Chapter 3 Topics in Labor Supply

McGraw-Hill/Irwin Labor Economics, 4th edition

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

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Introduction
Static model of Chapter 2 is not a complete depiction of how we allocate our time We extend the basic model to consider: - The long run - Husband-wife joint-decisions to supply labor

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Labor supply over the life cycle

Wage rates change over the workers life cycle - Wages are low when young - Wages rise with time and peak around age 50 - Wages decline or remain stable after the age of 50 Change in wage over the life cycle is an evolutionary wage change altering the price of leisure

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Theoretical issues of evolutionary wages

A person will work more hours when wages are higher (i.e., the substitution effect tends to dominate) The profile of hours of work over the life cycle will have the same shape as the age-earnings profile Intertemporal substitution hypothesis: people substitute their time over the life cycle to take advantages of changes in the price of leisure

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The Life Cycle Path of Wages and Hours for a Typical Worker

Wage Rate

Hours of work

50

Age

50

Age

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Intertemporal Substitution Hypothesis

There should be a positive relationship between changes in hours or work and changes in the wage rate As a worker ages, increases in the wage rate should increase hours of work

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Hours of Work over the Life Cycle for Two Workers with Different Wage Paths
Wage Rate Hours of Work
Joe (if substitution effect dominates)

Joe Jack
Joe (if income effect dominates)

Jack

t*

Age

t*

Age

Joes wage exceeds Jacks at every age. Although both Joe and Jack work more hours when the wage is high, Joe works more hours than Jack only if the substitution effect dominates. If the income effect dominates, Joe works fewer hours than Jack.

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Labor Force Participation Rates over the Life Cycle in 2005

100

Labor force participation rate

90 Male 80 70 Female 60 50 40 30 15 25 35 Age 45 55 65

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Hours of Work over the Life Cycle, 2005

2,500 Male

Annual hours of work

2,000 Female 1,500

1,000

500 15 25 35 Age 45 55 65

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Labor supply over the business cycle

Added-worker effect - So-called secondary workers currently out of the labor market are affected by a recession because the main breadwinner becomes unemployed or faces a wage cut This implies the labor force participation rate of secondary workers has a counter-cyclical trend

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Labor supply over the business cycle

Discouraged worker effect - Unemployed workers find it almost impossible to find jobs during a recession, so they give up searching Implies that labor force participation is pro-cyclical The discouraged worker effect dominates the correlation between labor force participation and the business cycle

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Retirement
Lifetime incomes are higher the longer workers put off retirement If pension benefits are constant, wage increases have a substitution and income effect, so lifetime income will not be altered An increase in pension benefits reduces the price of retirement, increasing the demand for leisure, encouraging the worker to retire earlier

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The retirement decision

Consumption ($) F

V80

P U1 U0 V60

10

20 Retirement

Point E gives a workers leisureconsumption bundle if he retires at age 60. Point F gives the leisure-consumption bundle if the worker never retires. A utilitymaximizing worker chooses point P, and retires for 10 years.

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Effect of an increase in the wage on the retirement decision

Consumption ($)

G R

U1 F P U0 E 5 10 20 Years of Retirement

An increase in the wage rotates the budget line around point E, and generates both income effects and substitution effects as the worker moves from point P to point R. The figure assumes that substitution effects dominate and the worker delays his retirement.

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Effect of an increase in pension benefits on retirement decision

Consumption ($)

U1 U0 F R

An increase in pension benefits rotates the budget line around point F. It too generates income and substitution effects, but both effects encourage the worker to retire earlier.

10

15

20 Years of Retirement

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Policy Application: the decline in work attachment among older workers

Older workers have lower participation rates This can be attributed to work disincentives created by higher Social Security benefits and the Social Security Disability Program The Social Security Earnings Test: retirees between ages 65 and 69 can earn up to $17,000 per year without affecting their retirement benefits If earnings exceed $17,000 then every $3 of income reduces the Social Security benefit by $1, an implicit 33% marginal tax rate

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The Impact of the Social Security Earnings Test on Hours of Work

Consumption ($) H
Worker 2

R2 R3
Worker 3

$47,000 P3 $27,000 P1 $10,000

Worker 1

Hours of Leisure

The Social Security earnings test (which taxes retirees when they earn more than $17,000 per year) generates the budget line HGFE. The repeal of the earnings test moves retirees to budget line HE. The first retiree (worker 1) would not change his hours of work; the second retiree would reduce his hours; and the third retiree might increase or decrease his hours, depending on whether substitution or income effects dominate.

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Household Production
Leisure includes many forms of nonmarket work, including work around the home Why do some household members specialize in the market sector and other members specialize in the household sector?

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Allocation of Weekly Hours to Various Activities, By Gender and Marital Status

0 24 48 72 96 120 144 168

Married Men

40.2

14.3

77.6

22.4

13.5

Unmarried Men

32.9

12

76.9

24.2

22

Married Women

16.7

34.9

78.7

22

15.7

Unmarried Women

22.2

23.5

79.4

23.8

19.1

Market Work

Household Work

Personal Care

Passive Leisure

Other

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Household Production Function

Consider Jack and Jill, a married couple Their household opportunity set is greater than when Jack and Jill were not married (since each can specialize in the sector where they are relatively more productive)

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Jack and Jill unmarried opportunity sets

Market Goods ($)

Market Goods ($)

200 150

100

Household Goods ($)

250 (b) Jills Budget Line

Household Goods ($)

(a) Jacks Budget Line

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Budget Lines and Opportunity Frontier of Married Couple

At point E, Jack and Jill allocate all their time to the household sector. If they wish to buy market goods, Jack gets a job because he is relatively more productive in the labor market, generating segment FE of the opportunity frontier. After he uses up all his time in the labor market, Jill then gets a job, generating segment GF of the frontier.
E E 100 250 340 350
Household Goods ($)

350 G

200 150 Jacks

Jills

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Who Works Where?

Market Goods ($) Market Goods ($) Market Goods ($)

P U P U Household Goods ($) Household Goods ($) Household Goods ($) P U

(a)

(b)

( c)

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Division of Labor in the Household

(a) The indifference curve U is tangent to the opportunity frontier at point P. Jill specializes in the household sector and Jack divides his time between the labor market and the household. (b) Jack specializes in the labor market and Jill divides her time between the labor market and the household. (c) Jack specializes in the labor market and Jill specializes in the household sector.

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Increases in the Wage Rate or Household Productivity Lead to Specialization

Market Goods ($)

An increase in Jacks wage moves the household from point P to point P and Jack specializes in the labor market

U Household Goods ($)

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Increases in the Wage Rate or Household Productivity Lead to Specialization

Market Goods ($)

P U

P U

An increase in Jills marginal product in the household sector moves the household from point P to point P and Jill specializes in the household sector.

Household Goods ($)

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Fertility
Malthus Theory of Fertility: as incomes rise, families want more children (focus on income effect) An increase in the price of a persons time will increase the opportunity cost of rearing children when this person exits the market sector

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The Fertility Decision

Goods

I/pX

The households utility depends on the number of children and on the consumption of goods. A utility-maximizing household chooses point P and has three children.
Indifference Curve Number of Children

I/pN

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The Impact of Income and Prices on the Households Fertility

Good s I/PX Good s

R R P U0 3 4 Number of Children 1 2 U1

P U1

Q
U0 D 3 Number of Children

(a) Increase in Income

(b) Increase in the price of children

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End of Chapter 3