Chapter Two Labour Supply Individual Attachment to the

Chapter Focus ® Labour market attachment ® Labour Force Participation Rate ® Labour supply

Labour Supply ® How individuals earn a living by selling labour services through the labour market. ® Question: ® Is labour supply an upward sloping function of the wage rate? © 2002 Mc. Graw-Hill Ryerson Ltd. 3

Quantifying Labour Market Attachment ® Labour Force Participation ® the decision to participate in paid labour market activities ® influences the size and composition of our labour force ® impacts the economy © 2002 Mc. Graw-Hill Ryerson Ltd. 4

$Labour Force Participation Rate ® LFPR ® the fraction of the eligible population that$

Labour Force Participation Rate ® LFPR ® the fraction of the eligible population that participates in the labour force ® LFPR=LF/POP ® LF (Labour Force) ® individuals in the eligible population who participate in labour market activities either employed or unemployed © 2002 Mc. Graw-Hill Ryerson Ltd. 5

Figure 2. 2 Labour Force Participation Rates by Sex, 1901 -1991 © 2002 Mc.

Hours of Work ® Variety of dimensions ® Institutional arrangements ® Affects quantity and quality of labour supply ® Short run hours appear fixed ® altered by the need for flexible hours, part time and working structures © 2002 Mc. Graw-Hill Ryerson Ltd. 7

Basic Income - Leisure Model ® The choice of hours worked given opportunities and value of nonmarket time. ® preferences and constraints ® individuals choose the feasible outcomes which yield the highest level of satisfaction © 2002 Mc. Graw-Hill Ryerson Ltd. 8

Preferences ® Two “goods” ® consumption ® leisure ® Represented by indifference curves ®

Figure 2. 4 a Indifference Curve Slope - Marginal Rate of Substitution Consumption A A-abundance of consumption willing to give up for leisure B-abundance of leisure willing to give up for consumption C C-consumption and leisure are substitutable B 0 Leisure © 2002 Mc. Graw-Hill Ryerson Ltd. 10

Figure 2. 4 b MRS Of Two Different Consumers Consumption C 11 C 21

Preferences ® Preferences over all conceivable combinations of consumption and leisure ® All combinations lie on some indifference curve ® Represented by an indifference map © 2002 Mc. Graw-Hill Ryerson Ltd. 12

Indifference Curve Map For an Individual Figure 2. 4 c Consumption U 2 U

Constraints ® Constrained by economic properties of the market ® Transform consumption-leisure to income-leisure

Simple Full-Time/Part. Income Time Choice Figure 2. 5 a C IF+YN IF Full-time B

Figure 2. 5 b Linear Potential Income Constraint Income W 1 T+YN W 0

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 ® © 2002 Mc. Graw-Hill Ryerson Ltd. 17

Figure 2. 6 a Income Equilibrium of Nonparticipant U R Slope=-W 0 U 1 U 0 R 2 Market Wage less than the reservation wage Slope= -WR Corner Solution A=E 0 YN R’ 0 T © 2002 Mc. Graw-Hill Ryerson Ltd. Leisure 18

Figure 2. 6 b Equilibrium of a Participant U 1 Income W 0 h 0+YN U 2 Market wage exceeds the reservation wage U 0 E 0 Interior Solution Indifference curve tang To budget constraint R YN R’ 0 l 0 © 2002 Mc. Graw-Hill Ryerson Ltd. T Leisure 19

Figure 2. 7 The Effect of an Increase in Nonlabour Income on Supply Consume

The Effect of an Increase in Nonlabour Income on Labour Supply ® Normal goods income leads to consumption of leisure (decrease in labour supply) ® Inferior goods income leads to ¯ consumption of leisure (increase in labour supply) © 2002 Mc. Graw-Hill Ryerson Ltd. 21

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 © 2002 Mc. Graw-Hill Ryerson Ltd. 22

Change in Wage Rate ® Two effects ® Income effect ® the worker has more income to buy more goods including leisure (reduces work hours ® Substitution ® effect individual may work more because the returns are greater substituting away from leisure © 2002 Mc. Graw-Hill Ryerson Ltd. 23

Figure 2. 8 Income and Substitution Effect of W 1 T=YN Income W 0 T=YN Wage Increase -W 1 -W 0 E’ E 1 E 0 U 1 U 0 Net effect Substitution effect Income effect 0 l’ l 1 l 0 © 2002 Mc. Graw-Hill Ryerson Ltd. T leisure 24

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 © 2002 Mc. Graw-Hill Ryerson Ltd. 25

Effects of an Increase in Nonlabour Income on Participation ® Opposite to wage increase

Individual Supply Curve ® Substitution ® wage ® As ® effect > income effect leads to labour supplied wages continue to there is a point where substitution effect and income effect offset each other ® Supply curve bends backward when income effect > substitution effect © 2002 Mc. Graw-Hill Ryerson Ltd. 27

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 wages 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) © 2002 Mc. Graw-Hill Ryerson Ltd. 28

Added and Discouraged Worker ® Discouraged worker- in high unemployment drop out of the labour force ® Hidden Unemployment- unemployment underestimated due to amount of discouraged workers not counted ® Added worker- enter the labour force to supplement family income in high unemployment © 2002 Mc. Graw-Hill Ryerson Ltd. 29

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? © 2002 Mc. Graw-Hill Ryerson Ltd. 30

Figure 2. 11 a Income Fixed Hours Constraint Y 1 Yc 0 C Lc

Figure 2. 11 b Underemployment Income YT D Yd Ud C Yc 0 Uc

Overtime and Overemployment ® Prefer to work fewer hours at the going wage rate

Figure 2. 12 Overemployment and Overtime I Yt C Yc D Yd I 0

Overtime Premium ® Substitution effect is larger than the income effect ® Price of

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 © 2002 Mc. Graw-Hill Ryerson Ltd. 36

Choice in Working Hours ® Changing work force ® Different groups with different preferences for work-time arrangements ® 1985 - two thirds of the work force was discontent with work-time arrangements © 2002 Mc. Graw-Hill Ryerson Ltd. 37

Figure 2. 14 Gains for Alternative Work Schedules I C-some individual are discontent Yt C D- preferred work schedule Yf F- willing to give up wages for preferred work schedule D F Ud Uc 0 T © 2002 Mc. Graw-Hill Ryerson Ltd. L 38

Solution ® No difference in utility between C and F even though F implies a lower wage rate ® Allowing workers to work desired amount of hours saves on costs ® Flex-time ® Compressed work week © 2002 Mc. Graw-Hill Ryerson Ltd. 39