03laborsupply Practice
03laborsupply Practice
03laborsupply 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
4/21
Review Questions
5/21
Review Questions
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 )
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 )
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 )
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 )
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 )
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 )
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 )
8/21
Problem B
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?
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?
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?
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?
11/21
Problem C
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
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
14/21
Example: Solve model numerically if you want
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
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
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)
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)
21/21