Chapter Two

Labour Supply

Chapter 2-1
Learning Objectives
 Labour Market Attachment
 Labour Force Participation
 Measurement and Trends
 Hours of Work
 Basic Income-Leisure Model
 Utility Maximizing Behaviour
 Labour Supply
 Factors Influencing the Supply of Labour

Chapter 2 © 2007 McGraw-Hill Ryerson Ltd. 2

Chapter 2-2
 Learning Objectives,
cont’d
 Changes in the Wage Rate and the
Labour Supply
 Extensions and Applications
 Added and Discouraged Worker Effects
 Hidden Unemployment

 Moonlighting, Overtime, and Flexible Hours

Chapter 2 © 2007 McGraw-Hill Ryerson Ltd. 3

Chapter 2-3
Labour Force Participation
Rate
 LFPR
 the fraction of the eligible population that
participates in the labour force
 LFPR=LF/POP

 LF (Labour Force)
 individualsin the eligible population who
participate in labour market activities either
employed or unemployed

Chapter 2-4
Chapter 2 © 2007 McGraw-Hill Ryerson Ltd. 5
Chapter 2-5
Figure 2.2 Labour Force Participation
Rates by Sex, 1901-1991

Chapter 2-6
Chapter 2 © 2007 McGraw-Hill Ryerson Ltd. 7
Chapter 2-7
Chapter 2 © 2007 McGraw-Hill Ryerson Ltd. 8
Chapter 2-8
Chapter 2 © 2007 McGraw-Hill Ryerson Ltd. 9
Chapter 2-9
 Unemployment
 To be considered unemployed, a
person must be in one of the following
three categories:
1. Without work but has made specific efforts
to find a job within the previous four weeks
2. Waiting to be called back to a job from
which he or she has been laid off
3. Waiting to start a new job within four weeks

Chapter 2 © 2007 McGraw-Hill Ryerson Ltd. 10

Chapter 2-10
Basic Income - Leisure Model
 Max U(C,L) s.t. (1) P*C=wH+v and (2)
T=H+L.
 The maximization with fixed endowment
 The choice of hours worked given
opportunities and value of nonmarket time.
 preferences U and constraints (income and
time)
 individuals choose the feasible outcomes which
yield the highest level of satisfaction

Chapter 2-11
Preferences
 Two “goods”
 consumption (C)
 leisure (L)
 Represented by indifference curves, U
 Indifferent between various
combinations of consumption and
leisure

Chapter 2-12
Figure 2.4a Indifference Curve
Slope - Marginal Rate
of Substitution A-abundance of
consumption willing to
give up for leisure
A
Consumption

B-abundance of leisure willing

to give up for consumption

C C-consumption and leisure

are substitutable
B

0
Leisure
Chapter 2-13
Figure 2.4b MRS Of Two Different
Consumers
Consumption

C11

C21 A
C0 U20

U10

0 l1 l0
Leisure
Chapter 2-14
Preferences
 Preferences over all conceivable
combinations of consumption and
leisure
 All combinations lie on some
indifference curve
 Represented by an indifference map

Chapter 2-15
Figure 2.4 c Indifference Curve Map
For an Individual
Consumption

U2

U1

U0
0
Leisure
Chapter 2-16
Constraints
 Constrained by economic properties of
the market
 Transform consumption-leisure to
income-leisure by setting the price of
consumption

Chapter 2-17
Figure 2.5 a Simple Full-Time/Part-
Income Time Choice
C
IF+YN
IF Full-time
B
IP+YN

Part-time
IP
A
YN hP
YN No Paid Work

0 LF LP T
Leisure
hF
Chapter 2-18
Figure2.5 b Linear Potential Income
Constraint
Income
W1T+YN Slope depends on
W1 High wage Individual’s wage rate

W0T+YN W0 Low wage

YN

0 T Leisure
Chapter 2-19
The Consumer’s Optimum
 Optimal amount of income and leisure
 Utility-maximizing equilibrium
 highest indifference curve given the income
constraint
 Compare MRS with the Market Wage Rate
 MRS - measures the willingness to exchange time
for income
 Market Wage Rate - measures the ability to
exchange leisure for income

Chapter 2-20
Figure 2.6 a Equilibrium of
Nonparticipant
R U U1 2
Slope=-W0 Market Wage less than
Income U0
R the reservation wage

Slope= -WR

Corner
Solution
A=E0
YN
R’
0
T Leisure

Chapter 2-21
Figure 2.6 b Equilibrium of a
Participant
Income U1 U2
Market wage exceeds the
reservation wage

U0
E0 Interior Solution
W0h0+YN Indifference curve tangent
To budget constraint
R

YN
R’

0 l0 T
Leisure
Chapter 2-22
Figure 2.7 The Effect of an Increase in
Nonlabour Income on Supply

Consume more Consume less

Chapter 2-23
Effect of Non-labour Income
on Hours of Work
  in nonlabour income results in a parallel
shift outward of the budget constraint
 normal good-if leisure is a normal good more
will be consumed resulting in less work hours
 inferior good- if leisure is an inferior good less
will be consumed and more work hours are
spent

Chapter 2-24
Change in Wage Rate
 Two effects
 Income effect
 the worker has more income to buy more goods including
leisure (reduces work hours).
 The effect is positive on leisure if leisure is normal, I.e.,
dL/dv>0.
 Substitution effect
 individual may work more because the returns are greater
substituting away from leisure
 it is negative, I.e., dL/dw<0 (where d represents “change”)

Chapter 2-25
Figure 2.8 Income and Substitution Effect of
W1T=YN Wage Increase
-W1
Income

W0T=YN -W0
E1
E’
E0
U1

U0
Net effect
Income effect Substitution effect
0 l’ l1 l0 T leisure
Chapter 2-26
 Effect of Wage Increase on
Participation
 Both substitution effect and income effect
 If income effect dominates, hours of work
may decline (not withdraw )
 For a nonparticipant an  W may leave
the equilibrium unchanged or induce the
individual to participate
 Other institutional constraints such as fix
working hours may affect the result

Chapter 2-27
Effects of an Increase in Nonlabour
Income on Participation
 Opposite to wage increase
 Pure income effect
 May cause participants to leave the
labour force (which occurs when
nonlabour income is sufficiently high)
 Examples include transfer payments
from government (incentives are
reduced)

Chapter 2-28
Individual Supply Curve
 Substitution effect > income effect
 wage leads to labour supplied
 As wages continue toincrease,
 thereis a point where substitution effect
and income effect offset each other
 Supply
curve bends backward when
income effect > substitution effect

Chapter 2-29
Elasticity of Labour Supply
 Responsiveness of labour supply to changes in
the wage rate
 Uncompensated elasticity
 % change in labour supply from a 1% increase in wage
(indeterminate)
 Income elasticity
 % change in labor supply from a 1% increase in
nonlabour income (negative)
 Compensated elasticity
 % increase in labour supply from a 1% increase in wage
after compensating for increased income (positive)

Chapter 2-30
Moonlighting, Overtime,
Flexible Work Hours
 Why do some people moonlight at a
second job at a wage less than their
market wage on their first job?
 Why do some people require an
overtime premium to work more?

Chapter 2-31
Figure 2.11 a Fixed Hours Constraint
Income Y1

C
Yc

0 Lc T
Leisure
Chapter 2-32
Figure 2.11 b Underemployment
Income
YT

Yd D

Ud
C
Yc
Uc

0 Ld Lc T
Leisure
Chapter 2-33
 Overtime and
Overemployment
 Prefer to work fewer hours at the going
wage rate
 Induced to work more hours through an
overtime premium

Chapter 2-34
Figure 2.12 Overemployment and
Overtime Yt
I
C
Yc
D
Yd
ud

Uc
L
0 Lc Ld T
I Yo
O

Yt
C Ud
Uc
Tt L
0 Chapter 2-35
Overtime Premium
 Substitution effect is larger than the income
effect
 Price of leisure is higher for overtime hours
 Examples include medical doctors working
overtime
 People in safe cities often work overtime
(relative to those in unsafe cities)

Chapter 2-36
Overtime Premium vs Straight
Line Equivalent
 worker would not remain at overtime
equilibrium
 New equilibrium on a higher utility curve
 Income effect outweighs the substitution
effect causing the person to supply less
work

Chapter 2-37
Gains for Alternative Work Schedules
I
Yt C-some individual are
discontent
C D- preferred work schedule
Yf
F- willing to give up wages
D for preferred work schedule

F
Ud

Uc
0 T
LChapter 2-38
 Comparison:
 No difference in utility between C and F
even though F implies a lower wage
rate
 Allowing workers to work desired
amount of hours can improve utility as
long as w> T Yf line

Chapter 2-39
End of Chapter Two

Chapter 2-40