Module 2 Labor Supply PDF

MODULE 2: LABOR SUPPLY The Theory of Individual Labor Supply McGraw-Hill/Irwin 2-1 reserved. Copyright © 2010 by the McG...

MODULE 2: LABOR SUPPLY The Theory of Individual Labor Supply McGraw-Hill/Irwin 2-1 reserved. Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights  OBJECTIVES Discuss and understand the following concepts: Measuring the Labor Force Worker’s Preferences Budget Constraint Hours of work decision Labor Supply curve 2-2 2-3  Labor Force (LF = E + U) Where: E = Employed U =Unemployed Labor Force participation Rate = ( LF / P) Where: LF = Labor Force P = Population M EA SU RI NG Employment Rate = (E / P) LA BO R F OR CE Where: E = Number of Employed P = Population Unemployment Rate = ( U / LF) Where: U = Number of Unemployed LF = Labor Force 2-4 2-5 1. Basic Model: The Work- Leisure Decision (Worker’s Preference) 2-6  ASSUMPTIONS Individuals choose between work and leisure. Work is time spent on a paying job. Leisure includes activities where one is not paid. Education Rest Work within the household 2-7  INDIFFERENCE CURVE Income/day The indifference curve shows work and leisure combinations that yield the same amount of total utility. More hours of leisure implies fewer hours of work. 0 24 Leisure Hr 24 0 Work Hr 2-8  INDIFFERENCE CURVE PROPERTIES Negative slope To keep the level of utility the same, if one get more leisure, some of income must be given up. Convex to origin With low hours of leisure, individuals are willing to give up a large amount of income to get one more leisure hour. 2-9  INDIFFERENCE CURVE PROPERTIES With high hours of leisure, individuals are willing to give up a small amount of income to get one (1) more leisure hour. 2-10  MARGINAL RATE OF SUBSTITUTION The marginal rate of Income/day substitution (MRS) is the amount of income one must give up to compensate for 1 more hour if leisure. 4 At 3 hours of leisure (21 hours of work), one must give up 4 units of income to compensate for 1more hour of leisure. 1 At 8 hours of leisure (16 hours of work), one must give up 1 unit of income to compensate for 1 more hour of leisure. The MRS falls as one moves southeast along an indifference 0 34 89 curve. 24 Leisure 24 0 Work 2-11  INDIFFERENCE MAP Income/day Curves further from the origin indicate higher utility. Combination L2Y2 is preferred to combination L1Y1 since one gets both more income and Y2 more leisure. Y1 I3 I2 A person will maximize utility I1 by getting to the highest attainable indifference curve. 0 L1 L2 24 Leisure 2-12  WORK-LEISURE PREFERENCES Income/day “Leisure lovers” place a high value on leisure. The have a steep indifference curve. They are willing to sacrifice a large amount of income to get a IB small increase in leisure. IA “Workaholics” place a low value on leisure. The have a flat indifference curve. They must I2 be given a large increase in I1 leisure to compensate for a small decrease in income. 0 24 Leisure 2-13  BUDGET CONSTRAINT Income/day The budget constraint shows the combinations of income and leisure that a worker could get given a wage rate. $360 At a wage rate of $5, a worker could get a maximum income of $120 per day ($5/hour * 24 ). $240 At a wage rate of $10, a worker could get a maximum income of $240 per day. $120 At a wage rate of $15, a worker could get a maximum income of $360 per day. The slope of the budget 0 24 Leisure constraint is–wage rate. 2-14  UTILITY MAXIMIZATION The optimal or utility Income/day maximizing point is where the budget constraint is tangent to the highest attainable indifference curve (U). At U, the MRS (slope of the indifference curve) is the equal to the wage rate (slope of the $240 budget constraint) B At B, the MRS is greater than U the wage rate. The individual $80 I3 values leisure more than the I2 wage rate. A I1 At A, the MRS is less than the wage rate. The individual values leisure less than the 0 16 24 Leisure wage rate. 2-15  B ACKWARD BENDI NG LABOR SUPP LY CURVE Wage Rate For a given person, hours SL of work may increase as the wage rate rises. If the wage rate rises from $10 to $25 per hour hours $25 of work rises from 8 to 10 hours per day. Above $25 per hour, $10 hours of work fall. The backward bending labor supply curve is the result of the income and substitution effects of a wage change. 0 8 10 24 Hours of Work 2-16  INCOME EFFECT Income Effect The change in desired hours of work resulting from a change in income, holding the wage constant. Leisure is a normal good, so higher income implies a desire for more leisure (fewer hours of work). For a wage increase, income is raised and so the income effect lowers desired work hours. 2-17  SUBSTITUTION EFFECT Substitution Effect The change in desired hours of work resulting from a change in the wage rate, holding income constant. A higher wage rate raises the relative price of leisure. For a wage increase, the substitution effect raises desired work hours. 2-18  NET EFFECT For Wage Increases If substitution effect > income effect, then hours of work rise. If income effect > substitution effect, then hours of work fall. For Wage Decreases If substitution effect > income effect, then hours of work fall. If income effect > substitution effect, then hours of work rise. 2-19  FOR BETTER UNDERSTANDING https://www.youtube.com/watch?v=NmdVOeaFKfk https://www.youtube.com/watch?v=2-SQ-WFrIJU 2-20  EMPIRICAL EVIDENCE The labor supply curve is slightly backward bending for men. The income effect is slightly greater than the substitution effect. 2-21  EMPIRICAL EVIDENCE The labor supply curve is positive for women. If substitution effect is greater than the income effect. Women substitute between work at home and market work more than men. 2-22  QUESTIONS FOR DISCUSSION 1. What impacts do the backward-bending labor supply curve have on employers and business firms? Does this concept hold true for both men and women? Give concrete example. 2. How does the backward-bending supply curve relate to the concept of work-life balance? Give concrete example. 2-23  QUESTIONS FOR DISCUSSION 3. How does the substitution effect and income effect influence an individual's labor supply when wages increase? Give concrete example of workers in a particular industry. 4. How do policies that alter the wage rate or provide income support influence the labor-leisure trade-off? Cite labor policies in the Philippines. 2-24