LABOR SUPPLY CURVE



Chapter16b: LABOR SUPPLY CURVE

Time is an important factor when thinking about a worker’s supply curve for labor. Every worker has only 24 hours a day that can be spent working or consuming leisure (eating, sleeping, reading, watching TV, etc.). An easier way to think of leisure is: any part of the day when a worker is not getting paid by his/her employer.

Most of us would choose to spend more time in leisure and less time in work, but we need to work in order to have income to purchase everyday needs (goods and services). Our income is determined by our wage rate and the number of hours we work. When we have more income, we can buy more goods and services. We must also keep in mind that every hour we spend in leisure is an hour less we spend doing work. For example, if our wage rate is $10/hour, we are giving up $10 when we decide to spend an hour in leisure. Therefore, the price that we pay for an hour of leisure is the wage lost from not working that hour—in this case $10.

By only looking at strictly at the goal of increasing income, it is reasonable to assume that we would want to work as much as possible so that we could buy more goods and services. However, if we worked 24 hours a day, we would not have any time to reap the benefits of our rewards. We need time to enjoy the goods and services that we purchased, so it follows that as our income increases we demand more leisure. If we assume that both income and leisure are normal goods in which more is preferred to less, the average worker faces the decision of how many work hours to supply. We’ll call this the income-leisure choice of the worker.

[pic]

|FIGURE 16.a.2 |

|The budget line shows the worker’s combinations of income and leisure. |

|The slope of the budget line equals the worker’s wage rate: $240/24hrs = $10/hr |

|Point E is the worker’s optimum because it represents the most preferred combination of income and leisure among the |

|choices on the budget line—in other words, point E puts the worker at the highest possible indifference curve given the |

|budget constraint. |

We see that at point E, the worker does not maximize his income. For instance, the worker could be working 17 hours and earning an income of $170 as seen by point B in Figure 16.a.2. However, the extra income of $50 that he earns is worth less to him than the 5 hours of leisure he gave up to earn that extra income. This is shown by the fact that point E is on a higher indifference curve than point B. Thus, the worker should forgo the higher income (point B) in order to obtain more leisure (point E) because the marginal value of leisure exceeds the opportunity cost of leisure (forgone income) at point B. In order to increase his utility, the worker should pursue leisure until the MRS between income and leisure (slope of IC) equals the wage rate (slope of IC).

|Worker’s Utility Maximization |

|*Point (choice of combination of income and leisure) must lie on budget constraint |

|*Slope of IC (MRS between income and leisure) = slope of BL (wage) |

By using the work-leisure choice model, we now understand how a worker can maximize his utility by choosing a certain combination of income and leisure, given a particular budget constraint. This work-leisure choice model can also help us to understand how a worker responds to a change in his wage rate. Will a higher wage induce a worker to work longer hours?

There are two effects that occur as a result of a change in the wage rate of a worker. These two effects are in opposition to one another; they are the substitution effect and the income effect. When the wage rate increases, the price of leisure increases. The increase in wage rate causes the worker to spend less time in leisure and more time in work. We call this the substitution effect of an increase in the wage rate. At the same time, the increase of the wage rate increases the income of the worker (for a given number of hours he works), allowing the worker to purchase more goods and services. As we learned before, the worker will also want to spend more time in leisure because he needs time to enjoy the goods and services he has purchased. We can think of leisure as a normal good; the worker will want to consume more leisure as his income increases. The increase in wage rate causes the worker to spend more time in leisure and less time in work. We call this the income effect.

The substitution effect of a higher wage encourages the worker to work more, and the income effect encourages the worker to work less. If the substitution effect is stronger than the income effect, a worker will work more as a result of the wage increase. However, if the income effect is stronger than the substitution effect, the worker will work less as a result of the wage increase.

[pic]

|FIGURE 16.a.3 |

|The budget line pivots from AZ to BZ as a result of the wage increase. The income and substitution effects are shown by |

|the hypothetical budget line CD that is parallel to the BZ budget line and tangent to IC1. |

|The substitution effect is the movement from L1 to L3 (more work). |

|The income effect is the movement from L3 to L2 (less work). |

|The combined effect in this case causes the worker to work more at the higher wage. |

The supply curve of labor slopes upward for the worker whose preferences are depicted in Figure 16.a.3. However, this outcome is not always the case because income effect of a higher wage may be greater than the substitution effect. This causes the worker to work less at higher pay. This makes perfect sense because beyond some point the worker may prefer to work a little less so that he can have more time for leisure. This way he can enjoy the fruits of the higher income that was made possible by his higher salary. Consequently, a supply curve of work hours can be backward-bending beyond some wage rate. There are no special circumstances that are required for a backward bending supply curve; the only requirement is that the normal income effect of a higher wage exceeds the substitution effect.

[pic]

[pic]

|FIGURE 16.a.4 |

|The worker’s choices of how much to work at three different wage rates are represented by E1, E2, and E3. |

|The worker’s labor supply choices are plotted as the supply curve of work hours. When the income effect exceeds the |

|substitution effect, the supply curve becomes backward bending. |

[pic]

|FIGURE 16.a.5 |

|Backward bending supply curve is the normal case for most workers. |

|Most economists agree that a worker’s supply curve for labor slopes upward at lower wages and bends backward at higher |

|wages. |

STUDY QUESTIONS:

True/False

____ 1. People work less hours when the wage rate increases.

____ 2. If leisure is normal, then SL must bend backward.

____ 3. In the income-leisure model, mowing one’s own lawn is not considered labor.

Multiple Choice

1. An individual’s supply curve will bend backwards when

a. the substitution effect of a higher wage is greater than the income effect.

b. there are an unusual set of circumstances.

c. the worker decides to retire.

d. the income effect of a higher wage is greater than the substitution effect.

2. If a worker enjoys his work, then

a. he will work as much as his employer will allow.

b. his supply curve may not bend backwards as soon as it would if he didn’t like to work, but it will still bend backward eventually.

c. the income effect of a higher wage will cause him to work more hours as long as leisure is a normal good.

d. he will not have a backward-bending supply curve.

3. Which of the following statements is true?

a. The substitution and income effect of a higher wage both cause a worker to work less.

b. The substitution and income effect of a higher wage both cause a worker to work less.

c. The substitution effect of a higher wage causes a worker to work more, while the income effect of a higher wage causes a worker to work less.

d. The substitution effect of a higher wage causes a worker to work less, while the income effect of a higher wage causes a worker to work more.

Short Answer

[pic]

1. At which point does the worker work the most hours?

2. If the wage rate changes so that the budget line shifts from AZ to BZ, what happens to the wage rate?

3. What does the slope of CZ measure?

ANSWERS:

True/False

1. False

2. False

3. True

Multiple Choice

1. d

2. b

3. c

Short Answer

1. E2

2. Wage rate increases from $10/hr to $15/hr.

3. Slope of CZ measures the wage rate.

-----------------------

R2

R3

1

E

3

E

2

E

TE

IE

SE

R1

D

C

Z

$1

B

2

IC

1

IC

A

Leisure (hours)

0

Income ($)

$35

$100

4

E

5

E

3

E

E2

1

E

30

40

25

$25

$20

$10

(Weekly Hours)

Labor

provide no labor

Wage

................
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