Illustrate the logic of Backward Bending Labor Supply Curve. Is this relevant in the organizational context?

Income-Leisure Choice

In order to illustrate the logic of backward bending labor supply curve, we first highlight the incomeleisure choice. Income is earned by devoting some of the leisure time to do some work. That is, income is earned by sacrificing some leisure. The greater the amount of this sacrifice of leisure, that is, the greater the amount of work done, the greater income an individual earns. Further, income is used to purchase goods, other than leisure for consumption. Leisure time can be used for resting, sleeping, playing, listening to music etc. all of which provide satisfaction to the individual. Therefore, in economics, leisure is regarded as a normal commodity the enjoyment of which yields satisfaction to the individual. The trade-off between income and leisure depends on the income at which an individual is willing to sacrifice one hour of leisure time. The actual choice between income and leisure by an individual depends upon the market rate of exchange between the two, that is, the wage rate per hour of work. The wage rate is the opportunity cost of leisure, that is, to increase leisure by one hour, an individual has to forego the opportunity of earning income equal to the wage rate per hour.

Wage Offer Curve and the Supply of Labor

Figure 1

Figure 2

The supply curve of labor shows how an individuals work effort responds to changes in the wage rate. As can be seen in figure 1, at the wage rate w0 (=OM0/OT), the wage line or income-leisure line is TM0 and the individual is in equilibrium at point Q where he chooses OL0 leisure time and works for TL0 hours. That is, at the wage rate w0 he supplies TL0 amount of labor. This supply of labor is directly shown against wage rate w0 in figure 2. Now, when the wage rate rises to w1, wage line or income leisure line shifts to TM1, (w1=OM1/OT), the individual reduces his leisure to OL1 and supplies TL1 hours of work; L0L1 more than before. Thus, TL1 hours of work supplied is shown against w1 in figure 2. The same thing happens when wage rate increases to w2. In figure 1, on joining points Q, R and S, we get what is often called wage-offer curve. In figure 2, the information supplied by the wage offer curve, that is, the supply of labor (workhours) by the individual at different wage rates is shown directly. The supply of labor (hours worked) is measured along the X-axis and wage rate is measured along the Y-axis.

The supply curve of labor is upward sloping indicating positive response of the individual to the rise in wage rate.

Income Effect and the Substitution Effect of the change in Wage Rate

Income Effect

As stated before, in economics, leisure is a normal commodity which means that increase in income leads to increase in leisure enjoyed (that is, less work-hours supplied). That means that the income effect of the rise in wage rate on leisure in positive, that is, leads to the increase in the hours of leisure enjoyed (that is, tends to decrease labor supply).

Substitution Effect

On the other hand, the rise in wage rate increases the opportunity cost or price of leisure, that is, it makes enjoyment of leisure relatively more expensive. In order to enjoy one hour of leisure, the individual is giving up a larger potential income (equal to the higher wage rate per hour). Therefore, as a result of the rise in wage rate, the individual substitutes work (and therefore income) for leisure which leads to the increase in the supply of labor.

Interaction of Income and Substitution Effect

It is thus clear that for an individual supplier of labor, income effect and substitution effect work in opposite directions. Whereas income effect of the rise in wage rate tends to reduce supply of labor,

substitution effect tends to increase it. If the income effect is stronger than the substitution effect, the net combined effect of the rise in wage rate will be to reduce labor supply. On the other hand, if the substitution effect is relatively larger than the income effect, the rise of wage rate will increase labor supply.

Therefore, the labor supply curve does not always slope upward as shown in Figure 2. It can slope or bend backward too which implies that at a higher wage rate, the individual will supply less labor, that is, work for less hours.

Backward Bending Supply Curve of Labor Figure 3

(These two diagrams can be combined)

As can be seen in figure 3, the labor supply curve moves upwards to a certain point and then begins to go backward.

The backward bending supply curve of labour is a thesis that claims that as wages increase, people will substitute leisure for working. Eventually, wages can increase to a point where less labour is offered in the market. Referring to Figure 3, if real wages were to increase from W1 to W2, then the worker will obtain a greater utility due to their higher income. Therefore, they would be willing to increase their hours worked from L1 to L2. This may be hours worked per day, month, year or even lifetime. Over this section of the curve, the substitution effect is greater than the income effect. Therefore, the increase in the real wage rate will cause an increase in the number of hours worked. This is because the wage rate is small so the demand for more income to purchase goods and services is very strong. The net effect of the rise in the wage rate is to reduce leisure and increase supply of labour.

However, if the real wage increased from W2 to W3, then the number of hours worked would fall from L2 to L3. This is because the income effect has now become greater than the substitution effect. This is because utility gained from an extra hour of leisure is greater than the utility gained from the income earned working. Basically, beyond the wage of W2 we see that the worker is being paid enough to sustain their current lifestyle without having to work more hours, therefore creating the backwards bend in the curve.

Assumptions made and Implications for the Organizational Context

The following are the assumptions that the above analysis is based on:

Workers choose their hours Workers are homogeneous There are no contractual obligations Workers are utility maximizing agents

As we can see from these assumptions, this condition is rare in aggregate under real world conditions, though at any time individual workers may have a personally backwards bending labour supply curve. Early retirement can sometimes be considered an example of the phenomenon over an entire lifetime. Overtime can reduce or negate the effect of a backward bending labour supply curve, by increasing wages only for hours worked beyond a certain amount. This increases the substitution effect at high labour supply but does not increase the countervailing income effect by as much as a higher flat wage rate would. This can cause workers to work more hours than they would under any flat wage rate, high or

low. Note as well that the graph is not to scale and reflects only a small portion at the far end of an individual's supply curve of labour and then only at a point in time. In real world terms, one can think of jobs which will pay a lot but which require extra long work weeks. A worker may choose such a job for a while, but as their life changes, assets build, and family or personal relationships develop, they might opt for much less pay in order to have more regular hours. This also accounts for shift premiums to induce workers to work less desirable shifts.

(The points below have been written according to our understanding of what we read- this may not be completely correct so use cautiously)

A direct implication for the companies of this curve can be that in order to get workers to work more, they need to pay more wages but only till a certain wage level. After that, increase in the salary can decrease the efforts by the employees.

This also has implications for the economy as a whole in which organizations function. In times, of recession, cuts in salaries can actually worsen the situation. The backward-bending supply curve of labour suggests that cutting real wages will have the opposite effect on the supply of labour than its supporters claim. It is commonly found that as real wages fall, hours at work become longer and the number of workers in a family increases. This is because the labour supply curve is negatively slopped as families need to work more (i.e., provide more labour) to make ends meet. This means that a fall in real wages may increase the supply of labour as workers are forced to work longer hours or take second jobs simply to survive. The net effect of increasing supply would be to decrease real wages even more and so, potentially, start a vicious circle and make the recession deeper.