CHAPTER TWO

LABOUR SUPPLY THEORY

• What is labour supply?
• How do we measure labour supply?
• What factors affect labour supply?
Introduction

• LS is human inputs in the production process.

• LS depend on – supply of workers in the short run

- supply of hours

- size and structure of the population

- quality of the population in the long run
 Measurement and the labour force participation

Labour force
Major flows between labor market
• Employed unemployed
• Unemployed employed
• Employed and unemployed leave the market
• Not in the labour force labour force
Measurement

• Labour supply can be measured in a number of ways.

1. A head count or “the number of people”
• A head count may include under age children, and does not convey the
notion of engagement in economically productive activities, which is
implied by the concept of labour supply.
• The inclusion in the count people of working age only improves the
measurement of labour supply but, this too is defective.
2. Measuring Activity Rate
• Activity rate measures the extent of involvement in economic activities, or the
participation in the production and distribution of economic goods and services.

•
• The size of the labor force does not say anything about the “intensity” of work.

• Given adult population =425

unemployed =9 employed =201

discouraged workers =15 Retired =200
Limitations of the estimated labour supply

1. labour supply encompasses notions which go beyond the number of

people in the workforce.

2. It is difficult to identify and measure comprehensively the level of all

economic activities.

3. It is not possible to measure all employed or unemployed individuals.

4. Reference period is a factor affecting the (estimated) labor supply.
5. Is difficult when the frequency of economic status change is high
 Short run LS model
The Work-Leisure Decision Model
Workers preference
Utility and Indifference Curves
• Utility
An individual receives satisfaction both from the consumption of goods
(which we denote by C) and from the consumption of leisure (which we
denote by L) in a particular time period.

• Indifference curve: shows the various combinations of real income and

leisure time that will yield some specific level of utility or satisfaction.
 Properties of IC

• Downward sloping slope

• Convexity
• Higher IC –higher utility
• Ics never intersect each other
 Marginal Utility & the Slope of Indifference Curves

• MUL=change in utility resulting from an additional hour devoted to leisure activities, holding
constant the amount of gods consumed.
• MUC= change in utility if the individual consumes one more dollar‘s worth of goods, holding
constant the number of hours devoted to leisure activities.

• MRS: is the slope of indifference curve.

Budget constraint
• The person’s consumption of goods and leisure is constrained by her/his
income.

• The wage rate plays a central role in the labor supply decision.

so , the budget constraint can be explained as

OR wt + V

Budget Line

V E
0
 Utility maximization
Combining IC and budget line

• Utility function: utility is a function of income and leisure.

Maximization
• Max
• Subject to
 Example

• H= 24-L
• P=5birr
• W= 10 birr
• V= 60
• Solve the utility maximizing choice of the consumption
and leisure in a24 h day.
 The Hours of Work Decision
• The optimal consumption of goods and leisure, therefore, is given by the
point where the budget line is tangent to the indifference curve.
• This type of solution is called an interior solution because the worker is
not at either corner of the opportunity.
• Interior Solution to the Labor–Leisure Decision, utility-maximizing
worker chooses the consumption–leisure bundle, where the indifference
curve is tangent to the budget line.
 Factors affecting the Equilibrium
1. The effect of change in non-labour income on hours of work
 Assume V rise
• If leisure is a normal good, hours of work fall.
• If leisure is an inferior good, hours of work rise.
F1 F1
P 1

F0 F0 U 1
P1
U1
P0 P 0
$200 $200 E 1
E1 U 0
U0

$100 $100
E0
E 0

70 80 110 Hours of
Leisur e 60 70 110 Hours o f
Leisur e
 2. The effect of change in wage on hours of work

• Wage increase, working hours increase.

• Wage increase, working hours decrease.
G
G

U1
U1

Slope = −$20
F P Slope = −$20 F
P
U0 U0

V E V E
Slope = −$10 Slope = −$10

0 70 75 110 Hours of 0 65 70 110 Hours of

leisure leisure
Income and Substitution Effects….cont.
• An increase in the wage rate generates both income and substitution effects.
U 1

G
G

U 1
R

R D Q
D
Q U 0
D
U 0
D
F P F
P

E E

0 70 75 85 110 Hours of leisure 0 65 70 80 110 Hours of leisure

• An increase in the wage rate increases hours of work if the substitution effect
dominates the income effect. ∙
• An increase in the wage rate decreases hours of work if the income effect
dominates the substitution effect.
 Reservation Wage
• What factors motivate a person to work in the first place?
• Reservation wage (RW): a wage which make an individual indifferent to
work or not to work.
Consumption ($)

• RW , when V H
Has Slope − whigh

Decision to work or not to work

• A person work when RW< market wage
• A person not working when RW> market wage
Y

G
X
UH
E
Has Slope − wlow
U0
UG
Has Slope − w*
Hours o f
0 Leisur e
T
 The Labour Supply Curve & Elasticity of Labour Supply
1. Individual Worker's Labour Supply Curve

• Labour supply curve explain the relation between hours of work and the
wage rate.
• It is backward-bending
because of substitution w = $25
25
Labor Suppl
Cur ve
y

and income effect.. 20

w = $20

13
w = $13

10

U
E
w * = $10

0 70 80 90 110 Hours of 0 20 30 40 Hours of

Leisur e Wo rk
 2. The Market Labour Supply Curve, cont..

• We can use the utility-maximization framework to derive a labor supply

curve for every person in the economy.
• The labor supply curve in the aggregate labor market is then given by
adding up the hours that all persons in the economy are willing to work at
a given wage.
• The labor supply curve in the market is obtained by adding up the supply
curves of all workers horizontally.
• It is upward sloping. WHY??
 Elasticity of Labour Supply
• =
• The coefficient of elasticity could be 0 (perfectly inelastic), infinite
(perfectly elastic), <1 (relatively inelastic), >1 (relatively elastic), or <0
(Backward-bending).
• The elasticity will depend on the relative strengths of the income and
substitution effects generated by a wage rate change.
• Example: Suppose that the worker‘s wage is initially $10 per hour and
that she works 1,900 hours per year. The worker gets a raise to $20 per
hour, and she decides to work 1,000 hours per year. Es=?
 Factors affecting elasticity of LS

• Variations in defining hours of work; and errors in measuring hours of

work
• Errors in measuring wage rate
• Non-Labor Income
 Labour Mobility

• In the labour market there are two parties who had opposite intereset,
Workers are continually searching for higher-paying jobs and firms are
continually searching for cheaper workers.
Determinants of Labour Mobility
Education and training Outlook or urge
Social set-up Means of transportation
Industrialization Trade
Peace and security
 Labour Market Effects of Migration

Impacts of immigration on the labor market depend on:

the skills of migrants,
the skills of existing workers,
time horizon and
the characteristics of the host economy.
The impact: on labour SS
on labour DD
on wage rate
 Policy Implications on labour supply
Welfare Programs and Work Incentives
• Its impact on labour supply has debate among researches and policy
makers.
A. Cash Grant
B. Welfare program
• A welfare program that includes a cash grant and a tax on labor earnings
must reduce the probability of a person working and the number of hours worked .
C. ‘Standard’ Workday
• It is practice to set legal limitations for hours of work; whereby most wage and salary
earners are subject to the standard eight (8) hours per day and five days per week.
• with this standard, some workers may find the eight hours workday a bit long and feel
over employed, while other individuals in similar circumstances find themselves
underemployed.
D. Premium Wages & Straight-time equivalent wage
• Premium wage rate is a payment made for hours worked in excess of the
standard workday
• A straight time equivalent wage rate provides an identical daily or
weekly income from the same number of hours of work.
• Straight time equivalent wage will result in fewer hours of work in general
than the combination of a lower regular wage and an overtime premium.

• Does it make any difference with respect to work incentives to pay say
birr 4 per hour for the first 8 hours of standard work time and birr 6
per hour for an additional 2 hours of overtime or to pay birr 4.40 per
hour for each 10 hours of work?