1. CHAPTER 2 – Labor Supply 2-1 Measuring the Labor Force
2-2 Basic facts about Ls
2-3 The worker’s preferences
2-4 The budget constraint
2-5 The hours of work decision
2-6 To work or not work?
2-7 The Ls curve
2-8 Estimates of Ls elasticity
2-9 Ls of Women
2-10 PA: Welfare programs
2-11 PA: EITC

2. Individuals must make choices such as: Whether to work or not
If work, how much?
Total Ls in the economy  Σ Individual choices
Why interested in these issues?
Drastic changes in Ls over the 20th century
In this chapter:
Develop a framework to analyze allocation of time among work and leisure
Key economic variables
Impact of public policy on work incentives

3. 2-1 Measuring the Labor Force
Bureau of Labor Statistics (BLS):
collect information on trends in the US Labor Force
conducts a monthly survey, Current Population Survey (CPS)
survey 50,000 individuals
classification of individuals (age≥16) into 3 distinct groups:
Employed (E): Must be in a paid job with at least 1 hours
Unemployed (U): not employed but actively looking for a job in the last 4 weeks)
Out of the Labor Force: residual
Labor Force = E + U
Size of LF does not tell us about “intensity” of work.

4. 2-1 Measuring the Labor Force
Labor Force Participation Rate (LFPR)
LFPR = LF/Pop
Pop = civilian adult population 16 years or older not in institutions.
Employment Rate (ER)
ER = E/P  % of Population employed
A better measure of fluctuations in economic activity
Unemployment Rate (UR)
UR = U/LF
Hidden unemployment: Recession Discouraged workers
March 2011  UR = 8.8%
Imputation: 15.7% with discouraged workers

5. 2-2 Basic Facts About LS Labor Force Participation Facts (USA)
Labor force participation (LFP) is greatest for all groups during the ages of 25 to 55.
Men: labor force participation rates declined from 80% in 1900 to 72% in 2009.
Women: labor force participation rates rose from 21% in 1900 to 59% in 2009.
Hours worked fell from 40 to 34 per week during the same time period.

6. 2-2 Basic Facts About LS Labor Force Participation Facts (Men) - 11%
+6.8%
- 11%
- 8%
-24%
+5.6%
Temporary changes during wars, downward trend over the century
Heterogeneous changes: Middle-aged vs Older males

7. 2-2 Basic Facts About LS Labor Force Participation Facts (Women)
+8.4%
+17.4%
+ 38.6%
+ 54.8%
Drastic increase of participation over the 20th century
Larger effect on married women

8. LFPR Facts (cont.) LFPR  Males > Females though closing gap
Part –time work: More women than men
Correlation (Education, LFPR) > 0
LFPR
College Grad.
HS Dropouts
Males
92%
74%
Females
80%
48%

9. Labor Market Indicators (Turkish Data - Overall)
Both Labor force participation rate (LFPR) & Employment rate (ER)
are currently (in 2012) around 50% and 45% respectively.
followed a downward trend (by 7%) in the last 24 years.
Unemployment rate
Is currently (in 2012) around 9.2%.
Increased (by 2.37% on average) in the post 2000 era.
Hours worked
Is most frequently observed around hours per week
Overtime decreased, but part-time increased in the last decade.

10. Both Labor force participation rate (LFPR) & Employment rate (ER)
are currently (in 2012) around 50% and 45% respectively.
followed a downward trend (by 7%) in the last 24 years.

11. Unemployment rate
Is currently (in 2012) around 9.2%.
Increased (by 2.37% on average) in the post 2000 era.

12. Hours worked
Is most frequently observed around hours per week
Overtime decreased, but part-time increased in the last decade.

13. Labor Market Indicators (Turkish Data – Male vs Female)
Labor force participation rate (LFPR)
Males have a higher participation rate than females.
Moreover, both Males and Females downward trend.
Employment rate (ER)
Similar to LFPR, Males have a higher rate than females.
Declining employment rate for both males and females.
Unemployment rate
Cyclical, fluctuates around 9% (both sexes).
Before 2000, males have a slightly larger unemployment rate, but observe opposite trends during the post 2000 era.

14. Labor force participation rate (LFPR)
Males have a higher participation rate than females.
Moreover, both Males and Females downward trend.

15. LFPR of Males by Age groups
Decreases by age.
Highest for
Lowest for 65+.
Increased for and 65+.
LFPR of Females by Marital Status.
Highest for single women.
Lowest for widowed/separated.
Single – Consistent vs Married/Widowed – More Variation.

16. Employment rate (ER)
Similar to LFPR, Males have a higher rate than females.
Declining employment rate for both males and females.

17. Unemployment rate Cyclical, fluctuates around 9% (both sexes).
Before 2000, males have a slightly larger unemployment rate, but observe opposite trends during the post 2000 era.

18. 2-3 The Worker’s Preferences
Neo-Classical Model of Labor-Leisure Choice
Utility Function: Measures the satisfaction that individuals receive from consumption (C) of goods and leisure (L).
U = f(C, L)
U is an index.
The higher is U, the happier is the person.
Each bundle of C and L yields a particular level of satisfaction, Uo
Using total differentiation:
dU= 0 = MUC dC + MUL dL where MUC = and MUL=
Gives the slope, MRS as:
Value of one more hour of leisure to an individual

19. Indifference Curves (IC)
Consumption ($)
MRS not constant across the IC
As L increases, slope decreases (flatter), willing to give up less consumption for an additional hour of leisure. A
500 C
450 B
400
40,000 Utils
25,000 Utils
100
125
150
Hours of Leisure

20. Indifference Curves
Downward sloping  Tradeoff between consumption and leisure (C and L are “good” not “bad”)
Higher curves  higher utility (more satisfaction)
Do NOT intersect (Complete preferences: each bundle yields a unique level of satisfaction)
Convex to the origin, indicating that opportunity costs increase (willingness to substitute consumption for leisure decreases as leisure becomes abundant)

21. Differences in Preferences
Workers with steeper indifference curves value their leisure relatively more than workers with shallower indifference curves.
What is the implication of the differences in the preferences illustrated above on the labor market attachment individuals? U0 U1
Consumption ($)
Hours of Leisure

22. 2-4The Budget Constraint (BC)
The budget constraint defines the worker’s opportunity set, indicating all of the consumption – leisure combinations the worker can afford.
C = w*h + V
Consumption (C) equals labor income (wages (w) × hours worked (h)) plus non-labor income (V).
Hours worked (h), by definition, equal to total time endowment (T) minus hours of leisure (l): h = T – L
We can rewrite the budget constraint as:
C = w(T – L) + V
Note that the slope of the BC equals to:

23. Graphing the Budget Constraint
C=w(T-L)+V
C=(wT+V)-wL
Slope = -w (constant)
Forego the market wage rate for each additional hour of leisure consumed.
BC has a kink at the maximum amount of leisure consumed. T E V
wT+V
Hours of
Leisure
Consumption ($)
Budget Line
Homework: Comparative statics  How does changes in w and V (increase vs decrease) affect the Budget Constraint?

24. In-class Exercise: What is the impact of changes in the wage rate,
non-labor income,
and prices
on the budget line?

25. 2-5 The Hours of Work Decision
Individuals choose consumption and leisure to maximize utility.
Optimal consumption is given by the point where the budget line is tangent to the indifference curve.
At this point the marginal rate of substitution (MRS) between consumption and leisure equals the wage.
Any other consumption – leisure bundle on the budget constraint would give the individual less utility.

26. Optimal Consumption and Leisure
V=0 for simplicity
U1 yields the highest utility but outside the BC
A, B and P are attainable
A and B are inferior to P since they are on a lower IC
P is the optimal choice (Interior Solution)
$1200 A Y
$1100 P
$500 U1 U* E
$100 B U0
Hours of Leisure 70
110
Hours of Work
110 40

27. Optimal Consumption and Leisure
Identification of the Optimal Choice
Tangency of BC & IC
Slopes are equal
MRS = wage rate
Trade L for C until willingess to pay for leisure equals the wage rate
To the left of P: MRS>W
To the right of P:
MRS<W
$1200 A Y P
$500 U1 U* E
$100 B U0
Hours of Leisure 70
110
Hours of Work
110 40

28. The Effect of a Change in Nonlabor Income on Hours of WorkP1
$200 U1 U0 E1 E0 P0 70 80
110 F0
$100
Consumption ($)
Important:
Pure Income Effect!!!
ΔC<ΔV
Hours of Leisure
An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P0 to point P1. If leisure is a normal good, hours of work fall.

29. The Effect of a Change in Nonlabor Income on Hours of WorkP1
$200 U1 U0 E1 E0 P0 70 60
110 F0
$100
Consumption ($)
An increase in nonlabor income leads to a parallel, upward shift in the budget line, moving the worker from point P0 to point P1. If leisure is inferior, hours of work increase.

30. More Leisure at a Higher Wage
When the income effect (IE) dominates the substitution effect (SE), the worker decreases hours of leisure in response to an decrease in the wage.
w creates two effects:
SE: OCL lower
L h
IE: Feel poorer
L h
Final outcome: depends on which effect is larger!
Original eq: “R”
Original BC: GRE
Wage rate 
New BC: FPE
New eq: “P”
Breakdown:
SE: Same IC (U0) with different wages
R  Q
IE: Same wage (DD and FE) but different IC’s (U0 vs U1)
R  P
Consumption ($) G U0 R D Q U1 D F P V E 70 75 85
110
Hours of Leisure

31. More Leisure at a Higher Wage
When the substitution effect (SE) dominates the income effect (IE), the worker increases hours of leisure in response to an decrease in the wage. G D F E U0 Q R P U1 V 80 70
110 65
Consumption ($)
Hours of Leisure
SE>IE, therefore, end up buying more leisure, from 65 hrs to 80hrs, when wage rate decreases

32. Homework:
What is the effect of an increase in the price of market goods on worker’s reservation wage, probability of entering the labor force, and hours of work?

33. 2-6 To Work or Not to Work?
Are the “terms of trade” sufficiently attractive to “bribe” a worker to enter the labor market?
Reservation wage: the lowest wage rate that would make the person indifferent between working and not working.
Rule 1: if the market wage is less than the reservation wage, then the person will not work.
Rule 2: the reservation wage increases as nonlabor income increases

34. The Reservation Wage
Consumption ($)
Identification of the reservation wage graphically
Reservation wage: Slope of the IC at the maximum amount of time endowment (T) of the individual H G X E U0
Has Slope -w T
Hours of Leisure
Homework: What happens to the reservation wage when non-labor income increases?

35. The Reservation Wage
Consumption ($)
Identification of the reservation wage graphically
Reservation wage: Slope of the IC at the maximum amount of time endowment (T) of the individual H
Has Slope -whigh Y G X UH E U0
Has Slope -w T
Hours of Leisure
Homework: What happens to the reservation wage when non-labor income increases?

36. In-class Exercise:
What is the impact of changes in the non-labor income on the reservation wage?

37. 2-7 Labor Supply Curve
LS curve illustrates the relationship between hours worked and the wage rate.
At wages slightly above the reservation wage, the labor supply curve is positively sloped (the substitution effect dominates the income effect).
If the income effect begins to dominate the substitution, hours of work decline as the wage rate increases (a negatively sloped labor supply curve).

38. The Backward Bending Labor Supply Curve
Wage Rate ($) 25 20 10 20 30 40
Hours of Work

39. Labor Supply Elasticity
The labor supply elasticity (σ) measures responsiveness in hours worked to changes in the wage rate.
Hence:
Sign of σ depends on the relative magnitude of SE and IE
If σ <1 is inelastic: Hours worked respond proportionally less than the change in wages.
If σ >1 is elastic: Hours worked respond proportionally more than the change in wages.

40. 2-8 Estimates of the LS Elasticity
Obtained from empirical studies, many estimates reported using a wide variety of samples & methods
Blundell & MaCurdy (1999): -0.1 for males
-ve IE>SE
σ <1  Inelastic: Hours worked not very responsive
Caution: Main focus on prime-age men, heterogeneity among other sub-groups (young vs old, male vs female)

41. 2-8 Estimates of the LS Elasticity
Problems with estimates:
1) Definition of hours worked
Per day, per week, etc.
2) Imputation of wage rate & measurement error
Calculation in practice: =Earnings(w*h)/hours worked
Hours worked  self-reported, generally overestimated
3) Sample bias
Working individuals, what about non-workers?
4) Endogeneity
Today’s labor income and tomorrow’s non-labor income
Corr (h,V) > 0 since h today, E today, if savings>0, V tomorrow

42. 2-9 Labor Supply of Women
Substantial cross-country differences in women’s labor force participation rates.
Over time, women’s participation rates have increased.
In most studies on female labor supply, the substitution effect dominates the income effect for women, implying an upward sloped labor supply curve.

43. Growth in Female Labor Force Participation Rates and the Wage Cross Countries, 1960-1980
Source: Jacob Mincer, “Intercountry Comparisons of Labor Force Trends and of Related Developments: An Overview,” Journal of Labor Economics 3 (January 1985, Part 2): S2, S6.

44. Labour Force Participation Profiles - Males
LFP Profiles show how the LFPR changes at different ages
Expected to be steeper at younger & older ages and flat at mid-life.
LFP Profiles of males are stable across different cohorts
Peaks around 30, starts to come down around 60.
Slight differences in participation at older ages (early retirement)

45. Labour Force Participation Rates - Females
LFP Profiles of females are drastically different across cohorts
LFP profiles shifted upwards across time.
Static comparisons are misleading.
Consider a woman born 1945, 25yrs old  in 1971 where LFPR25 = 60%
LFPR of 35 yr olds in 1971 = 40% so ΔLFPR2535 = -20%?
If 1945 cohort 10 years later LFPR35 = 65%  ΔLFPR2535 = 5%

46. Cohort Effect
Refers to the difficulty of separating out age from vintage (or year of birth) at a single point in time.
Best understood in the context of trying to isolate the effect of age, or time, for the evolution of a variable (not necessarily labour supply)
For women, the age-participation profiles have been shifting upward over time, as each subsequent cohort of women is more attached to the labour market than previous ones.

47. 2-9 Labor Supply of Women 5) Sociological
Determinants of the drastic changes in the LFPR of women:
Wage rate
Small but positive wage elasticity of hours worked
2) Reservation wage
Preferences over fertility, Marital Status, Educational Attainment
3) Fertility rate
Decreased over time: 3.3 in 1950s vs 2.1 in 2000s
4) Advances in Technology
Birth Control (The Pill), Child Mortality, Telecommunication
5) Sociological
2nd World War, LR effects of female participation in the labor markets

48. Homework:
Using the leisure-labour income model, using a graph, explain why some individuals would require “overtime premium” in order to work longer hours?
Overtime premium = Higher wage rate
Hint: Start from an initial equilibrium with zero non-labor income and then consider the equilibrium that would entice the individual to work longer than originally desired.

49. 2-10 PA: Welfare Programs & Work Incentives
Cash grants reduce wage incentives.
Welfare programs create work disincentives.
Welfare reduces supply of labor by increasing non-nlabor income, which raises the reservation wage.

50. Effect of a Cash Grant on Work Incentives
A take-it-or-leave-it cash grant of $500 per week moves the worker from point P to point G, and encourages the worker to leave the labor force.
Cash grant generates a positive income effect and positive substitution effect due to 100% clawback!!!
Both IE and SE reinforce h F
Consumption ($)
500
Hours of Leisure
110 70 G U1 U0 P

51. Effect of a Welfare Program on Hours of Work
Work disincentives are still present when clawback occurs at a rate less than 100%, but they are less perverse.
Both IE and SE still reinforce the same outcome: h
Hours of Work
$500 U0 U1 G E P F R Q H D
110
100 70
slope = -$5
slope = -$10
Consumption ($)

52. 2-11 PA:The Earned-Income Tax Credit
Began in 1975, by 2007 it is the largest cash-benefit entitlement ($40 billion)
Contains several “phases”:
Phase-in: Wage subsidy of 40% up to $11k earnings
Receive the subsidy until $14,370 ($4400 max)
Phase-out: Clawback of 21% until the subsidized amount of $4400 is completely exhausted:
Earnings of full exhaustion = $4400/0.21 = $35,263

53. The EITC and the Budget Line

54. In-class Exercise:
Explain why a lump-sum government transfer can entice some workers to stop working while the earned income tax credit can entice some people who otherwise would not work to start working (and entices no one to stop working)

55. In-class Exercise:

56. In-class Exercise:

57. 2-11 PA:The Earned-Income Tax Credit
The EITC should increase labor force participation of non-workers of targeted groups.
The EITC encourages some non-workers to start working and never encourages a worker to quit working.
The EITC produces an income effect.
Hours worked should change.

58. Homework:
In 1999, 4,860 TANF (Temporary Assistance for Needy Families) recipients were asked how many hours they worked in the previous week.
In 2000, 4,392 of these recipients were again subject to the same TANF rules and were again asked their hours of work during the previous week.
The remaining 468 individuals were randomly assigned to a “Negative Income Tax” (NIT) experiment which gave out financial incentives for welfare recipients to work and were subject to its rules.
Like the other group, they were asked about their hours of work during the previous week. The data from the experiment are contained in the table below. (In class example)

59. Homework:
What effect did the NIT experiment have on the employment rate of public assistance recipients? Develop a standard difference-in-differences table to support your answer.
(b) What effect did the NIT experiment have on the weekly hours worked of public assistance recipients who worked positive hours during the survey week? Develop a standard difference-in-differences table to support your answer.