lecture2 _2011

10/5/2011 1 ECON 3027 Labour Economics 2.1 Labour Supply 10/5/2011 2 Topics covered here � How to measure the labour force � Labour Supply: the labour-leisure choice – Individual choice of hours to work – Individual choice to participate or not to the labour market – The effect of a change in income and wage – Market labour supply Policy applications 10/5/2011 3 Average hours worked/week 1900- 2007: US 30 35 40 45 50 55 60 1900 1920 1940 1960 1980 2000 2020 Year W e e k ly h o u rs 10/5/2011 4 Measuring the Labor Force – Labor Force = Employed + Unemployed � LF = E + U – Labor Force Participation Rate � LFPR = LF/P � P = civilian adult population 16 years or older not in institutions. – Employment Rate = E/P – Unemployment Rate = U/LF 10/5/2011 5 Introduction to Labour Supply � The neoclassical theory of labour supply: – To hold a job, you must first have decided to do so! � Individuals dispose of a limited amount of time, which she/he chooses to allocate between paid work and leisure (unpaid non-labour market activity) � Two sets of information required to determine the optimal distribution of an individual’s time between work and leisure: � Subjective information concerning individual’s preferences: indifference curves � Objective market information reflected in the budget constraint. 10/5/2011 6 Introduction to Labour Supply: Cont’d � In reality the allocation of time is more complex than a simple choice work-leisure – Leisure includes ``household production’’: planning, family negotiation – Trade-offs over the course of time � We start we the simple neoclassical model 10/5/2011 7 Preferences: indifference curves � Utility Function – Measure of satisfaction that individuals receive from consumption (C) of goods and leisure (L). – U = f(C, L) � U is an index. � Higher U means happier person. � Indifference curve – Combinations of real income and leisure time that will yield some specific level of utility or satisfaction to the individual: downward sloping (trade-off C&L), higher curves=higher utility; do not intersect, convex to the origin (increasing opportunity cost, diminishing MRS) 10/5/2011 8 Indifference curves Hours of leisure Consumption $ 40,000 Utils 25,000 Utils Z X Y 500 450 400 100 125 150 10/5/2011 9 The Slope of an Indifference Curve: MRS of Leisure for Consumption C L MU MU L C = ∆ ∆ 10/5/2011 10 Differences in preferences U0 U0 U1 U1 Consumption ($) Consumption ($) Hours of Leisure Hours of Leisure Tastes, kind of job, individul’s personal circumstances 10/5/2011 11 Budget Constraint � The budget constraint defines the worker’s opportunity set, indicating all of the consumption – leisure baskets the worker can afford. � C = wh + V – Consumption equals labor earning (wages × hours of work) plus nonlabor income (V). – As h = T – L, can rewrite C = w(T – L) + V. 10/5/2011 12 Graphing the Budget Constraint T E V wT+V 0 Hours of Leisure Consumption ($) Budget Line 10/5/2011 13 The Hours of Work Decision � Individuals choose consumption and leisure to maximize utility. � Optimal consumption is given by the point where the budget line is tangent to the indifference curve. – At this point the marginal rate of substitution (MRS) between consumption and leisure equals the wage. – Any other consumption – leisure bundle on the budget constraint would give the individual less utility. 10/5/2011 14 Optimal Consumption and Leisure $1100 $1200 A Y $500 P U1 $100 U0 U* E 110 110 40 70 0 0 Hours of Work Hours of Leisure 10/5/2011 15 The Effect of a Change in the Wage Rate on Hours of Work 10/5/2011 16 The Effect of a Change in the Wage rate on Hours of Work � Income Effect – An increase in income increases (decreases) the demand of all normal (inferior) goods, including leisure so the increase in wage increases (decreases) the demand for leisure which reduces (increases) hours of work � Substitution effect – the wage increase makes leisure more expensive, particularly for high-wage workers who reduce the demand for leisure and increases hours of work 10/5/2011 17 The effect of a change in wages: the Income Effect � Increase in non-labour income allows a ``jump’’ to a higher indifference curve: Income Effect – If leisure is a normal good the impact of an increase in non-labour income is positive (more leisure, less work) – If leisure is an inferior good the impact of an increase in non-labour income is negative (less leisure, more work) � Typically we assume leisure is a normal good so the impact is positive. 10/5/2011 18 The effect of a change in wages: the Substitution Effect � As wages change holding real income constant, changes in consumption-leisure bundle indicate the Substitution Effect � As the opportunity cost of leisure increases we consume less of the good (holding income constant), so this effect is negative (less leisure and more work) 10/5/2011 19 The Effect of a Change in Nonlabor Income on Hours of Work An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P0 to point P1. If leisure is a normal good, hours of work fall. F1 P1 $200 U1 U0 E1 E0 P0 70 80 110 F0 $100 Consumption ($) Hours of Leisure 10/5/2011 20 The Effect of a Change in Nonlabor Income on Hours of Work An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P0 to point P1. If leisure is inferior, hours of work increase. F1 P1 $200 U1 U0 E1 E0 P0 7060 110 F0 $100 Consumption ($) 10/5/2011 21 More Leisure at a Higher Wage When the income effect dominates the substitution effect, the worker increases hours of leisure in response to an increase in the wage. G U1 QD D R P U0 V F E 8575 1100 70 Hours of Leisure Consumption ($) 10/5/2011 22 More Work at a Higher Wage When the substitution effect dominates the income effect, the worker decreases hours of leisure in response to an increase in the wage. G D D F E U1 Q R P U0 V 8070 1100 65 Consumption ($) Hours of Leisure 10/5/2011 23 Ambiguous relationship between Hours of Work and Wage Rates � Changes in the wage rate induces both Income and Substitution Effects. The overall effect on hours worked is ambiguous � An increase in the wage rate increases hours of work if the substitution effect dominates the income effect. � An increase in the wage rate decreases hours of work if the income effect dominates the substitution effect. 10/5/2011 24 To Work or Not to Work � Are the ``terms of trade’’ sufficiently attractive to ``bribe’’ a worker to enter the labour market? � Reservation wage: the lowest wage that would make the person indifferent between working and not working. – Rule 1: if the market wage is less than the reservation wage, then the person will not work. – Rule 2: the reservation wage increases as nonlabour income increases 10/5/2011 25 The Reservation Wage H Y G X UH E U0 Hours of LeisureT0 Has Slope -whigh Has Slope -w∼ Consumption ($) 10/5/2011 26 Labor Supply Curve � Relationship between hours worked and the wage rate. – At wages slightly above the reservation wage, the labor supply curve is positively sloped (the substitution effect dominates the income effect). – If the income effect begins to dominate the substitution, hours of work decline as the wage rate increases (a negatively sloped labor supply curve). 10/5/2011 27 10/5/2011 28 10/5/2011 29 10/5/2011 30 Labour Supply Elasticity h w w h ww hh ∆ ∆ = ∆ ∆ / / �Labour supply is positive when substitution effect dominates income effect and negative when income effect dominates substitution effect. �Labour supply elasticity less than one in absolute value means inelastic 10/5/2011 31 Estimates of the Labour Supply Elasticity � There are many studies that estimate the labour supply elasticity – consensus on an elasticity for prime-age men around -0.1: inelastic and negative; – Differences men and women/younger and older workers – Problems with the estimated elasticities: � Hours of work, wage rate, non labour income. 10/5/2011 32 Labor Supply of Women � Substantial cross-country differences in women’s labor force participation rates. � Over time, women’s participation rates have increased. � In most studies on women, substitution effects dominate income effects (upward sloped labor supply curve). 10/5/2011 33 Growth in Female Labor Force Participation Rates and the Wage, Cross Countries 1960-80 � Source: Jacob Mincer, “Intercountry Comparisons of Labor Force Trends and of Related Developments: An Overview,” Journal of Labor Economics 3 (January 1985, Part 2): S2, S6. 1 2 3 4 5 6 7 8 9 Percentage Change in Wage 0 1 2 3 4 5 6 7 Fe m al e Pa rti ci pa tio n G ro w th R at e of USSR United States Israel Britain France Sweden Germany Italy Australia Spain Japan Netherlands 10/5/2011 34 Labour Supply of Women � Rising real wage and/or declining reservation wage – Fertility and real wage – Impact of household production and technological improvements (washing machine microwave oven, home- based work) � Labour force participation is very responsive to changes in the wage, less responsive labour supply for working women � Support for the family’s labour supply decision 10/5/2011 35 Policy Application: Welfare Programs and Work Incentives � Welfare programs can create work disincentives e.g. low income support in the UK � Welfare reduces supply of labour by granting non-labour income, which raises reservation wage � To illustrate the impact of welfare programs on work incentives, we can consider the following simple program. 10/5/2011 36 Effect of a Cash Grant on Work Incentives � A take-it-or-leave-it cash grant of $500 per week moves the worker from point P to point G, and encourages the worker to leave the labor force. F Consumption ($) 500 Hours of Leisure 0 11070 G U1 U0 P 10/5/2011 37 Effect of a Welfare Program on Hours of Work Hours of Work $500 U0 U1 G E P F R Q H D D 0 11010070 slope = -$5 slope = -$10 Consumption ($) �The Welfare Program gives the worker a cash grant of $500 and imposes a 50% tax on labour earnings. �It reduces work incentives from P to R. �Income and substitution effect, both, increase the demand for leisure. 10/5/2011 38 Policy Application: The Earned-Income Tax Credit � The EITC shifts the budget line so it should increase labor force participation of non workers of targeted groups. � The impact of the EITC on the labour supply of persons already in the labour market is less clear. 10/5/2011 39 The EITC and the Budget Line Hours of Leisure Consumption ($) 110 11,000 14,370 15,400 18,770 35,263 E J H G F Net wage is 40% above the actual wage Net wage equals the actual wage Net wage is 21.06% below the actual wage •The EITC grants the worker a credit of 40% on labour earnings as long as she earns less than $11,000. •Credit capped at $4,400. The worker receives this maximum amount as long as she earns between $11,000 and $14,370 •The tax credit is then phased out gradually 10/5/2011 40 EICT and labour supply 10/5/2011 41 The rationale behind In-Work Benefits � As a way to improve welfare of low-income without introducing adverse work incentives � Safety net, but it involves a dilemma of how to withdraw the financial support as an individual progresses up the income distribution – High rates of withdrawal damage work incentives – While low rates cost more as they involve making payments to people further up the income distribution 10/5/2011 42 Feature of UK labour market and in-work benefits � Persistent low attachment to the labour market by single mothers, particularly low skilled � Growth in workless couples with children � Low real wages for low-skilled � How is it possible to make work more attractive for those whose current labour market opportunities are not sufficient to induce work? 10/5/2011 43 Policy application: The Working Family Tax Credit in the UK � WFTC replaced Family Credit in 1999 (In 2003 new reform with Child Tax Credit and Working Tax Credit) with the aim to reduce poverty, encourage work and reduce stigma – Weekly, requires 16hrs/wk work – Awards depend on hrs/wk, earnings of claimant & partner, capital, expenditure on registered childcare � Comparison with Family Credit – More generous � Lower withdrawal (``phase-out’’) rate, more credits for younger children – Change in administration � Inland revenue instead of Benefit Agency 10/5/2011 44 Results � WFTC raised labor supply of lone parents by over 5% points from a base of around 50%, but other reforms (changes to tax and benefit system affecting families with children) reduced labour supply � Smaller effect for couples – Decline for women – Increase for men in workless household � Importance to evaluate programs as a whole � Equilibrium effects? 10/5/2011 45 Conclusions � The good-leisure choice: an optimal maximization decision – The income and substitution effect � Labour force participation and the reservation wage � Individual and market labour supply � Policy applications: EICT (US) and WFTC (UK) � Ch 2 Borjas and readings on Blackboard