EC306 Economics of Wages and Employment
Chapter 2: Labor Supply: Individual Attachment to the Labor Market
Labor Force Participation decision: a decision to participate in paid labor market activities as
opposed to other activities such as unpaid work in the home, volunteer work, education, or
Labor force(LF): consists of those persons in the eligible population who participate in labor
market activities, as either employed or unemployed.
- Employed (E), if they did any work at all in the survey period. Also considered as
employed if they are normally employed but happen not to be at work at the time of
- Unemployed (U), with the latter being not employed but seeking work.
- Work- work for pay
Eligible population: portion of the population that is surveyed as potential labor force
- Persons from that potential population of labor force participants (POP) are categorized
as either in the labor force or no in the labor force (NLF).
Labor force participation rate (LFPR): the fraction of the eligible population that participates in
the labor force (LFPR = LF/POP)
Unemployment rate (UR): the proportion of the labor force that is unemployed (UR = U/LF)
Population Labor force Employed/ unemployed
Non labor force
• Most of the variation in overall participation is due to differences in the participation
rate of women
• Participation rate for women seem to be positively related to the level of economic
development, with the richer countries having higher female participation rates, or at
least smaller gaps between men and women.
- As countries get richer and as women’s education and labor market opportunities
improve, a convergence occurs in the economic roles of men and women, at least as far
as their participation rate is concerned.
Hour-of-work aspect of labor supply: has variety dimensions including hours per day, days per
week, and weeks per year.
Change in hours of work can affect quantity and quality of our overall labor supply. EC306 Economics of Wages and Employment
Changes in hours of work, in turn, can be affected by changes in the age and sex structure of
the labor force, the prominence of two-earner families, government policies and laws, and the
Basic Income-Leisure Model
Labor supply model: to represent an individual’s choice of hours worked given his or her
market opportunities and the value he places on their nonmarket time.
We wish to model this person as doing the best they can, subject to the constraints of the labor
market and the limited availability of time.
We divide the individual’s decision-making problem into two parts:
- What he would like to do (preferences)
- The choices available (constraints)
The assumption of rationality brings the two parts together, yielding a unique characterization
of an individual’s choice as a function of preferences and market constraints.
- consumption of goods and services
embodies all nonlabour market activities, including household work and education, pure
We can graphically represent consumer preferences with indifference curves. EC306 Economics of Wages and Employment
- The individual is indifferent between various combinations of consumption and leisure
as given by the U0.
- The slope of the indifference curve exhibits a diminishing marginal rate of substitution
between consumption and leisure.
At point A, the individual has an abundant of consumption and hence is willing to
give up considerable consumption to obtain more leisure. Steeply sloped.
At point B, the individual has an abundance of leisure and hence is willing to give up
considerable leisure. relatively flat sloped.
At intermediate point C, consumption and leisure are more subsumable because the
individual is not saturated with either.
We cannot compare utility across individuals, but we can compare marginal rate of
substitution across consumers.
Consumer 1, bundle A lies on indifference curve U1, while for consumer 2 the same
bundle lies on indifference curve U2.
- Consumer 1 has a higher MRS at A than consumer 2. Consumer 1 places a higher
value on leisure (at A) than does consumer 2.
- To induce consumer 1 to give up leisure from l0 to l1 requires compensating him with an
increase in consumption from C0 to C1 to keep him equally happy, whereas it would
require an increase to only C2 to compensate consumer 2.
The value of consumption is PC.
We ignore saving so that we can set PC = income
This allows a simple transformation of our model from consumption-leisure to income-leisure. EC306 Economics of Wages and Employment
Potential income constraints: indicate varying amounts of income that can be obtained by
giving up leisure and working.
The actual amount of income earned will depend on the chosen amount of work, in addition to
the amount of income received from other sources, referred to as “non labor” income and
shown as the amount Yn.
Alternative phrases for the potential income constraint include budget constraint, income
constraint, and full-income constraint.
Individual has only three discrete choices.
1. Spending all of her available time, T, engaged in nonmarket activities, including leisure.
The most that she can consume is given by her nonlabar income, Y (which migN, be
2. Could work part-time, increasing her income by I , to IP+Y, rPducing her leisure by
hpto lP= T – h P
3. Could work full-time, earning I + YF, aNd consuming l = T- hFunits Ff leisure.
In this case she need only compare the unitity of three bundles, choosing the one on the
highest indifference curve. EC306 Economics of Wages and Employment
- This linear budget constraint allows the individual to choose from a continuum of
income-leisure bundles, ranging from 0 hours of work to T hours of work.
- The slope of the constraint depends on the person’s wage rate, W.
- For each hour worked, the individual gives up one hour of leisure but earns W of
- The constant slope reflects an assumed constant wage rate for each hour worked.
- Stepper slope indicates higher market wage, will be able to earn more income by giving
up leisure and working more.
T is the maximum amount of leisure available (T), the most they can earn is WT + Y , commonNy
called full income. EC306 Economics of Wages and Employment
Allowing the returns to work to vary with the amount worked. Example: self-employed
If income as a function of hours worked, I = F(h).
If she has diminishing marginal productivity for each hour worked beyond a certain point.
- Her income is also a function of the number of hours she works, but the wage rate is the
value the market places on an hour’s worth of the goods she produces.
The Consumer’s Optimum
Putting the individuals’ potential income constraint and indifference curves together, we can
obtain the consumer’s optimum amount of income and leisure optimal amount of work or
The utility-maximizing individual will reach the highest indiffere