Income, Labour Supply and Related

So far, we have used the theory of consumer choice to analyse how a person decides to allocate income between two goods. We can use the same theory to analyse how a person decides to allocate time between work and leisure.

Consider the decision facing Sally a freelance software designer. Sally is awake for 100 hours per week. She spends some of this time enjoying leisure riding her bike, watching television, studying economics and so on. She spends the rest of the time developing software at her computer. For every hour she works developing software, she earns $50 which she spends on consumption of goods. Thus, her wage ($50) reflects the trade-off Sally faces between leisure and consumption. For every hour of leisure she gives up, she works one more hour and gets $50 of consumption.

If she spends all 100 hours enjoying leisure, she has no consumption. If she spends all 100 hours working, she earns a weekly consumption of $5,000 but has no time for leisure. If she works a normal 40-hour week, she enjoys 60 hours of leisure and has weekly consumption of $2,000.

Here consumption and leisure are the two goods between which Sally is choosing. Because Sally always prefers more leisure and more consumption she prefers points on higher indifference curves to points on lower ones. At a wage of $50 per hour, Sally chooses a combination of consumption and leisure represented by the point labelled optimum This is the point on the budget constraint that is on the highest possible indifference curve, which is a curve.

Now consider what happens when Sally’s wage increases from $50 to $60 per hour. Figure shows two possible outcomes. Sally gets more consumption for every hour of leisure that she gives up.

Sally’s preferences determines the resulting responses of consumption and leisure to the higher wage. The responses of leisure to the change in the wage is different in the two cases. Sally responds to the higher wage by enjoying less leisure. Sally responds by enjoying more leisure.

Sally’s decision between leisure and consumption determines her supply of labour because the more leisure she enjoys, the less time she has left to work. A higher wage induces Sally to enjoy less leisure and work more, so the labour supply increases. A higher wage induces Sally to enjoy more leisure and work less, so the labour supply decreases.

Why would a person get to a higher wage by working less? The answer comes from considering the income and substitution effects of a higher wage.

Consider first the substitution effect. When Sally’s wage rises, leisure becomes more costly, relative to consumption and this encourages Sally to substitute consumption for leisure. In the other words, the substitution effect induces Sally to work harder in response to the higher wages, which tends to make the labour supply curve slope upward.

Now consider the income effect. When Sally’s wage rises, she is now better off than she was. As long as consumption and leisure are both normal goods, she tends to want to use this increase in well-being to enjoy both higher consumption and greater leisure. In other words, the income effect induces her to work less.

In the end, economic theory does not give a clear prediction about whether an increase in the wage induces Sally to work more or less. If the substitution effect is greater than the income effect for Sally, she works more. If the income effect is greater than the substitution effect, she works less.

Evidence indicates that the labour supply curve    considered over long periods of time does in fact slope backward.

A hundred years ago, many people worked 6 days a week. Today, 5 day weeks are norm. At the same time the length of the workweek has been falling, the wage of the typical worker (adjusted for inflation) has been rising.

Here is how economists explain this historical pattern:  Over time, advances in technology raise workers’ productivity and thereby the demand for labour. The increase in labour demand raises equilibrium wages. As wages rise, so does the reward for working. Yet rather than responding to this increased incentive by working more, most workers choose to take part of their greater prosperity in the form of more leisure. In other words, the income effect of higher wages dominates the substitution effect.

Further evidence that the income effect on labour supply is strong comes from a very different kind of data:  winners of lotteries. Winners of large prizes in the lottery see large increases in their incomes and, as a result large outward shifts in their budget constraints. Because the winner wages have not changed their budget constraints remain the same. There is, therefore no substitution effect. By examining the behaviour of lottery winners, we can isolate the income effect on labour supply.

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