3.3 Labour Supply 3.3.1 Assumptions of the Model 3.3.2 Deriving the Budget Constraint 3.3.3 Labour Supply Decision 3.3.4 Summary

3.3.1 Assumptions of the Model People have a choice: to work or not to work If not working, they will remain at home or engage in leisure Supply labour if Price (wage) > reservation wage Reservation wage is the minimum wage needed to attract a person away from leisure and into work Represents the opportunity cost of labour

Can we model this decision making? Can analyse using indifference curve analysis Simplify the analysis to a choice between work and leisure Assume seven days of 24 hours available Assume labour is homogeneous and waged Assume the wage rate is

3.3.2 Deriving the Budget Constraint Income If no work undertaken then 168 hours of leisure taken and income is zero (a) If worker then decides to work one hour then leisure decline and income rises to One more hour gives income of 2 c 2w b w a Leisure Hours 168 Work Hours

Income Maximum income is 168 Slope = - w 1 168 Leisure Hours

Indifference curve for income-leisure trade off Leisure Hours Work Hours

3.3.3 Labour Supply Decision Once someone is working how do they respond to a change in the wage rate? Two key elements: Substitution effect – as wages rise, person works more and substitutes work for leisure as the opportunity cost of leisure rises Income effect – as wages rise, person works less as his/her income has risen thus allowing him/her to spend more time in leisure activities

Substitution: a to c (wage up, work up) Income Income: c to b (income up, work down) Y2 b Y1 c U2 a U1 168 Leisure Hours

For most workers, SUBSTITUTION > INCOME effects but…... (no I curves shown) Y5 Price consumption curve Y4 Y3 Y2 Y1

BACKWARD BENDING SUPPLY CURVE FOR LABOUR Wage W1 H1 Hours worked BACKWARD BENDING SUPPLY CURVE FOR LABOUR

3.3.4 Summary Reservation wages determine the point of entry into the labour market Need to trade-off between leisure and income Can analyse using indifference curve approach Income effects can outweigh substitution effects to give a backward bending supply curve Implications for tax/benefit policy