l. Note MRS is decreasing in l, MPN is increasing in l.

Figure: Competitive Equilibrium

“Why Do Americans Work So Much More Than Europeans?” by

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