Supply of Labour Market:

Theoretical Framework

Background
Economics deals with the resources that are scarce in nature Market generates efficient outcomes Various market structure

Assumptions Perfect information

Uniform price for homogeneous goods

No perfect information Stigler (1962)

Asymmetric information Two types of Asymmetric information ex-ante and ex-post

Hidden information problem Akerlof (1970) Purchase of used motor vehicles example

Social structure
Example
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Background - Job shopping problem

Stigler (1962) As Stigler (1962) put it:
The information a man possesses on the labour market is capital: it was

produced at the costs of search, and it yields a higher wage rate than on average would be received in its absence (p.154)

Strategy for shopping Dispersion in wage offers Stiglers study of 44 graduates Major limitations
Decision is based on optimal sample size problem Cost of job search appears to be zero

Wage offers are given- Individuals are to make choices on offers that

they received Pragmatically, wage distribution is known, but which firm offers that wage is unknown Search

Neo-classical model of labour-leisure choice

U f (C , L)
Time allocation between the labour market and leisure
Ignore household activities Objective Maximize the utility; higher the utility, higher

the happiness Both C and L are goods Utility maximization depends on the particular combination of C and L the locus of many points representing the combinations of C and L generate a particular level of utility, called IC Characteristics of indifference curve
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The time and budget constraints

Constraints imposed by time and budget Time constraint T L h Two types of income: Labour income and non-labour income Budget constraint ( C = wh+V) wh is the labour earnings and v is the non-labour income Assumption: same hourly wage regardless of how many hours he/she works Rewrite budget constraint C = wh+v C = w (T-L) +v = wT-wL+V C + wL = wT+V Right hand side: full time income generates from devoting full time to the labour market (labour earnings + non-labour earnings) The left hand side: the way in which income is being spent, between consumption goods and leisure activities (wL is the forgone earnings associated with consuming leisure activities)
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Figure 4
Point E is the endowment point Numerical example
wT+v

Hours of leisure

Factors motivate a person to enter the labour market

Reservation wage

Reservation wage is greater than offer wage

Reservation wage is less than offer wage Non-labour income and the reservation wage Being leisure a normal good, the reservation wage tend to rise as nonlabour income increases There are two distinct effects on work incentives
Reduces the chances of being employed in the labour market Reduces the number of hours allocate in the labour market

Do people respond to incentives?

One of the fundamental economic principles

An incentive is something that induces a person to act

Rational people respond to incentives Example: when wages start rising, people decide to participate

in the labour market A tax on gasoline encourages people to drive smaller and more efficient cars Implementing speed governors

Backward bending supply curve

Labour supply curve
Wage rate

Hours of work

Backward bending supply curve is one of the many possible supply curves The link between wage rates and hours of work Rs 10 is the reservation wage, below which the workers does not enter the Labour market The worker enters the labour market, only if wage is greater than RS 10 There are two segments: Upward and backward bending The upward slope indicates that the substitution effects dominate the income effects the backward bending segment represents that income effect dominates the substitution effect

 Relation between tax rates and tax revenue

Theory at work The laffer curve

some tax rate of t per cent tax system is confiscating labour earnings and further increase on tax rates shackle the creativity and productivity of the labour force and reduce tax revenue

Increase in the income tax rate initially increases tax revenues. After

When income effects dominate, an increase in the tax rate leads to

increase hours of work, because the decrease in income encourages workers to consume less leisure. An increase in the income tax rate increases tax revenue, and gives rise to the upward sloping portion this does not support the argument that income tax cuts could increase tax revenues in the United States
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Household production function

A simple model that represents two married persons A and B Maximize utility, which in effect depends on the value of the

goods from the market place and commodities that they produce in the household Time available for both activities = 10 hours (Labour market and household) Allocation of weekly hours (remaining 14 hours for personal care and leisure)

The labour market

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The household sector

Personal care

Passive leisure

Other

Household production function

Interesting question-allocation of 10 hour between

labour market and non-market sector? Three different feasible conditions

Condition 1: Both decide to allocate all of their time to

the household Condition 2: B (Wife) specializes in the labour market and A (Husban) specializes in the household sector Condition 3: A specializes in the labour market, and B divides her time between household and labour market

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The allocation of time- empirical evidence

Men 1965 1981 Women 1965 1981

Labour market
Household work

51.6
11.5

44.0
13.8

18.9
41.8

23.9
30.5

Leisure
Personal care

36.7
68.2

41.8
68.2

35.4
71.9

41.9
71.6

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Labour supply elasticity

Percentage

change in hours of work due to percentage change in wage rate. Or, the responsiveness of hours of work to changes in the wage rate
It gives the percentage change in hours of work

associated with a 1 percent change in the wage rate. The sign of the labour supply elasticity depends on the upward and downward slope of the labour supply curve
The labour supply elasticity is positive when the

substitution effects dominates, and is negative when income effect dominates Example

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Thank you

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