Topic 3, 4. Labor Supply (1st and 2nd parts)

This topic examines the determinants of labor supply. The framework for this discussion relies on the basic neoclassical model in which individuals are assumed to face a trade-off between labor and leisure time. In this model, it is assumed that there are only two possible uses of time: labor and leisure. Each individual is assumed to select the mix of time and purchased inputs that maximizes his or her level of satisfaction (utility).

Trends in labor force participation rates

During the past century, the labor force participation rate for males has declined, primarily for relatively young males and males aged 65 and older. These changes are primarily the result of increased education attainment (delaying entry into the labor force) and earlier retirement. (In fact, retirement is a relatively recent phenomenon, induced in part by the introduction of the Social Security system and increases in private pension plans.)

The labor force participation rate for females, on the other hand, have increased rather dramatically over the past century. This increase is most pronounced for married females (partly because this group began the century with very low labor force participation rates). Among the reasons for the increase in female labor force participation rates are:

• World War II,

• rising real wages,

• reduced fertility,

• increased educational attainment,

• rising divorce rates, and

• changing societal norms.

Opportunity costs and the optimal allocation of time

Since there are only two uses of time in the basic neoclassical model, the opportunity cost of an additional hour of leisure time is the wage payment that is given up by choosing to not work. Individuals choose to not work an additional hours if the value of leisure time exceeds the market wage rate. Individuals will work an additional hour if the value of the products that can be purchased with the wage outweigh the benefits of an additional hour of leisure time.

Substitution and income effects of a wage change

A change in the wage results in two effects on an individual's labor supply:

• a substitution effect, and

• an income effect.

As the wage rate rises, the opportunity cost of leisure time rises. In response to this higher wage, individuals consume less leisure time and spend more time at work. This is the substitution effect resulting from a higher wage.

An increase in the wage, however, also raises an individual's real income. This leads to an increase in the consumption of all normal goods. Since leisure is expected to be a normal good for most individuals, a higher wage will generally induce individuals to consume more leisure time (and reduce hours of work). Individuals who receive a higher wage can afford to take more time off from work. This is the income effect resulting from a wage increase.

If we assume that leisure is a normal good, an increase in the wage will cause the quantity of labor supplied to:

• increase if the substitution effect is larger than the income effect, and

• decrease if the income effect is larger than the substitution effect.

This may result in a backward-bending labor supply curve (as illustrated below).

In the diagram above, it is suggested that, at relatively low wages, individuals respond to an increase in the wage by working additional hours (since the substitution effect exceeds the income effect). Eventually, though, when the wage becomes sufficiently high, individuals will begin to work less in response to a higher wage rate. (In practice, it appears that most labor supply curves are either upward sloping or vertical.)