CH 6. SUPPLY OF LABOR TO THE ECONOMY: THE DECISION TO WORK Trends in Labor Force Participation Rates. • In both the U.S. and other industrialized countries, • women’s labor force participation rates have increased since 1900, particularly among married women • men’s labor force participation rates have decreased since 1900, particularly among older men. • Trends in hours worked per week. • In both the U.S. and other industrialized countries, since 1950 • unskilled workers (high school or less) have reduced hours per week. • skilled workers (college graduates) have had relatively stable hours per week.
Labor Supply Theory • Labor supply can be thought of as the inverse of the demand for leisure. • When a person purchases more leisure, they work fewer hours. • The price of leisure is the wage rate. • Effect of a wage increase • income effect: holding the wage rate constant, an increase in income will lead a person to purchase more leisure (work fewer hours). • substitution effect: holding income constant, an increase in the wage rate will lead a person to substitute market goods for leisure (work more hours). • net effect: depends on whether income effect or substitution effect dominates.
Labor Supply Theory • Individual labor supply curve is “backward bending”. • At low wages, substitution effect dominates. • Eventually, income effect dominates.
Labor Supply Theory • Indifference Curves
Labor Supply Theory Properties of indifference curves: • person is “indifferent” between any two points on a given indifference curve. • I-curves slope down (a person is willing to give up leisure if compensated with additional income). • I-curves are “bowed toward the origin”(law of diminishing marginal utility) • All points above and to the right of an I-curve are preferred to those on an I-curve. • All points below and to the left of an I-curve are less preferred to those on an I-curve. • I-curves further from the origin are preferred to those close to the origin. • I-curves never intersect (implied by D and E)
Labor Supply Theory • A person’s willingness to substitute money for leisure is reflected in her indifference curve. • How would young children affect I-cuve? • How would improvements in “home technology” affect I-curve?
Labor Supply Theory Utility maximization
Labor Supply Theory THE DECISION TO WORK. The person with the preferences illustrated would choose not to work at the wage rate of $8/hour. if the wage rate was increased sufficiently, the budget constraint would become sufficiently steep as to induce the person to begin working.
Labor Supply Theory • The “reservation wage” is the minimum wage rate at which a person would begin to work. If the wage rate is below the reservation wage, the person will not work. • The reservation wage is given by the absolute value of the slope of the indifference curve at zero hours of work. • A person with a steeper indifference curve has a higher reservation wage. • Children • Other sources of income
Labor Supply Theory INCOME AND SUBSTITUTION EFFECTS OF A WAGE INCREASE. Income Effect: Higher wealth, purchase more leisure (work less). • Example of a pure income effect: inheritance, lottery Substitution Effect: • Price of leisure has increased, substitute market goods for leisure by working more. • Example of a pure substitution effect: reduce tax rate on wages, but add a “lump sum tax” that keeps total tax payments constant if person’s work hours remained unchanged. • Net effect of a wage increase is ambiguous.
Labor Supply Theory Pure income effect
WILL THE INCOME OR SUBSTITUTION EFFECT DOMINATE? • If number of hours working originally is small, • IE is small and SE will be more likely to dominate. • As number of hours working originally rises, • IE larger and more likely to dominate. • This is the source of the “backward bending labor supply curve. • These results help explain why women’s hours worked per week have increased over time whereas men’s have decreased.
Effect of Eliminating Social Security • Retirement Earnings Test. • January 2000: Retirement Earnings Test was eliminated for individuals age 65-69. It remains in effect for ages 62 through 64. A modified test applies for the year an individual reaches age 65. (The Senior Citizens' Freedom To Work Act of 2000, signed into law by President Clinton on April 7, 2000.) • Prior to 2000: • One dollar in benefits withheld for every $3 in earnings above $17,000 year for workers aged 65-69 • No earnings test for workers age 70 & over. • After 2000 • No earnings test for workers age 65 & over.
Assume SS benefits=$10,000 year if $0 of labor earnings. • No other nonlabor income. • Up to 2500 hours of leisure/labor (50 weeks * 50 hours) • Wage rate = $20/hour • The effects of eliminating the earnings test.
Ohio’s unemployment insurance system. • An applicant's "weekly benefit amount" is the dollar amount he/she may receive for a week of total unemployment. • The "weekly benefit amount" is approximately 50% of the applicant's average weekly wage during the base period. • The "weekly benefit amount" cannot exceed the state's maximum payment for each dependency classification. • The law allows an applicant to earn up to 20 percent of the weekly benefit amount before deducting earnings from benefits. All earnings must be reported.
Ohio’s unemployment insurance system. Example: The weekly benefit amount is $100.00, and weekly earnings are $50.00. To calculate the earnings deduction: • Total earnings in week $50.00Minus earnings exemption(20% of $100.00) - 20.00Equals earnings deduction $30.00 • To calculate amount of benefits paid: • Weekly benefit amount $100.00Minus earnings deducted - 30.00Equals benefits amount paid $ 70.00
Ohio’s unemployment insurance system. Budget line for Ohio UI • Assume 40 hours per week at $10/hour prior to unemployment • No nonlabor income, other than UI. • What’s budget line for UI system assuming 0 dependents & worker has opportunity to take new job at $10/hour? • What hours would be “irrational” for a worker to choose if on UI?