Chapter 2 Applies theory of consumer demand to individual’s decision to supply labor. Descriptive evidence concerning hours worked. Develop: Neoclassical labor- leisure model. Then explain using model; various extensions to introduce more real-world factors into original model.

To Note in Figure 2.1 Graph (a): shows distribution of workers by weekly hours worked; shows 1 point in time. See two peaks: Fact: % parttime has  over time. Graph (b): shows time trend in weekly hours. 1900: 1998:

Neoclassical Labor/Leisure Model Assumptions: individuals choose paid work hours based on individual preferences, income, and wages. Assume: –100 discretionary hours per week; –only 2 uses for time: work and leisure, so that 100 hours = work hours + leisure hours. Define: –Supply work hours = 100 – demand for leisure hours. –Demand leisure hours = 100 – supply work hours.

Preferences Define: how much I like or dislike different goods; includes how I might be willing to trade off one good for another. Simplify: only two goods to choose from: Leisure (or L) and a single composite good (that includes all goods that can be purchased); represent composite good as income, or Y. Preferences: goods give me utility Indifference curve: shows different combinations of income and leisure, all of which yield same utility.

Properties of Indifference Curves 1: Negative slope: shows tradeoffs: to keep utility constant, if increase income, must decrease leisure. Slope shows MRS: marginal rate of substitution =  Y/  L. 2. Convex to origin: as move up to left, must get more and more income to give up continually same amount of leisure; As give up more and more leisure, it becomes more valuable. Curve gets flatter as move down to right; so slope or MRS getting smaller; called diminishing MRS.

More Properties of I.C. 3- For an individual: whole set of indifference curves, each corresponding to specific utility level; called indifference map. 4- Indifference curves for individual never intersect. 5- Each individual has own indifference curves (because has own MRS).

More about MRS MRS: measures rate at which a person is willing to trade income for leisure. As move up to left on indifference curve: This means:

Budget Constraint When making labor supply decisions, individual cares about preferences, income and wages. Budget constraint: shows relationship between wage, hours worked, and income:

Further Detail on Budget Constraint Price of leisure: measured in terms of opportunity cost of leisure; So price of leisure is the wage. Budget constraint: –Wage * hours = earned income. Market wage: Individual treats wage as given.

Properties of Budget Constraint 1. Negative slope (as  leisure,  work hours, so Y  ) 2. Slope = -wage (tells rate at which able to give up leisure) 3. Change wage shown as change in slope of budget constraint (pivot around pt. A) 4. If add in nonlabor Y: parallel shift upward of b.c.

Utility-Maximizing Point Individual’s goal: Max point: Max point: MRS = w. Decision rule: keep  work hours as long as the extra income you get for each extra hour worked (wage)  your own valuation of that extra hour of foregone leisure. When market values the extra hour just as you do: at utility max level.

Effect of a  Nonlabor Income on Hours Worked Remember:  Y  parallel shift in budget constraint. Demand theory: For any normal good:  Y causes  demand: So  Y   demand for leisure   hours worked. Income Effect: (  Hrs/  Y)  W fixed  0 Or: An  in nonlabor income, holding wage fixed, will cause hours worked to go down.

Effect of  Wage on Hours Worked First, remember:  wage will  slope of budget constraint:  w will pivot b.c. up to right. Pure substitution effect: Comes from demand theory:  W causes  demand for leisure, so  work hours. (  Hrs/  W)  Y fixed  0. But this is holding Y fixed. With  wage, income also  es.

Full Effect of  Wage on Hours Worked  Wage is more complicated:  Wage has two components: Substitution effect causes substituting away from leisure, which is now more costly. Subst. Effect:  hours worked. Income effect comes from fact that  wage causes  earned Y:  Y causes  demand for leisure which is same as  hrs worked. Income effect:  hours worked. Net Effect is Uncertain.

Showing Y and Subst. Effects Graphically Steps: 1. Show initial situation. 2. Show final effect of  wage. 3. Back to starting point: show Y effect first: shift old b.c. out parallel shift till tangent to new indiff. curve. This is pure Y effect since no  slope of b.c. This must show  hrs worked. 4. From (3) above: show subst. effect: pivot this “temporary” b.c. till reach final point in (2) above: this portion is subst. effect. This must show  hours worked.

Further Details on Y and Substitution Effects Y effect: isolates pure income effect without any change in relative prices, so no substituting between goods. Y effect answers question: With  W, what is effect on hrs worked if hold wage fixed but allow Y to  enough to lift the individual to the higher utility level? Substitution effect: here there is a change in relative prices, reflected in change in slope of b.c.: yes there is substituting between goods; holding effect of  Y fixed.

Key Points for Effect of  Wage on Hours Worked Income effect: always increases demand for leisure (because  Y always  demand for all normal goods); so reduces hours worked. Substitution effect: always reduces demand for leisure (because now leisure relatively more expensive); so increases hours worked. Net effect is uncertain: depends on shape of indifference curves.

Deriving Supply of Labor Curve Using b.c./indifference curve model: see effect of  W on hours worked. S L curve plots relationship between wage and willingness to supply labor. S L curve can be upward or downward sloping; or both (backward bending). Backward bending: at low wages, subst. effect dominates; at high wages, income effect dominates. For class: assume S L slopes upward unless told otherwise.

Policy Application: Welfare TANF: Temporary Assistance for Needy Families (1996) Details of TANF: Funded by federal $$ but block- granted to states so largely state-designed.

Details of TANF G: Income guarantee: D: level of disregard: T: implicit tax rate on earnings: BE: break-even point: So: BE = D + G/T

Welfare Policy Issues Three goals of welfare policy: – improve living standards (high $G); –encourage self-sufficiency (low T); – minimize costs of program. Dilemma: the three goals are incompatible: (1) and (2) push up costs federal welfare reform tried to address this dilemma--gives power to states. –Some states very strict. –Many ongoing studies.

Welfare-to-Work Barriers * not enough jobs, particularly in local, low Y areas. * low wages for entry level jobs (and have  in real value) * lack of job readiness (poor skills; literacy; work habits) * disability * child care (costly; low quality; unavailable for shiftwork) * transportation problems

Extensions to Simple Labor/Leisure Model Employer-mandated work schedules: if mandated hours  desired hours; individual ends up on lower indifference curve. Costs of working: affects budget constraint (fixed money cost; time cost; variable money cost)

Policy Response Recall in Figure 2.1: with time- series data, showed  in average hours worked per week from 53 in 1900 to 40 in One cause was an institutional response: a policy change. Fair Labor Standards Act (FLSA) of 1938: Imposed a national overtime standard:

Another Cause for  Hours is  Wage. Note: real wages have increased over time. If increase in real wages leads to a decrease in hours worked per week, then the income effect dominates the substitution effect. See Figure 2.13.

Effect of an Income Tax Start: assume nonlabor Y = 0; wage = W 1 ; t = 0. Show utility-max choice of hours worked. Then impose an income tax = t; where t = a percentage of income that increases as income increases. Called a progressive tax. See Figure 2.15.

Empirical Estimates of Labor Supply Response to Income Taxes Based on estimates of labor supply elasticities. Male elasticity = -0.1, So a 10 %  in net wage (from a  marginal tax rate) causes male labor supply to fall by 1%. Female labor supply elasticity is positive, so increase in tax has opposite effect. Reaganomics: assumed  taxes caused  work effort so that total tax revenues would increase  so tax cut pays for itself. Read conflicting evidence in book.