Lecture 2

Labor Supply
Noah Williams
University of Wisconsin - Madison
Economics 312

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Economics 312

The Representative Household

We will now begin formal modeling by considering

individual household behavior.
As an abstraction, we will think of one household as a
stand in for the whole economy.
Who is the representative household?
Robinson Crusoe in a desert island.
Justification: aggregation.
Some problems with aggregation.

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Economics 312

What are we going to do?

Think about the goods existing in the economy.

Think about what does Robinson prefer.
Think about his constraints.
Think about what will Robinson do given his preferences
and his constraints

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Economics 312

Commodity Space

2 goods, consumption c and leisure l.

Total time of h hours, N =labor N = h l.
Each goods set:
1
2

c R+
l [0, h]

Then (c, l) R+ [0, h]

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Economics 312

Preferences

Preferences: binary relation  defined over pairs (c, l):

(ci , li )  (cj , lj )
Basic assumptions on preferences:
1

2
3

Complete: for (ci , li ) , (cj , lj ) R+ [0, h] either

(ci , li )  (cj , lj ) or (cj , lj )  (ci , li ).
Reflexive: for (ci , li ) R+ [0, h] (ci , li )  (ci , li ).
Transitive: for (ci , li ) , (cj , lj ) , (ck , lk ) R+ [0, h], if
(ci , li )  (cj , lj ) and (cj , lj )  (ck , lk ) (ci , li )  (ck , lk ).

Violations of transitivity lead to Dutch books, and

agents would become a money pump.

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Economics 312

Indifference Curves

Loci of pairs such that:

(ci , li )  (cj , lj ) , (cj , lj )  (ci , li ) (cj , lj ) (ci , li )
Additional assumptions on preferences:
1
2

Monotonicity: If ci cj , li lj then (ci , li )  (cj , lj ).

Convexity: If (ci , li )  (ck , lk ) and (cj , lj )  (ck , lk ) then
[0, 1]
(ci , li ) + (1 ) (cj , lj )  (ck , lk )

Under these assumptions, the indifference curves are:

1
2

Negatively sloped.
Convex.

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Economics 312

Figure 4.1 Indifference Curves

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Economics 312

Utility Functions

Working directly with binary relations difficult.

Can we transform them into a function?
Definition: a real-valued function u : R2 R is called a
utility function representing the binary relation  defined
over pairs (c, l) if for (ci , li ) , (cj , lj ) R+ [0, h],
(ci , li )  (cj , lj ) u (ci , li ) u (cj , lj ).
Theorem: if the binary relation  is complete, reflexive,
transitive, strictly monotone and continuous, there exist a
continuous real-valued function u that represents  .

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Economics 312

Utility Functions II

u simply represents the indifference curves. Indifference

curves are level sets {(c, l) : u(c, l) = u }.
u is only defined up to a positive monotone transformation.
If f is an increasing function f (u(c, l)) also represents the
indifference curves.
Well always assume u is continuous and differentiable.
The properties of preferences imply properties of u:
1
2

Monotonicity uc 0, ul 0.
Convexity ucc 0, ull 0

Notation: uc (c, l) =

u
c (c, l).

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Economics 312

Utility Function and Indifference Curves

Utility Function

Indifference Curves

0.9
2

0.8

1
0.7

0.6

Leisure

Utility

3
4

0.5

0.4

5
0.3
6
1
0.2
3
0.5

0.1

1
Leisure

Consumption

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0.5

Economics 312

1.5
2
Consumption

2.5

Marginal Rate of Substitution

The slope of an indifference curve is given by minus the
ratio of marginal utilities:
u(c(l), l) = u
0

uc (c, l)c (l) + ul (c, l) = 0

c 0 (l) =

ul
uc

Minus this slope is called the marginal rate of substitution.

MRS =

ul
.
uc

Monotonicity MRS 0.
Convexity MRS decreasing in l.

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Economics 312

Figure 4.2 Properties of Indifference

Curves

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Economics 312

Budget Constraint

Leisure l labor supply N = h l.

Wage w. Unearned income .
Then
c = Nw + = (h l)w +

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Economics 312

Figure 4.3 Representative

Consumer's Budget Constraint (T >
)

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Economics 312

Figure 4.4 Representative

Consumer's Budget Constraint (T <
)

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Economics 312

Households Problem
Problem for Robinson is then:
max u (c, h N )
c,N

s.t. c = Nw +
Can either impose constraint or form Lagrangian. easy
here to impose constraint:
max u (Nw + , h N )
N

First order condition:

uc w ul = 0
ul
=w
uc
Interpretation: marginal rate of substitution equal to
relative price of leisure.
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Economics 312

Figure 4.5 Consumer Optimization

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Economics 312

Figure 4.6 The Representative

Consumer Chooses Not to Work

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Economics 312

A Parametric Example

u (c, l) = log c + log l

MRS =

1
ul
c
= 1l =
uc
l
c

FOC+Budget constraint:
c
=w
h N
c = N w +

Then:
N =

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wh
(1 + )w

Economics 312

Income and Substitution Effect

We will follow the Hicksian decomposition.

Income Effect: changes in w induce changes in total income
even if l stays constant. Reduces work incentive: use more
income to buy leisure.
Pure income effect: Increase in .
Substitution Effect: changes in w make leisure change its
relative price with total utility constant. Increases work
incentive.
(Almost) pure substitution effect: One-time change in
wage, say in peak sales period.

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Economics 312

Figure 4.7 An Increase T for the

Consumer

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Economics 312

Figure 4.8 Increase in the Real Wage

RateIncome and Substitution Effects

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Economics 312

Income and Substitution Effects in the Example

N =

wh
(1 + )w

Income effect:
N

=
<0

(1 + )w
Suppose = 0, then
N =

h
1+

Labor supply does not respond to the wage at all! So

income and substitution effects completely offset.
With > 0 income effect only partly offsets substitution
effect.
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Economics 312

Labor Supply
Labor supply curve N (w) plots response of labor supplied
by households to a change in wage, holding fixed unearned
income (and preferences).
For individual workers, slope of labor supply unclear.
Depends on income and substitution effects. For high
enough wage, may be backward bending. That is
N 0 (w) > 0 for low w but N 0 (w) < 0 for w high enough
In the aggregate, labor supply supply curve embodies both
intensive and extensive margins, and is is upward sloping.
Intensive margin: for those already working, increase in
wage has income and substitution effects.
Extensive margin: increases in wages may induce some who
were not in labor force to enter and supply labor.
Aggregate labor supply curve also smoothes out kinks in
individual supply, for example due to fixed costs of work.
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Economics 312

Figure 4.9 Labor Supply Curve

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Economics 312

Figure 4.10 Effect of an Increase in

Dividend Income or a Decrease in
Taxes

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Economics 312