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ECN 421 – Labor Economics

Labor Supply: Practice

Andreas Kostol
(andreas.kostol@asu.edu)

Spring 2021

1/21
Summary

The reservation wage is the wage that makes a person indifferent between
working and not working. A person enters the labor market when the wage rate
exceeds the reservation wage
Utility-maximizing workers allocate their time so that the last dollar spent on
leisure activities yields the same utility as the last dollar spent on goods
An increase in non-labor income reduces hours of work because of worker’s
convex preferences over leisure and consumption
An increase in the wage generates both an income and a substitution effect
among persons who work.
The income effect reduces hours of work; the substitution effect increases hours
of work. The labor supply curve, therefore, is upward sloping if substitution
effects dominate and downward sloping if income effects dominate.

2/21
Summary

An increase in non-labor income reduces the likelihood that a person enters the
labor force. An increase in the wage increases the likelihood that a person
enters the labor force.
Welfare programs create work disincentives because they provide cash grants to
participants as well as tax those recipients who enter the labor market. In
contrast, credits on earned income create work incentives and draw many
non-workers into the labor force.
Models of dynamic labor supply introduces savings and a motive to smooth
utility over periods. Introduces new concepts such as the Frisch elasticity, the
change in labor supply following a wage change, holding constant the marginal
utility of wealth (λ). Applies where a change in the tax rate tomorrow may
affect behavior today.

3/21
Review Questions

1. What happens to the reservation wage if non-labor income


increases, and why?
2. What economic factors determine whether a person participates
in the labor force?
3. How does a typical worker decide how many hours to allocate to
the labor market?
4. What happens to hours of work when non-labor income
decreases?

4/21
Review Questions

5. What happens to hours of work when the wage rate falls?


Decompose the change in hours of work into income and
substitution effects.
6. What happens to the probability that a particular person works
when the wage rises? Does such a wage increase generate an
income effect?
7. What is a work disincentive?
8. Why do welfare programs create work disincentives?
9. Why does the earned income tax credit increase the labor force
participation rate of targeted groups?
10. Give two reasons why we like to study the labor supply of taxi
drivers?

5/21
Review Questions

11. What do we call the elasticity of labor supply to an anticipated


wage increase, let’s say after 10 years of loyal service in a firm?
12. Why does the worker not experience an income effect during
those periods?
13. What happens to the labor supply effect (in 11) when the
person has a credit score below 400, and cannot borrow against
future income?
14. What is the discouraged worker effect?
15. What factors account for the secular decline in labor force
participation rates among older workers in the United States?

6/21
Problem A

Lindas hourly wage if she chooses to work is $5 per hour and she can work up to 168
hours in a week. Her utility function is

U = ln(C ) + ln(F )

where C is consumption and F is leisure.


a) Draw Lindas budget constraint in consumption-leisure space (leisure on the x axis),
and report the point in which the budget constraint crosses the y-axis
b) How many hours per week will Linda choose to work?
c) How much income will she have to consume?

7/21
Problem A

Lindas hourly wage if she chooses to work is $5 per hour and she can work up to 168
hours in a week. Her utility function is

U = ln(C ) + ln(F )

where C is consumption and F is leisure.


a) Draw Lindas budget constraint in consumption-leisure space (leisure on the x axis),
and report the point in which the budget constraint crosses the y-axis

8/21
Problem A

Lindas hourly wage if she chooses to work is $5 per hour and she can work up to 168
hours in a week. Her utility function is

U = ln(C ) + ln(F )

where C is consumption and F is leisure.


a) Draw Lindas budget constraint in consumption-leisure space (leisure on the x axis),
and report the point in which the budget constraint crosses the y-axis
A: Budget constraint is C = 5(168 − F ) so intersection at vertical axis is 840.

8/21
Problem A

Lindas hourly wage if she chooses to work is $5 per hour and she can work up to 168
hours in a week. Her utility function is

U = ln(C ) + ln(F )

where C is consumption and F is leisure.


a) Draw Lindas budget constraint in consumption-leisure space (leisure on the x axis),
and report the point in which the budget constraint crosses the y-axis
A: Budget constraint is C = 5(168 − F ) so intersection at vertical axis is 840.
b) How many hours per week will Linda choose to work?

8/21
Problem A

Lindas hourly wage if she chooses to work is $5 per hour and she can work up to 168
hours in a week. Her utility function is

U = ln(C ) + ln(F )

where C is consumption and F is leisure.


a) Draw Lindas budget constraint in consumption-leisure space (leisure on the x axis),
and report the point in which the budget constraint crosses the y-axis
A: Budget constraint is C = 5(168 − F ) so intersection at vertical axis is 840.
b) How many hours per week will Linda choose to work?
A: Do it with the Lagrangian or by substituting the budget into the utility
constraint. Both ways give the same result. Let’s do it the direct way:
5
maxF {ln(5(168 − F )) + ln(F )}, so first order condition is 5(168−F )
= F1 so
rearranging this gives 5F = 5(168 − F ) .... F = 5 × 168/10

8/21
Problem A

Lindas hourly wage if she chooses to work is $5 per hour and she can work up to 168
hours in a week. Her utility function is

U = ln(C ) + ln(F )

where C is consumption and F is leisure.


a) Draw Lindas budget constraint in consumption-leisure space (leisure on the x axis),
and report the point in which the budget constraint crosses the y-axis
A: Budget constraint is C = 5(168 − F ) so intersection at vertical axis is 840.
b) How many hours per week will Linda choose to work?
A: Do it with the Lagrangian or by substituting the budget into the utility
constraint. Both ways give the same result. Let’s do it the direct way:
5
maxF {ln(5(168 − F )) + ln(F )}, so first order condition is 5(168−F )
= F1 so
rearranging this gives 5F = 5(168 − F ) .... F = 5 × 168/10
b) How much income will she have?

8/21
Problem A

Lindas hourly wage if she chooses to work is $5 per hour and she can work up to 168
hours in a week. Her utility function is

U = ln(C ) + ln(F )

where C is consumption and F is leisure.


a) Draw Lindas budget constraint in consumption-leisure space (leisure on the x axis),
and report the point in which the budget constraint crosses the y-axis
A: Budget constraint is C = 5(168 − F ) so intersection at vertical axis is 840.
b) How many hours per week will Linda choose to work?
A: Do it with the Lagrangian or by substituting the budget into the utility
constraint. Both ways give the same result. Let’s do it the direct way:
5
maxF {ln(5(168 − F )) + ln(F )}, so first order condition is 5(168−F )
= F1 so
rearranging this gives 5F = 5(168 − F ) .... F = 5 × 168/10
b) How much income will she have?
A: Plug in the solution for F = 84, so that she has (168 − 84) × 5 in income.

8/21
Problem B

Let’s say utility is U(C , L) = a · log (C ) + b · log (L)


and non-wage income is 500 and available hours is 120.
What is the reservation wage when a=3 and b=2?
Then redo it when preferences for leisure and consumption are
reversed.

9/21
Problem B
Let’s say utility is U(C , L) = a · log (C ) + b · log (L)
and non-wage income is 500 and available hours is 120.
What is the reservation wage?

10/21
Problem B
Let’s say utility is U(C , L) = a · log (C ) + b · log (L)
and non-wage income is 500 and available hours is 120.
What is the reservation wage?

∂U/∂L ∂b · log (L)/∂L b·C


wR0 = MRS = = =
∂U/∂C ∂a · log (C )/∂C a·L

10/21
Problem B
Let’s say utility is U(C , L) = a · log (C ) + b · log (L)
and non-wage income is 500 and available hours is 120.
What is the reservation wage?

∂U/∂L ∂b · log (L)/∂L b·C


wR0 = MRS = = =
∂U/∂C ∂a · log (C )/∂C a·L

Now, using a=3 and b=2


2 · 500
wR0 = ≈ $3
3 · 120

10/21
Problem B
Let’s say utility is U(C , L) = a · log (C ) + b · log (L)
and non-wage income is 500 and available hours is 120.
What is the reservation wage?

∂U/∂L ∂b · log (L)/∂L b·C


wR0 = MRS = = =
∂U/∂C ∂a · log (C )/∂C a·L

Now, using a=3 and b=2


2 · 500
wR0 = ≈ $3
3 · 120

Now, using a=2 and b=3


3 · 500
wR1 = ≈ $6
2 · 120

10/21
Problem B
Let’s say utility is U(C , L) = a · log (C ) + b · log (L)
and non-wage income is 500 and available hours is 120.
What is the reservation wage?

∂U/∂L ∂b · log (L)/∂L b·C


wR0 = MRS = = =
∂U/∂C ∂a · log (C )/∂C a·L

Now, using a=3 and b=2


2 · 500
wR0 = ≈ $3
3 · 120

Now, using a=2 and b=3


3 · 500
wR1 = ≈ $6
2 · 120

In theory, can stronger preferences for leisure explain why labor


force participation in sourthern Europe is lower than US? 10/21
Problem C

Consider a worker with preferences over leisure and consumption given by


U(R, C ) = RC where R denotes the number of hours spent on leisure
and C the number of units consumed. Let R̄ denote the total number of
hours available, and M the nonlabor income of the consumer.

Suppose that R̄ = 24, M = 10, w0 = 1 (wage), and p = 2 (price of


consumption unit).

11/21
Problem C

i) Where does the budget constraint cross the y-axis?

ii) What is the optimal relation between the hours of leisure and the
consumption level?

iii) Find the optimal number of leisure hours, working hours, and the
optimal amount of consumption.

iv) Suppose now that the wage rate becomes w1 = 2. What is the new
optimal choice of leisure, labor and consumption?

v) If you compare you are answers in (iii) and (iv), what can you say
about the importance of the income effect relative to the substitution
effect on R?

12/21
Problem C Answers

i) Where does the budget constraint cross the y-axis?


Answer: 2C + R = 24 + 10, so C = (24-R)/2 + 5. When R=0, we get C=17

ii) What is the optimal relation between the hours of leisure and the
consumption level?
Answer: This is just the MRS equal to the wage: C/R = 1/2

iii) Find the optimal number of leisure hours, working hours, and the optimal
amount of consumption.
Answer: C = 8.5, R = 17

iv) Suppose now that the wage rate becomes w1 = 2. What is the new optimal
choice of leisure, labor and consumption?
Answer: C = 14.5, R = 14.5

v) If you compare you are answers in (iii) and (iv), what can you say about the
importance of the income effect relative to the substitution effect on R?
Answer: The individual works more, therefore the subsitituion effect dominates
the income effect.

13/21
Example

V = 500, T = 120, h = T − L, w = 20
C0 = V + T ∗ w − L ∗ w

Now: Introduce a tax of 30 percent on wages


But: Tax only applies to hours above 30 per week

Draw the new budget set

14/21
Example: Solve model numerically if you want

Solve the static labor supply model with Python

15/21
Example: Budget Constraints

3000
No tax on earnings
Tax on hours above 30 per week
2500 Optimal hours of leisure without tax
Optimal hours of leisure with tax
2000
Consumption ($)

1500

1000

500

0
0 20 40 60 80 100 120
Leisure (hours per week)

16/21
Problem D

Lindas hourly wage if she chooses to work is $15 per hour and she can work up
to 100 hours in a week. The price on consumption is normalized to 1. She
receives $100 non-labor income per week. Her utility function is
U = 2ln(C ) + 3ln(L) where C is consumption and L is leisure.
a) Draw Linda’s budget constraint in consumption-leisure space on a piece of
paper (leisure on the horizontal x-axis), and report the numeric value in which
the budget line crosses the y-axis.
b) How many hours per week will Linda choose to work?
c) How much income will she have to spend on consumption goods?
d) Linda’s workplace is moved to another city, so she will have to commute 2
(in total, including the return home) hours per day. She does not work during
weekends. Draw Linda’s budget constraint in consumption-leisure space on a
piece of paper (leisure on the horizontal x-axis), and report the numeric value
in which the budget line crosses the y-axis.

17/21
Problem D: Solution

a) The budget set is a straight line going from 1600 at zero hours of leisure
and stopping at 100 at 100 hours of leisure
b) We have 3C2L
= 15 and C = 100 + (100 − L)15. Plug first into second
equation, giving 25L = 1600 ⇒ L = 64 so labor supply is 100 - 64 = 36.
c) She can consume C = 100 + 36 ∗ 15 = 640
d) This reduces her available hours to 90 when she starts working. The budget
set is a straight line going from 1450 at zero hours of leisure and with a kink at
100 dollars at 90 hours of leisure and stops at 100 dollars at 100 hours of
leisure.

18/21
Problem E (Advanced)

Suppose you do not think about the future and your utility is
U(C , L) = log (C ) + log (L), your wage is $10 per hour, allowance is $500 per
week and hours available to work or relax is 120.
V = 500, T = 120, h = T − L, w = 10

a) Draw the budget line. Where does it cross the C-axis?


b) Solve the optimal labor supply.
c) Suppose you won $500 in stock market. How much do you work when your
weekly income increases once to V = 1000
Suppose you do think about the future, and the future has 100 weeks. Capital
markets are perfect, there is no interest rates and you never expect to win on
the stock market ever again.
d) How much do you work after you win on the Gamestock stock?

19/21
Problem E Answers

Suppose you do not think about the future and your utility is
U(C , L) = log (C ) + log (L), your wage is $10 per hour, allowance is $500 per
week and hours available to work or relax is 120.
V = 500, T = 120, h = T − L, w = 10

a) Budget line crosses C at 500 + 120*10 = 1,700


b) Optimal labor supply is C = 10L ⇒ 10L=(120-L)10 + 500. Next, move L
to LHS, and divide by 20, L = 1700/20=85, hence, labor supply is h = 120 -
85 = 35.
c) After stock win, L = (500+1700)/20=110, so h=10

20/21
Problem E Answers
Suppose you do think about the future, and the future has 100 weeks. Capital
markets are perfect, there is no interest rates and you never expect to win on
the stock market ever again.
U(C , L) = log (C ) + log (L)

d) Attacking this problem requires the lifetime budget constraint.


With 100 periods, no interest rate, no dicounting of future utility, this is really
easy.
P100
Ct = 100 (120 − Lt ) + 500 · 100
P
Before Gamestop:
Since you can move money freely, and you want to keep UC1 = UC100 and as
nothing changes over time, BC is just 100C=100(120-L)+50000

21/21
Problem E Answers
Suppose you do think about the future, and the future has 100 weeks. Capital
markets are perfect, there is no interest rates and you never expect to win on
the stock market ever again.
U(C , L) = log (C ) + log (L)

d) Attacking this problem requires the lifetime budget constraint.


With 100 periods, no interest rate, no dicounting of future utility, this is really
easy.
P100
Ct = 100 (120 − Lt ) + 500 · 100
P
Before Gamestop:
Since you can move money freely, and you want to keep UC1 = UC100 and as
nothing changes over time, BC is just 100C=100(120-L)+50000
After Gamestop: 100C = 100(120 − L) + 50500
We now know that you smooth consumption, and sets MRS1 = w and
MRS100 = w so we get L = (5 + 1700)/20 = 85 14 . Instead of reducing labor
supply by 25 hours per week, the dynamic model says you cut labor supply by
15 minutes.

21/21

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