3.

labor supply

3.1 Labor supply, Concept and Measurement

A. Definition of Labor supply

Labor supply is the term used to describe the human inputs into the production process. It is
defined as the amount of labor, measured in person-hours, offered for hire during a given
period of time. Taking population as given, the quantity of labor supplied depends on two
main factors. First, there are the numbers engaged in or seeking paid employment, which
together make up the labor force or the supply of workers. Second, there is the number of
hours that each person is willing to supply once he or she is in the labor force – the supply of
hours.

There are essentially three dimensions to variations in the volume of labor supply in the short
run, in particular:

• Participation in the labor market: - the number of persons who supply labor from a
population of given size (labor force approach to the labor supply). Various Head Count
measures were being used in measuring the labor supply to the economy. The measures
were crude and needed refinements. Head count of the number of people as a measure of
labor supply was refined to the number of people in the working age and this in turn was
refined by the number of working age population adjusted by participation rates (labor
force). The labor force approach or participation rate approach needs to be adjusted by
qualifications in skill, education, experience, hours of work and effort to serve as a better
measure of the economy wide labor supply.

• The number of hours supplied by each person to the labor market. At the individual level
labor supply could be the number of hours the individual is willing to work.
• The intensity of effort associated with each "person-hour" (the number of hours qualified
by the speed and efficiency level.) In this case the unit of labor would be the amount of
work performed in unit time by worker of average efficiency. The supply of labor would
then be the number of this unit of labor forthcoming at various wage rates.

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In the long run there are the issues of the size and structure of the population and the quality
of the labor force, which therefore give us two more dimensions to consider, in particular:

• The number of persons available to supply labor, associated with the size and structure of
the population due to demographic factors (i.e. births, ageing, deaths, immigration and
emigration)
• The amount of education, training and experience, including learning by doing (which
affect the level and nature of skills offered by each individual)

The bulk of labor supply theory treats the individual (person) as the decision making unit
attempting to choose between hours of work and leisure time to optimize personal utility.
However, while recognizing the importance of the individual there are a number of
alternative developments in the literature that focus on the individual within some larger
decision making unit; like the family and household the individual belongs. The economic
theories of labor supply can thus be categorized into four types, in particular:

1. The individual utility maximization model (the single person household)

2. The ‘Chauvinistic model’, in which one partner (normally assumed to be the male)
decides on his labor supply independently of the female. The latter treats the male
income as if it were gives exogenously (i.e. as if it were property income), and then
makes her own labor supply decision
3. The ‘family utility/family budget constraint’ model, which specifies some overall
family utility function containing the leisure of each family member. The earinings
from family members are pooled and the family maximized the overall utility function
4. The ‘individual utility/family budget constraint’ models. In this case, individual have
their own goals which they pursue within the various constraints set by the family unit

B. Earnings of Labor

The actions of buyers and sellers in the labor market serve both to allocate and to set prices
for various kinds of labor. From a social perspective, these prices act as signals for incentives
in the allocation process, a process that relies primarily on individual and voluntary decisions.
From the worker’s point of view, the price of labor is important in determining income- and

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hence purchasing power. Workers earn wage in return for the service they provide to firms
and employers.

Wage rate is the price of labor per working hour. The nominal wage is what workers get paid
per hour in current dollars; nominal wages are most useful in comparing the pay of various
workers at a given time. Real wages, nominal wages divided by some measure of prices
suggest how much can be purchased with workers nominal wages. Calculations of real wages
are especially useful in comparing purchasing power of worker’s earnings over a period of
time when both nominal wages and product prices are changing. The most widely used
measure for comparing the prices consumers face over several years is the consumer price
index. It is derived by determining what a fixed ‘bundle’ of consumer goods and services
(including food, housing, clothing, transportation, medical care, and entertainment) costs
each year. There are some problems associated with using price index to indicate the
purchasing power of wages in different years:

1. Consumers change the bundle of goods and services they actually buy over time,
partly in response to changes in prices.
2. Consumer price index fails to incorporate changes in qualities of goods and services
occurred each year.

We often apply the term wages to payments received by workers who are paid on a salaried
base. The term wage refers to the payment for a unit of time, while earnings refer to wages
multiplied by the number of time units (typically hours) worked. Earnings depend on both
wages and length of time the employee works. Income- the total command over resources of
a person or family during some time period (usually a year)- includes both earnings and
unearned income, which includes dividends or interest received on investments and transfer
payments received from the government in the form of food stamps, welfare payments,
unemployment compensation, and the like.

Wage rate (pay per unit of time) X units of time worked = earnings

Earnings + Employee benefits (in kind or deferred payment) = total compensation

Total compensation + unearned income (Interest, dividend, gov’t transfer pay’t) = Income

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 3.2 Labor supply of the economy as a whole

3.2.1 Labor force, participation rates and hours of work

Population of the country

Working age population Population below the working age

Labor force (currently active population) Population not currently active (Students, home makers, retired (old aged
pensioners), persons suffering from infirmity or disablement)

Employed Unemployed

Paid employment Self-employment Without work, currently available for work, and seeking work.

Activity rate or participation rate measures the extent of involvement in economic activities,
or the participation in the production and distribution of economic goods and services.

Economic activity rate =(Labor force / working age population) x 100.

The working age population is sometimes referred to as the potential labor force or age
eligible population. In other words

Economic activity rate = (actual labor force / potential labor force) x100

Potential labor force or age-eligible population is entire population less young people under
16 years of age and people who are institutionalized. Children – those under 16 – are
excluded on the assumption schooling and child labor laws keep most of them out of the
labor force. Furthermore, that segment of the population that is institutionalized – in penal of
mental institutions, nursing homes, and so on- is also not available for labor market activity.
The actual labor force consists of those people who are employed or unemployed but actively
seeking a job.

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Economic activity (according to ILO and SNA) covers all market production and certain
types of non-market production, including production and processing of primary products for
own consumption, own account construction and other production of fixed assets for own
use. It excludes unpaid activities such as unpaid domestic activities and voluntary community
services. The determination of economic activity is a matter of convention. As the convention
is revised, the measurement of economically active labor force and, therefore, the labor
supply changes.

The measurement of labor supply using the labor force approach has the following
shortcomings:

- It fails to incorporate the hours of work, effort on the job, labor commitment as
comprehensive measure of labor supply

- It fails to incorporate all economic activities particularly a large portion of the non
marketable production (production for own or home production)

- The setting of criteria in identifying economic activities is not always possible or may not
be easy to apply in all cases. For example the problems involved in applying the
economic activity criteria in case of begging with services, the categories of criminal
activities, actively seeking work etc.

- The reference period too affects the labor supply, since taking activity in a day’s time,
week’s time, month’s time, year’s time or a certain season would result different
estimates.

With all these shortcomings, the labor force approach of estimating the labor supply is a
popular method. However it needs refining by complementing it with time-use surveys and
labor efficiency approaches to produce relatively better estimates. The knowledge of the time
use is important because the total amount of labor supplied in the economy depends not only
on the number of labor force participants but also on the number of hours worked per week
and per year by those participants.

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Population and fertility

Labor supply has a dimension of quality and quantity. The quality of labor supply
encompasses elements of human capital such as education, training, mobility and health, and
human relations such as job enrichment, morale and alienation.

The quantity dimension of labor supply involves determining the size of various quantity
elements, including our domestic population, that portion of our population that participates
in the labor force activity, and the hours of work of those in the labor force. The size of our
domestic population in turn depends on fertility and deaths, as well as immigration and
emigration. Here we’ll see the economic theory of fertility.

The economic theory of fertility is basically an application of standard microeconomic

consumer demand theory to household decision making. Factors affecting fertility includes
income, price of cost of children, price of related goods, tests and preferences, investment
aspect, and spacing and timing of children.

3.2.2.a Trends in labor force participation rates (long-term or secular changes in

participation rate)

In case of USA, the labor force participation rate has declined for males (primarily for males
in their early 20s and over 62) and participation rate has increased for females (particularly
for married females). The literature indicates that there is a clear difference in the trend of
participation rates of males and females. The trend varies, however, from culture to culture.
The variation also depends on the levels of development and social classes. The actual
situation could be laid bare by disaggregated studies.

The major causal factors for the change in trends are:

• Declining participation rates of older males because of

o Rising real wages and earnings: the income effective of this has dominated
the substitution effect, and consequently many in the old age have chosen
more leisure in the form of retirement
o The increasing availability of public and private pensions

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 o An increasing access to disability benefits: three of these factors indicate
that the availability of nonlabor income in the form of public or private
pensions, disability payments, or income from accumulated wealth
generates a pure income effect that is sufficient to induce many older
males to become nonparticipants.
o The allocation of time over one’s life cycle: some economists also argue
substitution effects are also important. In particular these economists
observe that the real earnings of many workers rise quite significantly until
they reach, say, their mid-fifties, and earnings grow slowly or decline
gradually. Reason for decline in the earnings of older workers is that, on
average, their formal education and on-the-job training become obsolete
and their mental and physical capabilities diminish. This means in
allocating time over one’s life time, it is rational to work continuously and
for long hours during one’s younger years because one’s earnings potential
is high and therefore leisure is expensive. Conversely, as a person grows
older, the earnings potential becomes smaller and leisure becomes
relatively cheaper, meaning that one is inclined to substitute leisure for
work. In the extreme this substitution is complete and retirement is chosen
• Rising female participation rates
o Rising real wage rates for women: for many married women the
substitution effect of rising real wage is greater than the income effect.
Since many of the married women has a small hour for paid work, as wage
increase there is little to do with reducing number of working hour
resulting from the income effect.
o Changing preferences and attitudes: changing attitudes of the society,
legislations of equality and ‘equal pay for equal job’, accessibility of job,
education and training of women, all may change the preference of
married women in favor of labor market work.
o Raising productivity in the household: advancement in technology has
increased productivity in home and reduced the amount of time needed to
accomplish both production and consumption within the home. Married
women then gained freed time to go to work either in part time or in full
time paid work in the labor market.
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 o Declining birth rates: the presence of children and associated highly time
intensive child care keeps many wives out of the labor force. However
widespread availability and use of birth control techniques, coupled with
changing lifestyle, has reduced birth-rates and compacted the span of time
over which a family’s children are born. Higher wage rate and more
education are associated with fewer children. Child rearing is a highly
time-intensive activity, and thus the opportunity cost of children- the
income sacrificed by not being in the labor market – is higher for more-
educated women than for those who are less educated.
o Rising divorce rates: marital instability as evidenced in rising divorce rates
has undoubtedly motivated many women to establish and maintain labor
market ties.
o Expanding job accessibility
o Attempts to maintain living standards

What about that in Ethiopia?

Trends in working age population, economically active population and participation rate of
Ethiopia between 1994 and 2005 by gender and place of residence (Rural and Urban)

1994 2005 Mean % Change

Total population 53477000 63229000 58353000 18.24%
Working age Population (10 years and above) 36626000 41018000 38822000 11.99%
Economically active population (labor force) 26503000 32380000 29442000 22.17%
Participation rate 72.36% 78.94% 75.65% 9.09%
Male 72.40% 84.75% 78.58% 17.06%
Female 62.80% 73.50% 68.15% 17.04%
Urban 49.70% 59.30% 54.50% 19.32%
Rural 76.40% 82.90% 79.65% 8.51%
Source: CSA's 1994 Population and Housing Census, CSA's 2005 Labor force survey and
computations made on the basis of these reports.

In the case of Ethiopian labor force, participation rate is generally increasing. Seen from the
point of urban and rural dwellers, although there is growth in both urban and rural
participation, the participation rates of the former are growing at a higher rate. Can you guess
why?

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 Sectoral shifts in employment

In US, Primary sector (agricultural) employment has declined as a share of the labor force,
Secondary sector (industrial) employment has declined slightly as a share of the labor force,
but only in the past few decades, and Tertiary sector (service sector) employment has
increased as a share of the labor force. What about in Ethiopia?

Trend in sectoral employment in Ethiopia

1984 1994 2005 Difference b/n Difference b/n Difference b/n

employment rates employment rates employment rates of
of 1994 and 1984 of 2005 and 1994 2005 and 1984
Agricultural 88.60 89.30% 80.20% -9.10% -8.40%
employment % 0.70%
Industrial 2.50% 2.30% 6.70% 4.40% 4.20%
employment -0.20%
Service sector 9.80% 7.70% 13.10% 5.40% 3.30%
employment -2.10%
Trend in urban and rural un employment rates in Ethiopia
1984 1994 2005 Difference b/n Difference b/n
Difference b/n un unemployment unemployment rates
employment rates rates of 2005 and of 2005 and 1984
of 1994 and 1984 1994
Urban 7.90% 22.00 20.60% -1.40% 12.70%
Unemployment % 14.10%
Rural 0.40% 0.70% 2.60% 1.90% 2.20%
unemployment 0.30%
Source: Various CSA publications

Reasons for the shifts in employment

Historically in the developed world, employment in the agricultural sector has been declining
due to rapid growth in labor productivity and a low-income elasticity of demand for
agricultural products. The secondary sector is characterized by rapid growth in labor
productivity and a moderately high-income elasticity of demand, and the tertiary sector is
characterized by slow growth in labor productivity and a high-income elasticity of demand.
In Ethiopia similar declining trend in agricultural employment and increasing percentage in
non-agricultural employments seem to be evidenced by the data. The rise in the urban
unemployment rate, however, suggests that the decline in the agricultural employment may
not be going together with the rise in share of the non-agricultural sectors' employment.
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3.2.2.b cyclical changes in participation rates

Primary workers are employed or unemployed workers that tend to remain in the labor force
in spite of all changes in the wage rate and working conditions while secondary workers, on
the other hand, lack labor force attachment to the same degree as primary workers. Male
household heads are examples of primary workers. Working age students having the option
of going to school or earn positive income, elderly people past the retirement age who may or
may not work to earn don’t have permanent attachment to the labor force and hence are
secondary workers.

Being a secondary worker affects participation rates during business cycle through either the
additional worker effect (added-worker effect) or through the discouraged-worker effect. The
added-worker effect is the idea that when the primary worker in a family loses his or her job,
other family members will temporarily enter the labor force in the hope finding employment
to offset the decline in the family’s income. Hence, according to the additional worker
hypothesis, participation rates tend to decline during periods of economic prosperity and
increase during economic recessions, as household members, particularly secondary workers
leave and enter the labor market, respectively, to maintain family income. In this case
participation rates are counter cyclical having a stabilizing and damping effect.

Participation rate could also come through the discouraged worker effect. The discouraged-
worker effect suggests that during recession some unemployed worker, who lost their job
during recession, become so pessimistic about finding a job with an acceptable wage rate that
they cease to actively seek employment and thereby temporarily become nonparticipant.
Hence, according to the discouraged worker hypothesis, the fall in the real wages and family
incomes during economic recession results in greater job cuts as potential workforce is
deterred from entering the labor market because the members of the workforce believe there
are no jobs for them. Secondary workers refrain from entering the labor market.

The added-worker effect increases and the discouraged-worker effect decrease participation
rates and labor force size during an economic downturn. So which effect dominates in a
particular situation is an empirical issue. Empirically research generally indicates that the
discouraged labor force is dominant, as is evidenced by the fact that the aggregate labor force

10
participation rate varies inversely with the unemployment rate. When the unemployment rate
increases the participation rate falls and vice versa.

3.3 Individual labor supply

Labor supply decisions are diverse which differs from person to person, from culture to
culture, from country to country etc. Some individuals wants to have part-time work in
addition to their full-time work, others want to have only full-time work, while others still
want to have only part-time work. Some others, however, wants not to work at all. While
some women with child to be rear go to work regularly, others devote their full time to take
care of their child. Some cultures motivate societies to work as much as possible, while other
cultures motivate more leisure.

• How are these diverse labor supply decision make?

• How do individuals decide on the number of hours, if any, to supply in the LM?

It is using the basic theory of individuals labor supply that helps give us answer to these
questions.

The decision to work is ultimately a decision about how to spend time. One way to use one’s
available time is to spend it in pleasurable leisure activities. The other way in which people
use time is to work. People then have a discretionary time that can be allocated either for
work or leisure. Since the amount of discretionary time spent on leisure is time not spent on
working, and vice versa, the demand for leisure can be considered the reverse side of the coin
labelled supply of labor. It is more convenient to analyze work incentives in the context of
the demand for leisure, because one can apply the standard analysis of the demand for any
good to the demand for leisure.

The demand for a good is a function of three factors:

1. the opportunity cost of the good (which is equal to market price)

2. one’s level of wealth
3. one’s set of preferences

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As wealth rise, the demand for normal goods is assumed to be increased. Economists usually
assume preferences are given and not subject to immediate changes. For policy purpose,
changes in prices and wealth are of paramount importance in explaining changes in demand
because these variables are more susceptible to change by government or market forces.

The opportunity cost of leisure is the wage rate. The cost of spending an hour entertainment
is what one could earn if one had spent that hour working. Thus, the opportunity cost of an
hour of leisure is equal to one’s wage rate – the extra earnings a worker can take home from
extra hour of work.

3.3.1 The work-leisure decision model

Imagine an individual with a certain amount of education and labor force experience and,
therefore, a certain level of skills. That individual having a fixed amount of time available,
must decide how that time should be allocated among work (labor market activity) and
leisure (non-labor market activity). In the present context, work is time devoted to a paying
job. The term leisure is used here in a broad sense to include all kinds of activities for which
the person does not get paid: for example, work within the house-hold and time spent on
consumption, education, commuting (travel), rest, relaxation, and so forth.

Two sets of information are necessary to determine the optimal distribution of an individual’s
time between work and leisure. First, we require subjective, psychological information
concerning the individual’s work-leisure preferences. This information is embodied in
indifference cure. Second, we need the objective, market information that is reflected in a
budget line.

Indifference curve

An indifference curve shows the various combinations of real income and leisure time that
will yield some specific level of utility or satisfaction to the individual. The IC slopes
downward because the additional utility associated ‘more’ leisure must be offset by ‘less’
income in order that total utility remains unchanged. The convexity of the curve reflects a
diminishing marginal rate of substitution of leisure for income.

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 Income (per day)

Fig. 1 Indifference

0 Hours of leisure (per day) 24

24 Hours of work (per day) 0

Indifference curve embody several salient properties

1. Negative slope: because an individual gets more of one good (leisure), some of other
good (real income) must be surrendered to maintain the same level of utility.
2. Convex to origin: (i.e., the absolute value of the curve’s slope diminishes as we move
down the curve to the southeast). The slope has two considerations; first, the slope of
the curve reflects an individual’s subjective willingness to substitute between leisure
income. Second, the individual’s willingness to substitute leisure for income, or vice
versa, varies with the amount of leisure and income initially possessed. The convexity
of an IC reflects the notion that an individual becomes increasingly reluctant to give
up any good (income) as it becomes increasingly scarce. The IC becomes flatter and
flatter as we continue substituting leisure for income. By definition, the curve that
flattens out as we move to the southeast is convex to the origin. In technical terms, the
slope of IC is measured by the marginal substitution of leisure for income (MRS L,
Y). The MRS L, Y is the amount of income one must give up to compensate for the
gain of 1 more unit (hour) of leisure.
3. Indifference map: an indifference map comprises a number of indifference curves.
Each successive curve to the northeast reflects a higher level of total utility. An
individual will maximize total utility by achieving a position on the highest attainable
indifference curve.

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 Fig.2 Indifference Map

Income per day

Hrs of leisure

4. Different work-leisure preferences: the work leisure preference are different for each
individuals, some value leisure while others value work more. Those who value work
more are willing to give up leisure for small amount of income. Whereas those who
value leisure more are reluctant to give up leisure for small amount of income, if they
do they need more amount of income. The IC of ‘workaholic’ is flatter, while that of
‘leisure lover’ is steeper. The difference for valuing leisure or income depends on
personal preference/test, type of person’s occupation and personal circumstance. For
those in creative and challenging and enjoyable occupations, like painter or
musicians, work entails very little disutility, and hence it takes only a small increase
in income to induce the individual to sacrifice an hour of leisure. Conversely, an
unpleasant job in a coal mine or garage involves substantial disutility, and a large
increase in income is required to induce one to give up an hour of leisure.

Workaholic (person with Leisure lover (person

strong testes for income with strong testes for
Income per day
Income per day

leisure

Hrs of leisure Hrs of leisure

Fig.3 Different Work-leisure preferences

Budget Constraint

Our assertion that the individual maximizes utility by achieving a position on the highest
attainable IC implies that the choice of curves is constrained. Specifically the individual is
constrained by the amount of monetary income that is available. Assuming that the

14
individual’s only source of income is from work, i.e., assuming the individual has no non-
labor income, no accumulated income to draw on, no possibility of borrowing, and no
potential to alter the hourly wage rate prevailed in the labor market, we can draw the budget
constraint of the individual, which shows all the various combinations of income (goods) and
leisure that a worker might realize or obtain, given the wage rate.

72
Income per day

Fig.4 budget constraint when wage

48 rate is $1, $2, and $3

24

0 Hours of leisure (per day) 24

24 Hours of work (per day) 0

Utility maximization

The individual’s optimal or utility-maximizing position can be determined by bringing

together the subjective preferences embodied in the indifference curve and the objective
market information contained in the budget constraint. The farther the indifference curve is
from the origin, the grater the person’s total utility will be. Therefore, an individual will
maximize total utility by attaining the highest possible IC. Utility will maximize when budget
constraint is tangent to the highest attainable IC. At the tangency point, the individual is
willing to substitute leisure for income at precisely the same exchange rate as the objective
information of the labor market requires. The optimal work-leisure position is achieved
where MRS L, Y (the slope of the IC) is equal to the wage rate (the slope of the budget line).

72
Income per day

48

b Fig. 5 utility maximization

24 c
I1
a

Hours of leisure (per day)

Hours of work (per day)

15
At point ‘b’, the IC is steeper than the budget line, i.e. the MRS L,Y is greater than the wage
rate. For instance let’s assume the slope of the IC is 4 and the slope of the BL which is the
wage is $2. Here the individual is willing to purchase leisure at $4 per unit (hour) i.e.
indicated by the slope of the IC; however the market price of leisure is $2. So, the individual
is beneficial if purchases leisure at the market price (wage). Hence, acquiring something
worth $4 at the cost of something worth only $2 is clearly beneficial exchange. Thus,
‘trading’ income (by working fewer hours) for leisure will be beneficial for the individual.
These trades in effect move the individual down the budget line and on to successively higher
ICs. At point ‘c’ all such trades are exhausted, and this individual and the market are in
agreement as to the value of work (income) and leisure at the margin. On contrary to this, at
point ‘a’ the slope of the IC is less than the slope of the budget line, i.e. the MRS L,Y is less
than the wage rate. For instance, if we assume the MRS is $1 and the wage rate is $2, it
indicates than the value of leisure is only $1 but the individual can actually get $2 worth of
income by sacrificing an hour of leisure. Getting something worth $2 by giving up something
worth $1 is obviously a beneficial trade. Thus trading leisure for income moves the individual
up the budget line to preferred position of higher IC. Again, all such beneficial exchanges of
leisure for income will be completed when point ‘c’ is achieved because here the MRS and
the wage rate are equal. At point ‘c’ leisure and income are of equal value. At point ‘a’ the
individual is would feel underemployed, so he/she can increase total utility by working more
hours.
mathematical derivation of the idividual utility maxmization problem
Individual budget constraint:
Y = WH + G; Y- is income, W- is wage rate & H-is numbers of hours of work & G-is other income
Y = W (24 - L) + G
Y = 24W + G − WL
Utility function:
U = f (Y , L)
Then, optimaization problem will be
max U = f (Y , L)
subject toY = 24W + G − WL

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In order to solve the problem we will use the lagrangian method of optimization
The lagrange will
Z = f (Y , L) − λ (Y − 24W − G + WL)
using the first order condition
∂Z ∂f
= − λW = 0.....................(1)
∂L ∂L
∂Z ∂f
= − λ = 0........................(2)
∂Y ∂Y
∂Z = Y − 24W − G + WL = 0 ⇒ Y = 24W + G − WL
∂λ

By dividing equ(1) by equ(2) we will get:

∂f
∂L = W ⇔ mu =W
∂f L
muY
∂Y
Hence the slope of the IC which is MRS L,Y, Marginal utility from leisure devided by marginal
utility from income (working), is equal to the slope of the budget line, the wage.

3.3.2. The individual labor supply curve (Back-ward bending labor supply curve:

The individual labor supply curve exhibits the amount of hours an individual is willing to
supply at different wage rates. It is derived from the individual utility maximization problem
dealt above. Hence, we need to see response of the individual with wage rate changes and the
optimal allocation of leisure and work associated with each wage rates. The diagram below
depicts the individual’s optimal position at each wage rate and subsequently the
diagrammatic derivation of individual labor supply curve. To obtain the individual’s labor
supply curve – the relationship between the supply of hours and the hourly wage rate as their
price – it is necessary to transpose the utility-maximizing positions shown by the wage-
leisure curve on the wage rate versus supply of hours plane.

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 Wage

Wage-leisure cure Back-ward

72
bending labor
48 supply curve
24

Hours of work
Hours of leisure (per day)

Hours of work (per day)

Fig. 6 Derivation of Labor Supply curve

The labor supply curve gives an answer for the question that will an individual choose to
work more or fewer hours as the wage rate changes? As can be seen from the back-ward
bending labor supply curve, for a specific person hours of work may for a time increase as
wage rates rise, but beyond some point, further wage increases may lead to fewer hours of
labor being supplied.

3.3.3. Wage rate changes: Income and Substitution effects

Income effect

The income effect refers to the change in the desired hours of work resulting form change in
come, holding the wage rate constant. The income effect of a wage increase is found by
isolating the increase in work hours resulting solely from the increase in potential income per
hour of work, as if the price of leisure (the wage rate) did not change. A wage rate increase
means that a larger money income is obtainable from a given number of hours of work. Part
of this larger income will be spent in goods and services to satisfy the material wants of the
individual. In the same way, if we assume leisure is a ‘normal good’ - a ‘good’ of which more
is consumed as income rise- then we can expect that a part of one’s expanded income might
be used to “purchase” leisure. Consumers do not derive utility from goods alone, but from
combination of goods and nonmarket time (leisure). Workers/individuals purchase leisure in
a unique way by working fewer hours. This means that when wage rate rise, and leisure is a
normal good, the income effect results in a reduction in the desired number of hours of work.

18
 ∆H − −
Income effect = W < 0, where H = hours of work , Y = income, W = constant wage
∆Y

Substitution effect

The substitution effect indicates the change in the desired hours of work resulting from a
change in the wage rate, keeping income constant. An increase in the wage rate raises the
‘price’ or opportunity cost of leisure. Because of higher wage rate, one must now forgo more
income (goods) for each hour of leisure consumed (not worked). The basic theory of
consumer choice implies that an individual will purchase less of any normal good when it
becomes relatively more expensive. The higher the price of leisure prompts one to consume
less leisure or, in other words, to work more. The substitution effect merely tell us that when
wage rates rise and leisure become more expensive, it is sensible to substitute work for
leisure. For a wage increase, the substitution effect results in the person desiring to work
more hours.

∆H − −
Substitution effect = Y > 0, where H = hours of work , W = wage, Y = constant income
∆W

Net effect

The net effect of wage rate change on hours of work supplied depends on the relative
magnitude of both the income and substitution effects. If the substitution effect dominates the
income effect, the individual will choose to work more hours when the wage rate rises. But if
the income effect is larger than the substitution effect, a wage rate increase will prompt the
individual to work fewer hours.

Size of effect Impact on hours of work Slope of labor supply

Wage rate increase Wage rate decrease curve
Substitution effect Increase Decrease Positive
exceeds Income effect
Income effect equals No change No change Vertical
substitution effect
Income effect exceeds Decrease Increase Negative
substitution effect

19
Graphic presentation of Income and Substitution effect

Substitution effect reflects the change in desired hours of work arising solely because an
increase in the wage rate alters the relative price of income and leisure. Therefore, to isolate
the substitution effect, we must control for the increase in income created by increasing in the
wage rate. Recall, too, that the income effect indicates the change in the hours of work
occurring solely because the higher wage rate means a larger income from any number of
hours of work. In portraying the income effect, we must hold constant the relative prices of
income and leisure, the wage rate.

W2 Fig. 7 Substitution and Income

effect
Income (per day)

U2
W’

I1 U2’

W1 I2

U1
N

H2 H1 H3
Work
leisure
Income effect

Sub. effect
Net effect

In the above diagram, an increase in wage rate shifts the budget line from HW1 to HW2, the
resulting movement of the utility-maximizing position from u1 on I1 to u2 on I2 is the
consequence of the combined income and substitution effects. The income effect is isolated
by drawing the budget line NW’, which is parallel to HW1 and tangent to I2 at point u2’. The
vertical distance HN measures the amount of nonlabor income that would be required to
make the individual just as well off (that is, attain the same total utility) at u2’ as at u2. But
by moving the individual form curve I1 to curve I2 with nonlabor income, we have left the
wage rate, that is, the relative prices of leisure and goods, unchanged. No substitution effect
is involved here. The movement from u1 to u2’ therefore measures or isolates the income
effect. The income effect would result the individual wanting to work H1H3 fewer hours.

20
The substitution effect occurs solely because the slope of the budget line – the relative price
of leisure and income – has been altered by the assumed increase in the wage rate. We are
concerned with budget lines nW’ and HW2 because their comparison involves no change in
the individuals wellbeing; they both pertain to the same IC I2. Line nW’, however, indicates
the original wage rate (also embodied in HW1), while HW2 mirrors the new higher wage
rate. The movement from u2’ to u2 on curve I2 is the substitution effect. It is solely the result
of change in the relative prices of leisure and goods or especially, the fact that goods have
become cheaper and leisure more expensive. This prompts the individual to substitute work
(goods) for leisure, i.e. for a wage rate increase, the hours of work rise (the substitution
effect). In this case, the individual wishes to work H3H2 more hours.

From the income and substitution effect we observe that, wage rate increase affects the
worker: by increasing monetary income and by increasing the relative price of leisure.

In the above diagram, the substitution effect (increased work hours) is larger than the income
effect (reduced work hours). The net effect is an increase in hours of work from HH1 to HH2;
at the higher wage rate, the individual wants to work H1H2 additional hours. This individual
is clearly on the upward-sloping segment of his or her labor supply curve; the wage rate and
the desired hours of work are directly related.

3.3.4. Elasticity of Labor supply

Elasticity of labor supply measures the sensitivity of changes in hours supplied resulting from
change in wage rate. Wage elasticity of labor supply is defined as:

percentage change in quantity of labor supplied

Es =
percentage change in the wage rate

The coefficient of elasticity could be zero (perfectly inelastic), infinite (perfectly elastic), less
than one (relatively inelastic), greater than one (relatively elastic), or less than one
(backward-bending). The elasticity will depend on the relative strengths of the income and
substitution effects generated by a wage rate change. This elasticity measures changes
occurred along the curve (the existing supply curve).

21
There are different factors which shifts the entire labor supply curve unlike the movements
along the curve resulted from changes on wage rate. These factors include:

• Nonlabor income: receiving a large inheritance, winning a lottery, qualifying for a

pension, or becoming eligible for welfare benefits may shift one’s labor supply curve
leftward. Conversely, the layoff of one’s spouse or a significant decline in dividend
income may produce an increase (rightward shift) in labor supply.
• A change in person’s indifference map: change in work-leisure preferences may cause
a shift in the labor supply curve. An improvement in working conditions, availability
of child care, or large medical bills may change person’s indifference map in ways
that increase his or her labor supply. Conversely, the purchase of a product requiring
leisure to enjoy or the attainment of a culturally acceptable retirement age may alter
one’s indifference map such that labor supply delines.

Empirical Evidence on Labor supply curve

The evidence on the labor supply curve differs sharply between males and females. Many
empirical studies have confirmed that the response of both men and women to changes in
wage rate is different.

Killingsworth in his review of empirical works concluded that

“male labor supply is much less sensitive to wage changes than in female labor
supply; indeed, the male labor supply curve appears to be gently backward-bending
with respect to the wage, whereas the female schedule….is strongly positive.”
Apparently the income effect slightly dominates the substitution effect when wage
rate rises. For women the substitution effec5 seems to dominate substantially the
income effect.

Borjas and Heckman estimate that “a 10 percent increase in male wage rates would decrease
the amount of labor supplied by approximately 1 to 2 percent”.

Keley in addition to Borjas and Heckman estimated that “a 10 percent increase in wage
would increase the hours of work of married women by about 10 percent”.

22
In general the summary of statistical studies on labor supply indicates:

• Cross sectional studies of male labor supply behaviour generally conclude that both
income and substitution effect are small, if not zero, i.e. responses to wage changes
are so small. Consequently male’s labor supply curve is very inelastic.
• Cross sectional estimates of labor supply behaviour among married women generally
find a greater responsiveness to wage changes than is found among women. The
studies also commonly find that the substitution effect dominates the income effect.
Recent works, however, indicate that women tend to be more sensitive to wages in
their participation decision; but indicated that the response of working women’s hours
of work to wage changes are about like those of men, i.e. hours of work tend to be
insensitive to wage rate changes.

Why labor supply responses of males and females to wage changes are different?

It is because of the existing differences in the allocation of time.

• High percentage of males work full-time and do relatively little hours of work.
Thus, for males increased hours of work in response to wage rate increase
would have to come at the expense of pure leisure, i.e. non-productive
activities or rest or relaxation. Apparently pure leisure and labor market work
are highly non-substitutable. The result of increase in wage rate is small
substitution effect and a nearly vertical or perhaps slightly backward-bending
labor supply curve.
• Labor market participation of women is less than that of men. Many women
work part-time, and women assume major responsibility of work within home.
At the expense of simplicity, we can say men use their time for market work
and pure leisure, whereas women use their time for market work, work at
home and pure leisure. For married women work in home and work in labor
market are highly substitutable. Thus, when wage rate increases, many women
substitute labor market work for work in the home. They enter the labor force,
switch from part-time to full-time jobs, or increase their hours on full-time
jobs. In other words, a strong substitution effect occurs, which implies an up-
ward sloping labor supply curve for married women.
23
 3.4. Extending The Model

3.4.1. Nonparticipation and the Reservation Wage

In this we will see how the work-leisure model is useful to describe the reasons for
nonparticipation in the labor market. Figure 8 below shows the case of nonparticipant, that is,
an individual who decides not to be in the labor force. From the figure we see that; first, the
person’s ICs are very steep, indicating that leisure (nonmarket time) is valued highly relative
to income. The marginal rates of substitution of leisure for income are high, meaning that the
individual is very willing to forgo real income for leisure or nonmarket time. This could
reflect the preference of young individuals who deems important to devote time and effort to
attending college. Second, the availability of nonlabor income which could take the form of
an ‘intrahousehold transfer’ to the young student from the earned income of parents. Finally,
the relative flatness of the NW budget line indicates that the wage rate that this individual can
earn in the labor market is relatively low.

The optimization principle is the same like in the previous cases. Given the budget line
HNW, choose that position that puts one on the highest attainable IC. In this case, the highest
level of utility is achieved at point N. Here the budget constraint touches I3. At this point the
individual is not participating in the labor market; all of the person’s time is devoted to
nonmarket activities. The technical reason is that at all points within the axes of the diagram,
the person’s ICs are more steeply sloped than the budget constraint. In other words, at all
points within the diagram, the individual values leisure (nonmarket) more highly at the
margin than does the market. The optimal outcome at N is not a tangency position but rather
a ‘corner’ solution. At N the wage rate is less than MRS L,Y, which means that the individual
values nonmarket time more highly than does the market. But given the fact that the
individual is nonparticipant, there is no further possible substitution of leisure for work to be
made.

24
 W’
I4
I3
I2
W I1
Income per day

u
Fig. 8 Nonparticipation: student
N

H
Hours of leisure (per day)

Hours of work (per day)

The importance of low earning capacity in the labor market and the availability of nonlabor
income can be understood if we replace the original budget line HNW with HuW’. This new
budget line reduces the nonlabor income to zero and assumes that a much higher wage rate
can be gained in the labor market. For example, if the student is a highly skilled computer
programmer who has immediate employment opportunities at a high wage. Under such
conditions the individual would prefer to participate in the labor force, and now the optimal
position will be at u.

Figure 8 allows us to introduce the concept of the reservation wage, which is useful in
understanding why some individuals participate in the labor force and others do not. The
reservation wage is the highest wage rate at which an individual chooses not to work or, the
lowest wage rate at which one would decide to work. When nonlabor income is HN, the
reservation wage is that market wage rate implicit by the broken line that is equal to the slope
of indifference curve I3 at zero hours of work. At this particular wage rate, the value of work
and value of nonmarket time (leisure) are equal. If the market wage is below the reservation
wage, the individual will clearly choose to be a nonparticipant. The relative low market wage
embodied in the NW segment of the HNW budget line demonstrates this decision not to be in
the labor force. At point N the value of nonmarket time to this individual exceeds the value of
work, and therefore this person’s well-being would be reduced by working. Conversely, if the
market wage rate were above the reservation wage, the individual would be induced to
become a labor market participant.

25
Figure 9 illustrates another common instance of nonparticipation in the labor force. Here we
assume that a rather elderly worker is initially participating in the labor force, at optimal
position u on IC I1. Suppose now that when the worker reaches age 65 a private or public
pension of HN becomes available, provided the individual retires fully from work. In other
words the choice is between budget line HW and the associated optimal position on u or
budget line NN’ and the corner solution at point N. we find that N is preferable to u because
it is associated with the higher IC I2. In this case, the availability of pension – for example
social security benefits – induces the individual to become a nonparticipant. Stated
differently, it shifts the person’s labor supply curve leftward such that no labor is supplied at
the market wage. Note that the decision to be a nonparticipant entails a reduction in money
income but a more than compensating increase in leisure. The individual is better off at N
than at u, even though income is reduced.

I3
W I2
Income per day

I1

u Fig. 9 Nonparticipation: pension

and elderly
N

H
Hours of leisure (per day)

Hours of work (per day)

From the above two figures we can generalize that; first, other things being equal college
attendance is a deterrent to labor force participation. Stated alternatively, those who attach
great marginal utility to nonmarket time (college attendance, child care) are more likely to be
nonparticipant in the labor force. Second, other things being equal, the higher the nonlabor
income available to a person from parents, spouses, social security benefits, private pensions,
welfare, and other sources, the less likely it is that person will be a labor force participant.
Finally, all else being equal, the greater the opportunity cost of not working – that is the
higher the wage attainable in the labor market – the more likely it is that a person will be a
labor force participant.

26
3.4.2. Standard Workday

In the above discussion we implicitly assumed that workers can individually determine the
number of hours they work. But this is not the case; rather there is a ‘standard’ workday
setted by legislations, like in our case 8hrs per day (40hrs per week). The standard workday
may make individuals feel over employed or underemployed.

W uj Figure. 10 Standard workday

Ij2

P
Ij1 ui
Ii3
Ii2

Ii1 N

H
Hj D Hi

Leisure Work

Looking at the solid line IC, the individual optimal location at ui where he prefers to work
only HHi hours per day. But this is not a relevant choice; he can either work HD hours or not
at all. That is, the relevant choice is between working the standard workday at P or being a
nonparticipant at N. what to do? In this instance, it is preferable to work the standard
workday because it entails a higher IC Ii2 as opposed to Ii1. At p, however, the slope of Ii2 is
greater than the slope of the budget line NW. the MRS of leisure for income exceeds the
wage rate, which means that the worker values leisure more highly at the margin than does
the market. Clearly he would be better off at ui with more leisure and less work per day.
Simply put, at point he will feel overemployed. Faced with a standard workday denying him
added leisure, he may compensate by engaging in absenteeism; he may more or less miss a
day of work every week or so. Also, the overemployed worker may have a relatively high
rate of job turnover. The worker may obtain more leisure by frequently being ‘between jobs’.

The broken ICs in the upper left-hand portray an underemployed individual. The individual
would prefer to be at uj where he would work the long workday of HHj hours as opposed to

27
the shorter standard workday of HD hours. P is not a tangency position. At P the slope of the
IC Ij2 is less than the budget line, i.e. MRS L,Y is less than the wage rate. He values leisure
less highly than does the market. This means the individual feels underemployed at P. thus,
the individual will realize his/her desire for more work and less leisure by moonlighting or
taking a second job.

3.4.3. Overtime working (Premium Vs Straight time pay)

The analysis so far has been confined to the case where the wage rate facing the worker
remains constant regardless of the number of hours worked. In practice, it is usual for hours
worked in excess of the workday be paid at a higher than standard rate (premium payment for
additional hours of work). What impact does this premium pay provision have on the work-
leisure decision? And how does it compare with a straight time equivalent wage rate that
provides an identical daily or weekly income for the same hours of work?

Suppose, for example, that in a given industry a 10-hour workday (50-hours workweek)
becomes common place. Does it make any difference with respect to work incentives to pay
$6 per hour for the first 8hours of work and $9 per hour for an additional 2 hours of overtime
or pay $6.60 per hour for each 10 hours of work? Since both payment plans yield the same
daily income of $66 one is inclined to conclude that it makes no difference. But we can find
that it does make a difference.

We assume that the worker is initially at the optimal point on u1, where HW is tangent to IC
I1. At u1 the individual chooses to work Hh1 hours, which we will presume to be the
standard workday. Let us now suppose that the employer offers additional hours of overtime
work at a premium pay. This renders the u1W segment of the HW irrelevant, and the budget
constraint now becomes Hu1P. We observe that the optimal position will move to u2 on the
higher IC I2 and that the worker will choose to work h1h2 additional hours. Daily earnings
will be u2h2.

Consider now the alternative of a straight line equivalent wage, that is, a standard hourly
wage rate that will yield the same daily income of u2h2 for Hh2 hours of work. The straight
line equivalent wage can be shown by drawing a new budget line HW’ through u2. The
budget lines Hu1P and HW’ will both yield the same monetary income of u2h2 for Hh2 hours

28
of work. The important point is that if confronted with HW’, the worker will want to move
from u2 to a new optimal position at u3, where fewer hours than Hh2 are worked. Stated
differently, at u2 IC I2 cuts HW’ from above; that is, MRS L,Y is greater the wage rate. This
means that the worker subjectively values leisure more highly at the margin than does the
market, and, thus, u2 is no longer the optimal position under a straight-line pay arrangement.
Our worker will feel overemployed when working Hh2 hours on a straight time pay plan.

W’ Fig. 11 overtime working

u2
u3
W
I3
I2
u1 I1

H
0 h2 h3 h1

Leisure Work

Conclusion: Premium wage rates for overtime work will call forth more hours of work than a
straight-time wage rate that yields the same income at the same number of hours as that
actually chosen by an individual paid the overtime. Why the difference? The use of premium
pay will have a relatively small income effect because it applies only to hours worked in
excess of Hh1. In comparison, the straight-time equivalent wage will have a much larger
income effect because it applies to all hours of work. Figure 11 is essentially the labor market
analog of price discrimination in the product market. Sellers of some products can obtain
more revenue by charging different prices for different quantities of output. In the present
analysis, we are observing that an employer can obtain a greater amount of labor for a given
outlay by paying different wage rates for different hours of work.

29
 3.5. Work Incentive Effect of Alternative Government Transfer Policies

One of the most important policy applications of labor supply theory is in predicting the
effect of government programs on labor supply behaviour. A particular interesting example is
the effect of government transfer programs (such as welfare) on work behaviour.

Does the presence of welfare program affect hours of work and labor force
participation?

A longstanding criticism of welfare programs to help the poor is that they tend to discourage
work, and thus lead to dependency and laziness, i.e. it discourages welfare recipients from
working. The welfare programs are proposed to raise the income of the poor and to
supplement low wages. But as they may tend to discourage work, they will tend to exacerbate
poverty in the long. If an income maintenance program provides little incentive to work, this
would raise the cost of the program to tax payers and hence make the program politically less
acceptable. In addition, it could prevent the poor from acquiring the on-job-training and labor
market experience that may raise their income in the long run.

To examine the work incentive effect of such welfare programs (like demogrant, negative
income tax, welfare and wage subsidies), the individual labor supply curve will help us more.

3.5.1. Demogrant

Demogrant refers to an income grant to a specific demographic group, such as female headed
families with children, or families with an income below the minimum threshold income
level. Demogrant could be seen as a non-labor income which shifts the budget constraint
vertically upward. Since the wage rate is constant, the slope of both the budget constraint in
the absence of demogrant and the budget constraint with demogrant are the same. In figure 12
below the budget constraint with demogrant is YZH, whereas without demogrant is XH. So
here the amount of the non labor income, the demogrant, is that of HZ. As the relative price
of leisure (wage rate) is not changed, there is no substitution effect resulted from the
demogrant.

The initial optimal point in the absence of demogrant is at point u1 while the optimal point
with demogrant is seen to be at point u2. Clearly, as the demogrant has no substitution effect,

30
the non-labor income has induced the recipient to enjoy more leisure than work. The amount
of earned-income, income from work, is reduced because the demogrant has discouraged
working and the hours supplied in the market have reduced, but the total income including
the demogrant has increased.

Fig.12 effect of demogrant: as an

Income (per day)

Y individual receives HZ amount of

u2 income as demogrant, this non earned
income shifts its budget constraint
X from XH to YZH without change in the
u1
wage rate. Subsequently it shifts the
Z optimal level of utility from u1 to u2
and hence leads to lower amount of
hours supplied to work and increased
H time for leisure
leisure
Work
3.5.2. Negative Income Tax

There are some income maintenance programs that have 100 percent implicit tax on earnings
of recipients. For instance, there are programs which give an individual some fixed amount of
income if his/her income is zero or below the fixed level of grant, but every one dollar earned
income greater than zero leads to one dollar reduction in the unearned income (grant). For
example if the individual were having zero earned income and the program offers him $30
per day, as he starts to gain one dollar per day the program will offer him $29 per day so as
his total income will be maintained at $30. In such cases every earned income up to $30 per
day are incurring a 100 percent implicit tax rate, because every one dollar earned income is
reducing the unearned income by one dollar. Hence such programs are discouraging work
highly. So anti-poverty programs call for other program with lower work disincentive effect.
Among such programs negative income tax (NIT) is the one. However, still negative income
tax has some work disincentive effect.

Under the simplified form of the NIT, the income tax has the formula
T = tY − S where t is the tax rate ( t < 1) and S is a fixed subsidy. workers with low incomes thus

pay a negative tax (receive a subsidy). The total income after tax and transfer will be:
y = Y − (tY − S ) ⇒ y = Y (1 − t ) + S , where y refers tototal income.

31
Initially, like the budget constraint with demogrant, the budget line with negative tax rate will
shift upward by amount of the grant (fixed subsidy) as the individual is unemployed or has no
earned income. But after the individual start to work, the budget line will come flatter than
the original labor market income constraint. Since as the individual start to work his labor
market earnings are subject to a positive tax rate, his take-home pay will not rise as fast as his
labor market earnings. For each increase in earned income the tax rate is increasing and
finally beyond a point where the total tax (tY) equals the subsidy the individual will face the
normal tax rate which is t. At a point where the total tax (tY) equals the subsidy, the budget
constraint with subsidy will cross the market constraint, i.e.:

The point in which the line y = (1 − t )Y + S cross the line Y (the market constraint)
(1- t )Y + S = Y ⇒ (1 − t )Y − Y + S = 0
−tY + S = 0 ⇒ tY = S

In the income tax plan, both the substitution effect and income effect works in the same
direction, and hence the new equilibrium for recipients of the NIT plan will unambiguously
lie to the right of the original equilibrium that the individual within the NIT plan is
consuming more leisure and have less work incentive resulted from the plan. The tax increase
on earned income reduces the relative price of leisure, inducing a substitution into leisure and
hence reducing work effect. The tax increase also has an income effect. Points to right of the
intersection between the two lines indicate that the budget line of the NIT recipient lies above
the market constraint line. Had the recipient been on points to left of the intersection point, he
wouldn’t be called a recipient. Because as seen from the upper budget constraint, the
recipient’s income is increased, so they will buy more of all normal goods including leisure.

Fig.13 negative income tax: a NIT with

Income (per day)

a subsidy of S has shifted the BC from

Y YH to XSH. The optimal position has
X shifted from u1 to u2, and as a result
u2 hours of work has reduced, that the
NIT has work disincentive effect in the
u1 labor supply.
S
H
leisure
Work

32
Thus, the income effect increases consumption of leisure as the substitution effect do and
both leads to reduce work incentive of the recipient.

3.5.3. Social Insurance Programs (Budget Constraint with Spike)

Some social insurance programs compensate workers who are unable to work because of a
temporary work injury, a permanent disability, or a layoff. Workers’ compensation insurance
replaces most of the earnings lost when workers are on the job, and private or public
disability programs do the same for workers who become physically or emotionally unable to
work for other reasons. Unemployment compensation is paid to those who have lost a job and
have not been able to find another.

To understand the consequences of paying benefits only to those who are not working, let us
suppose that a worker’s compensation program is structured so that, after injury, workers
receive their preinjury earnings for as long as they are off work. Once they work even one
hour, however, they are no longer considered disabled and cannot receive further benefits. In
figure 13, below the effect of this program is analyzed. Here, it is assumed that the preinjury
budget constraint was AB and preinjury earnings were E0. Further, we assume that the
worker’s ‘market’ budget constraint (that is, the constraint in the absence of a workers’
compensation program) is unchanged, so that after recovery the preinjury wage can again be
earned. Under this condition the post injury budget constraint is BAC, and the person
maximizes utility at point C – a point of no work.

u2 Fig.14 Budget constraint with a ‘Spike’

Income (per day)

u1

B
f C
E0

A
leisure
Work

33
The budget constraint BAC contains the segment AC, which looks like a spike. That is this
spike that creates severe work-incentive problems, for two reasons. First, the returns
associated with the first hour of work are negative. That is, a person at point C (a point of no
work) who returns to work for one hour would find his or her income to be considerably
reduced by working. Earnings from this hour of work would be more than offset by reduction
in benefits which creates a negative “wage rate”. The substitution effect associated with this
program characteristic clearly discourages work.

Second, our assumed no-work benefit of AC is equal to E1, the pre-injury level of earnings.
If the worker values leisure at all, being able to receive the old level of earnings while also
enjoying more leisure clearly enhances utility. The worker is better off at point C than at
point f, the preinjury combination of earnings and leisure hours, because he or she is on
indifference curve u2 rather than u1. Allowing workers to reach a higher utility level without
working generates a strong income effect that discourages, or at least slows, the return to
work.

For such income replacement programs, creating programs that avoid work disincentive is
necessary. With the preferences of the worker depicted in figure 13, a benefit of slightly less
than Ag would ensure minimal loss of utility while still providing incentives to return to work
as soon as physically possible (work would allow indifference curve of u1 to be attained at
point f while receiving a benefit of less than Ag would not). With programs that create
‘spikes’ the best policy maker can do is set a no work benefit as some fraction of previous
earnings and then use administrative means to encourage the return to work among any
whose utility is greater when not working. Unemployment insurance, for example, replaces
something like half of lost earnings for the typical worker, but puts an upper limit on the
weeks each unemployed worker can receive benefits.

3.5.4. Programs With Net Wage Rates of Zero

The program discussed above is intended to confer benefits on those who are unable to work,
and the ‘spike’ is created by the eligibility criteria that to receive benefits, one must not be
working. Once the individual starts to work, he/she will not be eligible to receive the benefit.
Other programs, such as “welfare”, have different eligibility criteria and calculate benefits

34
differently. These programs factor income “needs” into their eligibility criteria and then pay
benefits based on the difference between one’s actual earnings and one’s needs.

Welfare programs have generally taken the form of a guaranteed annual income. A welfare
worker determines the income needed by an eligible person (Yn in figure 14) based on family
size, area living costs, and local welfare regulations. Actual earnings are then subtracted from
this needed level. If the person does not work, he or she receives a subsidy of Yn. If the
person works, and if any earnings cause dollar-for-dollar reduction in welfare benefits, then a
budget constraint like ABCD is created. The person’s income remains Yn as long as he or she
is subsidized. If one is receiving the subsidy, then, an extra hour of work yields no net
increase in income, because the extra earnings result in an equal reduction in welfare benefits.
The net wage of a person on the program – and therefore his or her price of leisure – is zero,
which is graphically shown by the segment of the constraint having a slope of (BC).

u1 u2 Fig.15 Income and substitution effect

Income (per day)

of basic welfare system

D
F
E B
Yn
C

A
leisure
Work

Thus, a welfare program like the one summarized in the above figure increase the income of
the poor by moving the lower end of the budget constraint out from AC to ABC; this shift
creates an income effect tending to reduce labor supply from hours associated with point E to
those associated with point F. however, it also cause the wage to effectively drop to zero:
every dollar earned is matched by a dollar reduction in welfare effect, causing those
accepting welfare to reduce their hours of work to zero (point B). of course, if a person’s
indifference curve were sufficiently flat so that the curve tangent to segment CD passed
above point B (see in the figure below), then that person’s utility would be maximized by
choosing work instead of welfare.

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 Fig.16 The basic welfare system: a

Income (per day)

person not choosing welfare
D E

Yn
C B

A
leisure
Work

One “solution” to the work-incentive problems of guaranteed-income programs is a work

requirement. Suppose, for example, that the government were to require people to work three
hours a day to qualify for the welfare. This requirement is equivalent to saying that if they
work less than that they face their ‘market’ constraint. That is at less than three hours of work
per day they are not eligible for welfare and must rely solely on labor market earnings for
their income.

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