Econ 327

Labour Economics

2020/21 Week 1: Lecture 1.2.

Maria Navarro Paniagua

Economics, LUMS

1
 Labour Supply Curve
• We can derive an aggregate labour supply curve
from individual work-leisure preferences.

• There is some point (reservation wage) where

an individual would rather stay at endowment
point than supply labour

• We need to convert consumption-leisure space

into wage-hours worked space so:

2
 Wages and hours worked
• Note the assumption that substitution effects dominate income
effects at lower wage levels (so upward sloping LS)
• Backward bending part (IE>SE) empirically contentious
Consumption (£) (I) (II)

Wage Rate (£)

£30

£20

W=£7 £10

£7

20 35 50
Leisure Hours (L)
Hours Worked 3
 Market Level Labour Supply
• Can be derived by adding up all individual’s
labour supply curves
• This leads to an important aggregate concept,
labour supply elasticity:
%HoursWork h w
  
%Wage Rate w h

• Where (in absolute terms:

– σ<1 then labour supply is inelastic
– σ>1 then labour supply is elastic
4
 Estimates of LS Elasticity
Standard estimating equation

hi = βwi+σVi+λXi+εi

• Where h is hours worked, w is the wage rate, V is non-labour

income and X is a vector of controls for the ith individual
• Beta is the key variable of interest
• β>0, substitution effect dominates; β<0 income effect
dominates.
• A lot of empirical issues though:
– Measurement error in hours worked and wage rate (especially for
salaried workers on permanent contracts) and also for non-labour
income.
– Sample selection in non-participating workers (they are
unobservably different) 5
 Estimates of LS Elasticity
• Most existing estimates for male prime age workers

• And finds a small (inelastic) negative elasticity (-0.10) – which suggests the income effect dominates

• This suggests that workers do not change their behaviour much with wage changes!

• If true this is problematic for a number of reasons (a) government policies aimed at increasing labour supply
often rely on changes in effective wages (tax credits for instance) (b) at a macro level suggests little response to
changes in real wages.

• but:

– These estimates come from research on male prime age workers who (a) historically have worked 40 hour
weeks and (b) have had falling hours of work over recent decades (c) may face hours constraints on work
(may be difficult for them to change hours of work)

– Caveats apply – working hours of high skill workers have increased in some countries, most notably US (see
Lozano and Kuhn, 2008, “The Expanding Workweek? Understanding Long Work Hours Among US Men,
1979-2006” Journal of Labour Economics)

– But most importantly this evidence does not cover women (who have experienced the biggest growth in
participation and working hours) or young/old people who may also have different elasticities.
6
 Government Policy and Labour Supply
Consider 3 types of policies:

1. Income Taxation
2. Welfare Benefits
3. Earned Income Tax Credit

Income Taxation quite straightforward

– Levying an income tax as a proportion of wage is the same as a decrease in wages (rotates
the budget constraint down). Comes down to Income and Substitution Effects.

– Reducing wages leads to less demand for leisure (income effect) but leisure is cheaper
(substitution effect). So if labour supply is upward sloping, increasing income tax reduces
labour supply.

– Lets consider welfare payments 7

 Welfare policies and labour supply
– Cash Grant – i.e. Payment of a fixed amount for the unemployed (say
£250)
– Equivalent to an increase in V so (assume no non-labour income to start
with)
– There
Consumption (£)
is only an income effect (relative price of Leisure and Consumption
does not change)

• Can lead to individuals leaving the labour market

• more likely to be true for lower wage workers

£250
B
A

Leisure Hours (L)

90 110
8
 Welfare policies and labour supply
– This is a reason why don’t usually see such take it or leave it grants (i.e. That disappear the
moment you do 1 hour’s work)
– What about if it is removed 1 to 1 (each pound earned leads to a reduction in welfare by 1
pound)
– Puts a flat section on budget line (until welfare is exhausted)
– Wage rate is effectively zero and a big disincentive to work (still holds with gradual removal –
Consumption (£)
a ‘taper’)
Income effect leads to more leisure

And so does substitution effect (leisure

has become cheaper – free in this
example – in the flat range)

Much of modern welfare design is about

trying to avoid these types of `traps’

Let’s consider one, the Earned Income Tax

Credit (EITC), which exists in many forms
across a number of countries (including
£250
the UK)
A B

Leisure Hours (L)

90 110
9
 Tax Credits
– Tax Credits have become increasingly popular/common

– Targeted at low income workers/households and sometimes also need to be

a member of a particular group (women with dependents etc)

– Effectively a working subsidy for workers/households in a given income

range. So eligible individuals in work get paid an additional ‘tax credit’ (by
the government) on top of their wage.

– Aimed to bring targeted groups into work (i.e. Move them from non-
participation to employment).

10
 EITC - Theory
Tax Credits put kinks outwards in the budget constraint.

Consumption, Annual 3 main segments:

Income (£)

.
•A – B tax credits are higher than wage rate (so net
subsidy to worker conditional on entering labour
market)

d •B-C (maximum tax credit range). No additional

tax credits, but no removal of existing tax credits (so
same slope as original budget line)
c
•C-D (phase out range) tax credit amount reduced
b
at a rate less the extra amount earned – so for each
pound earned tax credits reduce (but less than 1 to
1)

a
Leisure Hours (L)
90 110
11
 EITC – Effects on Labour Supply
Has a theoretically ambiguous effect on overall labour supply
Can draw cases where it (a) brings people into labour market (as there is no income
effect for them but wage effectively increases)
and (b) reduces labour supply. So effect of these schemes is an empirical question
(a) (b)
.
Consumption, Annual
Income (£)
Consumption, Annual
Income (£)

Leisure Hours (L) Leisure Hours (L) 12

 Tax Credits - Evidence
– Consider Working Family Tax Credit (UK, 1999) – replaced Family Credit.

– Eligibility:

• Family with children

• One adult working 16 hours or more
• There is a cap on amount (which increases with number of children in household)

– Provides:
1. Credit for children under 11 of £14.85 per child;
2. Maximum threshold of £90 per week;
3. If you earn more than this it tapers out at 55 percent of each pound earned

Paid in 6 month bundles

Did it have an effect on labour supply? First a word about difference in

Difference.
13
Difference in Difference - estimation

Outcome
Observed outcome
A
A is treatment group
B is comparison group.

}
B
Fundamental identification problem don’t observe

Treatment Effect
time trend for A in
absence of treatment (missing counterfactual)

Need another group to estimate trend effect.

So difference between observed and estimated

counterfactual is treatment effect

(difference between treatment outcome and outcome

if treatment followed same trend as comparison)

Only correct if parallel trends hold

1 2 Time
 Tax Credits - UK Evidence
• Blundell (2005) “Earned income tax credit policies: Impact and
optimality” Labour Economics
• Tough to evaluate as no obvious control group.
• Blundell compares single mothers (eligible) with single women no
child (ineligible) via difference in difference approach

So leads to significant increase in employment amongst treated

group (about 3.5-3.8 percentage points)
15
 Tax Credits – US Evidence
• Eissa and Liebman (1996) “Labor Supply Response to the Earned
Income Tax Credit”, Quarterly Journal of Economics.

Some sign of a bigger

effect for less educated
workers (who on average
would have lower slope
budget constraints)
.

16
 Labour Demand
• Lets consider the firm side now

• Assume two inputs (labour and capital):

MPl = ΔQ/ ΔL holding capital constant

(a critical assumption is that there is diminishing returns to labour (MPL↓ L↑))

L

• Assuming a competitive labour market then

MRPL = MPL*P

• The return from employing an additional unit of labour (MRP) is its marginal
product times the price of the good/service it produces
17
 Derived Demand
• (profit maximising) Firm will employ more labour up to point where marginal
return equals marginal cost

• Marginal cost is wages (w). For simplicity assume the firm is a ‘wage’ taker
(will consider monopsony later).

• Then simply w = MRPL

• Which amounts to saying: MPL = W/P

– Assume w=hourly wage then rhs units of output per hour.

• A key point here is that anything that affects the market for goods
and services, will influence P and hence the demand to labour (i.e.
the demand is derived)
18
 Labour Demand
• We can consider this more generally (and diagrammatically) in the long run
With two inputs:

Where the straight line is the isocost (input

mix holding cost constant)
Capital (units)

• This is defined by relative prices (-

w/r)

And curved lines are isoquants (input mix

holding production level constant)

• This is defined by production

function (i.e. Technology) such
that at any point MRTS =
-MPL/MPK

Cost minimisation point at –w/r=MRTS

Labour (hours) 19
 Labour Demand
• Can use this to derive a downward sloping demand curve (under certain
assumptions – (substitution effect>income effect)
• And can also derive wage elasticity of demand.

Capital (units)

W=£10
W=£15
W=£20

20 30 40
Labour (hours) 20
 Wage determination
• With this done we can derive a wage equilibrium in a perfectly competitive
setting Under this set-up two important facts:

Everyone who is willing to work at w* is employed.

There is no `involuntary’ unemployment (only
people with reservation wages >w*)
Wages

Any intervention (government, union etc) that looks

to raise wages above w* will by definition cause
Supply involuntary unemployment.

No reason why firms would ever pay more than w*

(i.e. Efficiency wages)

The effect of immigration on wages is unambiguous

(it shifts labour supply outwards and decreases
wages)
W*
(binding) Minimum Wages will cause
unemployment

All of these issues are in fact highly contentious and

form the basis of much of the course material.

Demand

L*
Labour 21
 Next Week
1. Wage Determination (Continued)
2. Minimum Wages and Unemployment

Reading:

1. Borjas Chapters 3&4

2. (this week’s tutorial) Eissa, N and Hoynes, Hilary W. (2004). “Taxes and the
labor market participation of married couples: the earned income tax credit,”
Journal of Public Economics, 88(9-10): 1931-1958.

3. (next week’s tutorial) Dickens, Richard, Stephen Machin and Alan Manning
(1999) 'The Effects of Minimum Wages on Employment: Theory and Evidence
From Britain', Journal of Labor Economics, 17, 1-22

Labour 22