ECON 3027 Labour Economics

2.2 Labour Supply: Further Topics

Topics in Labour Supply (Borjas, Ch. 2 & 9.12)

• Labour Supply over the Life Cycle

• Labour Supply over the Business Cycle

• Retirement

• Household Production

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 Introduction

• “Static” model is not a complete depiction of how we

allocate our time

• We extend the basic model to consider:

- The long run
- Husband-wife joint-decisions to supply labour

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 labour supply over the life cycle

• Wage rates change over the worker’s life cycle

- Wages are low when young
- Wages rise with time and peak around age 50
- Wages decline or remain stable after the age of 50

• Change in wage over the life cycle is an

“evolutionary” wage change altering the price of
leisure

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 Theoretical issues of evolutionary wages

• A person will work more hours when wages are

higher (i.e., the substitution effect tends to dominate)

• The profile of hours of work over the life cycle will

have the same shape as the age-earnings profile

• Intertemporal substitution hypothesis: people

substitute their time over the life cycle to take
advantages of changes in the price of leisure

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The Life Cycle Path of Wages and Hours for a Typical
Worker

Wage rate Hours of Work

50 Age 50 Age

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 Intertemporal Substitution Hypothesis

• There should be a positive relationship between

changes in hours or work and changes in the wage rate

• As a worker ages, increases in the wage rate should

increase hours of work

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 Hours of Work over the Life Cycle for Two
Workers with Different Wage Paths
Wage Rate Hours of Work

Joe (if substitution e

dominates)
Joe
Jack
Jack
Joe (if income effect
dominates)
t* Age t* Age
Joe’s wage exceeds Jack’s at every age. Although they both
work more hours when the wage is high, Joe works more hours
than Jack only if the substitution effect dominates. If the
income effect dominates, Joe works fewer hours than Jack. 8
labour Force Participation Rates over the Life Cycle in
2005 (US data)

100
Labor force participation rate

90
Male
80

70
Female
60

50

40

30
15 25 35 45 55 65
Age

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Hours of Work over the Life Cycle, US data
(2005)
2,500

Male
Annual hours of work

2,000

Female

1,500

1,000

500
15 25 35 45 55 65
Age

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 labour supply over the business cycle

• Added-worker effect
- So-called “secondary” workers currently out of the
labour market are affected by a recession because
the main breadwinner becomes unemployed or
faces a wage cut

• This implies the labour force participation rate of

secondary workers has a counter-cyclical trend

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 labour supply over the business cycle

• Discouraged worker effect

- Unemployed workers find it almost impossible to
find jobs during a recession, so they give up
searching

• Implies that labour force participation is pro-cyclical

• The discouraged worker effect dominates the

correlation between labour force participation and the
business cycle

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 Retirement

• Lifetime incomes are higher the longer workers put off

retirement

• If pension benefits are constant, wage increases have a

substitution and income effect, so lifetime income will
not be altered

• An increase in pension benefits reduces the price of

retirement, increasing the demand for leisure,
encouraging the worker to retire earlier

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 The retirement decision

Point E gives a
Consumption ($) worker’s leisure-
consumption bundle if
V80 F he retires at age 60.
Point F gives the
leisure-consumption
P
bundle if the worker
U1 never retires. A utility-
U0
maximizing worker
V60 E chooses point P, and
retires for 10 years.
0 10 20
Years of
Retirement

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 Effect of an increase in the wage on the
retirement decision

An increase in the wage

Consumption ($)
rotates the budget line
around point E, and
generates both income
effects and substitution
G effects as the worker
R
moves from point P to
U1
point R. The figure
F assumes that substitution
P effects dominate and the
U0
E worker delays his
5 10 20 Years of retirement.
Retirement

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Effect of an increase in pension benefits on
retirement decision
An increase in pension
benefits rotates the
budget line around F.
Consumption ($)
It too generates income
and substitution effects,
but both effects
encourage the worker to
U1 retire earlier.
U0
F R
H

E
10 15 20 Years of
Retirement
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 Household Production

• Leisure includes many forms of non-market work,

including work around the home

• Why do some household members specialise in the

market sector and other members specialize in the
household sector?

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 Allocation of Weekly Hours to Various Activities,
By Gender and Marital Status

0 24 48 72 96 120 144 168

Married Men 40.2 14.3 77.6 22.4 13.5

Unmarried Men 32.9 12 76.9 24.2 22

Married Women 16.7 34.9 78.7 22 15.7

Unmarried Women 22.2 23.5 79.4 23.8 19.1

Market Household Passive Other

Personal Care
Work Work Leisure
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 Household Production Function

• Consider Jack and Jill, a married couple

• Their household opportunity set is greater than when

Jack and Jill were not married (since each can
specialize in the sector where they are relatively more
productive)

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Jack and Jill – unmarried opportunity sets

Market Market
Goods ($) Goods
($)

200

150

100 HH 250 HH
Goods ($) Goods ($)
(a) Jack’s Budget (b) Jill’s
Line Budget Line 20
Budget Lines and Opportunity Frontier of Married
Couple
At point E, Jack and Jill
Goods Market allocate all their time to
($) the HH sector. If they
wish to buy market
350 G goods, Jack gets a job
because he is relatively
more productive in the
labour market,
F generating segment FE
200
Jack’s of the opportunity
150
frontier. After he uses up
Jill’s all his time in the labour
E′ market, Jill then gets a
E job, generating segment
100 250 340 350 HH GF of the frontier.
Goods
($)
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 Who Works Where?

Market Market Market

Goods ($) Goods ($) Goods ($)

P
U P
U
P

U
HH HH HH
Goods ($) Goods ($) Goods ($)
(a) (b) (c)

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 Division of labour in the Household

(a) The indifference curve U is tangent to the

opportunity frontier at point P. Jill specializes in the
household sector and Jack divides his time between
the labour market and the household.

(b) Jack specializes in the labour market and Jill divides

her time between the labour market and the household.

(c) Jack specializes in the labour market and Jill

specializes in the household sector.

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Increases in the Wage Rate or Household
Productivity Lead to Specialisation

An increase
Market in Jack’s
Goods ($)
wage moves
the
P′
household
from point P
U′ to point P′
and Jack
specializes
in the labour
P U
market
HH
Goods
($)
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Increases in the Wage Rate or Household
Productivity Lead to Specialisation
An increase in
Jill’s marginal
product in the
Market
Goods ($)
household
sector moves
the household
from point P to
point P′ and
P Jill specializes
P′
U U′ in the
household
sector.
HH
Goods ($)

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