UNIT 2 LABOUR SUPPLY
Contents
2.0 Aims and objectives
1.1 Introduction
1.2 Labor Supply: Meaning and Measurement
1.2.1 Meaning
1.2.2 Measurement
1.3 Activity Rate (Participation Rate)
1.4 The Limitations of the Estimated Labor Supply
1.5 Some factors Affecting Participation Rate
1.6 Trends in Participation Rate
1.7 The Ethiopian Case
1.8 The Short-run Theory of Labour Supply
1.8.1 The Decision to Work
1.8.2 Constraint
1.8.3 Optimization
1.9 The Individual’s Labour Supply Curve
1.10 The Effect of a Wage Rate Change on Labour Supply
1.11 Derivation of the Backward Bending Labour Supply Curve
1.12 The Effect of Non-wage Incomes on Hours of Work (Labour Supply)
1.13 The Effect of a “Standard” Workday on Labour Supply
1.14 The Effect of Premium Wages and Straight-Time Equivalents on Labour Supply
1.15 Wage Elasticity of Labour Supply
1.16 Key Terms
1.17 Answer to Check Your Progress Exercise
1.18 Review Exercises
1.19 Reference
2.0 AIMS AND OBJECTIVES
The purpose of this unit is to acquaint you with the concept of labour supply and to examine how
it is measured and what factors affects it. After reading the unit you will be able to:
- understand the concept of labour supply,
- understand the problems encountered while measuring labour supply,
- explain some of the factors affecting the labour supply
- understand factors affecting the rates of participation in the Ethiopian case
- analyze the derivation of the labour supply curve.
- examine the effects of those determinantes of labour supply on hours of work.
2.1 INTRODUCTION
This unit focuses upon the basic theory of labour supply, which is prerequisite to an
understanding of all the various facets of labour supply. More specifically, first, we introduce a
basic model of work leisure choice to understand the critical variables, which determine an
individual’s optimum combination of work and leisure. Second, by manipulating the wage rate
confronting the worker we use the basic model to derive a short-run labour supply curve for the
individual. Next, the implications of the situation in which the individual worker is confronted
with the standard workday are discussed. Then we inquire whether different pay schemes affect
the number of hours an individual might choose to work.
2.2 LABOUR SUPPLY: MEANING AND MEASUREMENT
The concept and measurement of labour supply is one of the problem areas of labour economics.
According to a recent survey labour supply has become “the most active area of labour
economics” (Pencavel, 1986, p.1). This popularity is despite difficulties of concept and
measurement.
What is labour supply, how do we measure it and what determines the manner in which it
changes through time? These are the questions which is going to be answered in this part.
2.3.1 Meaning
Labour supply is the term used to describe the human input into the production process; it is the
term used to describe the supply of that factor of production which results from the activity of
individuals.
2.3.2 Measurement
Labour supply can be measured in a number of ways
1. A head count or “the number of people” are sometimes used to measure labor supply.
But a head count may include under age children, and does not convey the notion of
engagement in economically productive activities, which is implied by the concept of
labour supply. The inclusion in the count people of working age only improves the
measurement of labour supply but, this too is defective.
2. Measuring labour supply by the size of the labour force is an improvement over the crude
head count approach. Some think that “productivity” is a key element of the concept of
“labour supply” and that it is imparted by the notion of “labour force”.
3. According to the labour force approach or framework, labour supply is measured by the
product of the labour force and its activity rate.
By means of a sample survey or a population census both the labour force and its activity
rates are estimated. There are alternative methods of doing so and the one used recent
demographic surveys is that based on the concept of current economic activity status of the
work force. That is, the information concerning the economic activities of the labor force is
received on the basis of what the respondent was doing during the period of census taking,
also called the “reference period”. For current activity surveys, the reference period is
usually a short one, a day or a week. If the reference period is a year (and not a weak or a
day), the measurement yields the usually active population, which is another measure of the
economically active population.
The labour force estimation procedure based on the activity principle involves three steps or
stages (see Figure 2-1)
1. The working age population is defined and measured. Conventionally, in most countries
the lower limit is 14 or 15 and upper age limit is 65. However, the recommended
international standard does not set the upper age limit to determine the economically active
population.
2. The economically active population of working age (i.e. the labour force) is identified and
grouped into two.
(a) Employed and
(b) Unemployed. In other words, the labour force is defined as the sum of the
employed and the unemployed working-age population. The employed are all
persons in the labour force who, during the short reference period, performed
“some work” in wage, or in self-employment. Those in wage-employment are
classified as employed if they are at work during the survey period for pay in cash
or in kind; and, although temporarily absent from work during the period for pay
in cash or in kind; and, although temporarily absent from work during the period
of counting, have a formal attachment to their job. Those in self-employment
include persons engaged in some work for profit or family gain; and, although
“with a work attachment to an enterprise” are temporarily at work (during the
reference period or the period of counting).
Figure 2-1 Labour Force Frame work
Working-Age Population Below the
Population Specified Age
The Labour Force Population Not
(Currently Active Currently Active
Population)
Unemployed
Employed
Standard Modified
In paid In Self-
Definition Definition
Employment Employment
At work With a job At work for With an “Without work “Without work
for wage but not at profit or enterprise currently available for currently available for
or salary work family gain but not at work” and “seeking work and (in paid or
in cash (formal job in cash or in work work” (in paid or self- self-employment) but
or in attachment) kind employment) not seeking work”
kind
Source: ILO Manual
The unemployed consist of the working age population, who, during the reference period (of
(1990), P.37
census taking), are “without work”, “currently available for work”, and are “seeking work” (The
ILO manual, 1990, Ch.6)
3. The identification and measurement of the population that is not in the labour force. Those
not in the labor force” constitute a distinct category of the economically inactive population
(which include the inactive labour force and the under-school age children). The reasons
for inactivity are many and the not economically active labour force includes, students,
home-makers, retired or old-age pensioners, and persons of working age suffering from
disablement.
2.3 ACTIVITY RATE (PARTICIPATION RATE)
Activity rate measures the extent of involvement in economic activities, or the participation in
the production and distribution of economic goods and services.
The activity status of individuals is determined on the basis of what they have actually been
doing during the short time interval (the reference period) of census taking. Only if they were
engaged in the production and distribution of economic goods and services will they be counted
as economically active, or as a part of the currently active population, or the labour force (ILO
Manual, 1990).
The activity rate (usually expressed as a percentage) is calculated as a ratio of the labour force
(which is the sum of the employed and the unemployed) to the working age population, the
working age population is a socially determined demographic factor and is the sum of three
variables: the employed, the unemployed and the economically inactive of the specified age
group.
( Labour force
Economic Activity Rate = Working Age Population x 100
)
Labour Force = employed + Unemployed
Working Age Population = employed + unemployed + economically inactive working age
population.
The population of working age is sometimes referred to as the potential labour force or as the
age-eligible population. This is contrasted with the actual labour force, which is the sum of the
employed and unemployed population of working age. The economic activity rate (or the labour
force participation rate) is then defined as the ratio of the actual to the potential labour force
multiplied by 100, i.e.
Labour force participation rate (economic activity rate)
( Actual Labor force
)
Potential Labor force x 100
Apart from semantics, the two measures of activity rates are exact equivalents. Note too that the
activity rate (or the participation rate) can be computed for the total population or for any sup-
group, for example, for males or females, for urban or rural areas, for particular social groups or
regions, for each age category, etc.
The basic assumption of the labour force estimation method based on (current) activity principles
is that:
- It is possible to differentiate economic activities from non-economic ones and
- All activities can be grouped into these two mutually exclusive categories. It is only the
engagement in “economic activities” that qualifies individuals to be counted into the
labour force, i.e. as the economically active labour force.
2.4 THE LIMITATIONS OF THE ESTIMATED LABOUR SUPPLY
The concept and measurement of labour supply pauses many problems. The labour supply
estimate provided by the activity approach is no exception. It too fails to achieve a wholly
satisfactory approximation of labour supply.
First, the concept of labour supply encompasses notions which go beyond the number of people
in the workforce. The supply of hours of work, effort on the job, labour commitment, etc, are all
elements of a comprehensive measure of labour supply. The particular framework adopted (i.e.
the activity approach) is defective in that it does not include all these considerations.
Second, in the labour force approach attempt may be made to set criteria for the measurement of
economic activity, but it is difficult to identify and measure comprehensively the level of all
economic activities. This problem is especially serious in the underdeveloped mainly subsistent
economies where a large portion of the production is non-marketable (i.e. is produced for own or
home consumption), labour markets are largely disorganized, and labour force is largely self or
family - employed, and where a large portion of the population pursue not one “primary job” but
multiple jobs.
Third, there are many cases where treatment by a standardized procedure (or criteria set) is not
always possible. The simple method of counting into the labour force individuals “who are able
to work and either are working, temporarily absent from work (with job commitment) or actively
seeking work” is not easy to apply in all cases. There are various types of “begging” (e.g. “pure”
begging, begging with musical accompaniment, begging with service, etc.) and categories of
“criminal activities” where a consensus, to include or exclude in activity rate estimates, may be
difficult to reach. There are individuals who may not be “actively seeking work”, but are willing
to take one if offered.
Fourth, the reference period is also a factor affecting the (estimated) labour supply. The
reference period can be a day, a weak, a month or even a year and these yield different labour
supply estimates. If the census using short time intervals (reference period) is conducted during
slack seasons labour supply would tend to be underestimated. It would be overestimated if the
short reference period (a day or a week) were in a peak season.
Fifth, the measurement of labour supply is difficult when the frequency of economic status
change is high. If a large proportion of the labour force are in and out of the labour force count
too frequently, labour supply is overestimated and underestimated, respectively.
Are we to conclude that because the notion of economic activity is spurious in developing
economies and produces unstable and inefficient estimators of labor supply it must therefore to
be abandoned? The labour force approach of estimating labour supply is a popular one and can
be refined or improved by using complementary methods of estimation.
2.5 SOME FACTORS AFFECTING PARTICIPATION RATES
Evidence from the industrialized economies clearly show that the extent of “job attachment” is
not evenly distributed in the population. Some workers maintain permanent attachment to the
labour force until retirement. These are referred to as primary workers and their distinguishing
characteristics are that they tend to remain in labour force (as employed or unemployed person)
in spite of small changes in the wage rate and working conditions. Male household heads are
typical primary workers.
Secondary workers, on the other hand, lack labour force attachment to the same degree as
primary workers. Such individuals usually have highly valued options to market work.
Household work may turn out to be a better alternative to market work for married women with
children. The income differential (between the value of household work and market work) will
have to be raised significantly to induce their increased participation in market work. Students of
working age have the option of going to school rather than earn positive incomes from work.
Elderly people past the retirement age attach high value to leisure. All the three groups don’t
have permanent attachment to the labour force.
From the foregoing it is clear that, for the same sex and age group, primary workers have
relatively higher labour force participation rates than secondary workers
Labour force participation rates, whether for primary or secondary workers, are also affected by
the business cycle. Weather labour force participation rates increase or decrease during economic
recessions and during economic prosperity and vice versa has been the object of many labour
supply studies in the 1960s and 1970s. According to those who advanced the so called
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 labour market, respectively, to maintain family incomes.
Thus, according to this view labour force participation rates move counter-cyclically and hence
tend to stabilize employment.
There is also some validity of the discouraged worker hypothesis as an alternative explanation
for the behavior of labour participation rate during the business cycles. According to this view,
the fall in real wages and family incomes during economic recession results in greater job cuts as
potential workforce is deterred from entering the labour market because they “believe there are
no jobs for them” In other words, secondary workers as well as others are disheartened by the
fruitless search for jobs and refrain from entering the labour market in search of jobs.
The decline in labour force participation rates as unemployment rises, a phenomenon explained
by the discouraged worker hypothesis, is also observed in developing economies where long
periods of economic downturn (or economic stagnation) influence workers behavior in such a
way that worker become increasingly unresponsive to market signals. Job vacancies remain
unfilled for long duration because discouraged workers that qualify for the job are not applying.
School dropouts and graduates get used to depending on their family to provide for their living
and are not motivated towards active job search.
Whether the discouraged worker effect or the added worker effect is dominant is an important
policy question and one that constituted a distinct field of labour research in the industrialized
countries.
2.6 TRENDS IN PARTICIPATION RATES
A 1974 projection of activity rates covering the period up to the year 2000 (YPSilantis, 1974),
indicated that male participation rates tend to decline in both developed and developing countries
and that most adult female participation rates tend to rise in the industrialized countries and fall
in the developing ones. However, this forecast is not supported by other ILO projections.
Quoting one such ILO source, standing (G. Standing, 1982, p 20-24) reports that between 1950
and 1975 female participation rates increased and male participation rates declined in both the
“more developed” and the “less developed” countries of the world, and that during that same
period there had been a general increase in the dependency ratio. Differences in period and area
coverage variation in concept and accuracy of measurement etc make comparison of results
difficult.
Nevertheless, there are clear differences in male and female participation rates between different
cultures, levels of development, social classes, etc that are clearly brought out by less aggregated
studies.
2.7 THE ETHIOPIAN CASE
Demographic surveys in Ethiopia are of recent origin. Although guess estimates of the
population size are available since 1930 (CSO, march 1988, P-2-4), sample surveys of the 1960s
(which did not cover Eritrea, Bale, Ogden, and the nomadic frontier regions) constituted the
basis of demographic analysis in the country until the 1984 census.
Age-group specific estimates of activity rates for the total population are given in the results of
the 1984 population and housing census (OPHCC, 1991), all others providing estimates for the
rural population only. Urban activity rate estimates provided by most of these sample surveys
and censuses tend to cover Addis Ababa and a limited number of other towns. Since urban
participation rates were not comprehensively estimated (except in the 1984 census), it had not
been possible to provide activity rate estimates for the total population in these cases.
Fig 2.1 Activity Status: Total Population (1984)
Source office of the population and Housing Census Commission (OPHCC) (December 1991).
The 1984 population and Housing Census of Ethiopia: Analytical Report at the National Level.
As shown in Table 2.1 (see also figure 2.2) a high participation rate (of about 46 percent) by the
lowest age group (10-14) is noted, and participation rates reach their maximum values (of about
82 percent) for the age group 45-50. From that point on participation rates decline slowly
reaching the level of 53 percent for those aged 70 and above. The general picture is that of a
table with short legs on both ends. When compared to a typical profile for a developed economy,
the Ethiopian activity rates are relatively higher for each age group and the activity rate
differentials are most marked for the extreme age groups.
In Africa generally, the dominance of family-and- self-employment and the subsistence or
traditional economy, low level development of social infrastructures, especially child care and
schools, the absence of and /or non implement ability of child protective laws are among the
factors accounting for high participation rates by the youth (Bonnet, 1993) This is also true in
Ethiopia, where, the subsistence sector and family employment are still dominant and where only
a few go to school. Although the labour proclamation No. 42/1993 prohibits employment of
under fourteen’s (Art. 88)(and the civil code proclamation 165/1960 compels the “guardians” to
“educate” their minors (Art. 269), failure to implement the law meant that most youth do not go
to school and the employment of minors is not regulated in practice, which account for their high
activity rates.
The main factors accounting for the high activity rate of the elderly are low wage incomes, low
level development of non-wage income sources and the inadequacy of non-traditional social
security systems. Low incomes cause an increase in participation rates. Unable to provide for
the means to enjoy leisure, the elderly continue working to survive.
Inadequacy and poor coverage of social security is the other factor accounting for the observed
high activity rate by the elderly. The social security organization in the traditional mould include
the activities of mutual help societies where help to members is often dispensed with in kind and
not in cash payment. Very few people in the wage economy are involved in the purchase of
modern social security policies. Outside these, the pensions scheme for public sector employees
constitutes the only social security system in the economy (see, proclamation 199/1963 and
209/1963 and decree 46/1961)
Activity rates are also differentiated across the sex groups and between urban and rural areas.
The 1984 census results show (see table 2.2 and figures 2.3 and 2.4) that for each age cohort
male participation rates are higher than female participation rates.
Table 2.2 Activity rates of the total population by sex and urban/rural location (1984)
Age Group Activity Rates by Sex Activity Rate by Location
Male Female Rural Urban
10-14 47.8 43.1 52.8 11.4
15-19 63.6 54.9 66.6 28.7
20-24 80.6 60.1 72.4 54.5
25-29 94.2 60.8 77.5 59.8
30-34 96.6 60.8 79.2 62.7
35-39 97.6 61.8 82.0 63.4
40-44 97.2 63.1 81.6 67.9
45-49 97.4 63.5 83.7 68.0
50-54 95.4 61.3 80.1 58.8
55-59 94.2 59.4 82.2 53.9
60-64 91.5 53.2 75.3 48.5
65-69 89.3 49.0 75.9 45.0
70+ 70.9 33.3 56.1 30.4
Source: OPHCC, 1991
Fig. 2.3 Activity Rate of Total Population by Sex Groups (1984)
2.8 THE SHORT-RUN THEORY OF LABOR SUPPLY
In this section we are concerned with the basic theory of labour supply in the short run. A simple
model will be developed to illustrate the determinants of an individual’s decision to work, and of
the total number of hours supplied. Subsequently we shall aggregate across all individuals in
order to distinguish the total supply of labour in the short run.
The theory builds on the everyday maxim that individuals do the best they can under the
circumstances! stated more formally, individuals maximize their utility subject to the constraints
that confront them in the labour market. We therefore need to know something about an
individual’s preferences (what it is that gives him or her satisfaction or utility ) and to distinguish
the opportunities for realizing them that exist in the labour market. We shall argue that
individuals derive utility from the consumption of commodities and that in order to buy these
commodities they have to obtain an income. Undertaking paid work is one of the ways of
obtaining an income but the size of this income is limited by the opportunities that confront the
individual in the labour market.
The simple model of individual behavior we construct assumes that individuals work in order to
be able to buy commodities. It also assumes that as a result of their work individuals obtain the
commodities they want to buy; it is as if they were operating in a barter economy swapping their
labour directly for commodities. In practice, however, in a monetary economy individuals work
for money and only later do they translate this money into a demand for commodities.
First we provide a more formal statement of and derive a way of illustrating, the individual’s
decision of hours of work.
2.8.1 The Decision To Work
Whether or not individuals work and for how long they work depend on their preferences and the
opportunities that confront theme in the labour market. consider each of these in turn.
(1) An individual’s preferences
An individual’s preferences can be summarized in terms of
1. The objects of choice, the commodities from which they derive satisfaction.
2. The marginal rate of substitution, which indicates the relative intensity of the satisfactions.
Let’s consider both of these aspects further.
(1) the object of choice.
What are the objects of choice? In a simple theory we develop here they are assumed to be
goods and services, G, and Leisure, L. Commodities are those things that ultimately enhance, or
detract from, an individual’s satisfaction. Formally we can construct a utility function.
U=U (G, L)
Where G, is used to describe all the tangible and intangible commodities available to the
individual, with the single exception of time. The amount of goods and services we consume
also constitutes a measure of our real income, and hence the term real income, I, is offer used
interchangeably with that of the volume of goods and services, G=I
L, is used to describe all hours not spent working. At this stage in our analysis it is the generic
title for hours spent relaxing as well as hours spent either doing unpaid work (termed non-market
work) or studying or training (i.e. honors devoted to human capital investment). the objects of
choice (G and L ) are mapped along to the vertical and horizontal axes respectively in the and
we represent the individual’s preferences for G and L in a family of indifference curves in this
G,L space, Each indifference curve details all those combinations of G and L, which produce the
same level of utility and between which an individual is therefore indifferent .
Higher indifference curves, curves lying to the northeast, represent higher levels of utility, that
is I3>I2>I1. They are assumed to display the usual properties of smoothness, convexity with
respect to the origin and transitivity this latter property means-that they cannot cross.
(2) The Marginal Rate of Substitution
Some commodities will be more desired than others. One way of saying the intensity of our
preferences for particular commodities is to state the rate at which we are willing to trade off or
substitute one commodity for another. The more of one commodity we are willing to give up in
order to secure an extra unit of another commodity the more highly we prefer the latter
commodity. The marginal rate of substitution (MRS) is the slope of an indifference curve. What
does the slope of the indifference curve represent?
