The labor market is an inversion of the goods and services market: in the labor market, individual buyers from the goods and services market become the suppliers of labor, while the firms that sold goods in the goods and services market become the buyers. Firms need workers to produce and sell goods, and so after they have decided how many workers and how many hours of labor they want (a process which we will examine in the labor demand unit ), they enter the labor market and “buy” labor. Workers enter the labor market with an idea of how much they want to work and how much they want to be paid, and they “supply” the labor. The combination of the two, labor supply and labor demand, determines how the labor market behaves. Let’s take a look at labor supply.
Workers, when deciding whether or not they want to work, and how much they want to work, are faced with a choice between two possibilities: leisure and consumption. (Economists assume that leisure can be treated as a normal good: more is better) There is a tradeoff, however, between leisure and consumption). If a person decides that they want leisure, then they will work less (or not at all), but this means that they won’t be able to buy as many things. If they decide that they want to consume, then they will work more (or all of the time), but this means that they won’t have as much free time to themselves. Their preferences for leisure (free time) and all other goods (consumption), combined with the current market wage, will determine what combination of leisure and all other goods they will choose, much in the same way that an individual’s indifference curves and the market price of different goods will determine what combination of goods that individual will buy. Even though workers are the suppliers of labor, they make their working decisions in a manner similar to the way they make their buying decisions: based on preferences and price.
Recall that when buyers in a goods and services market are making decisions, we can model their decision-making behavior through a combination of their indifference curves and their budget constraints. Since the decision to work or not to work is made in a similar fashion, we can do the same thing for labor supply. Workers will try and maximize their utility based on their preferences between having free time and having money, and on their budget constraint (how much of each good: leisure or all other goods, that they can afford).
How do we represent a budget constraint for leisure and all other goods (AOG)? Typically, leisure is measured in one hour units, so that in one day, a worker can choose to take up to 24 hours of leisure. All other goods (AOG) are measured by their dollar value, so that a worker can choose to work 24 hours a day and buy up to 24 hours times the wage (24w) worth of all other goods. Graphically, a budget constraint would look like this:
The indifference curves between leisure and all other goods would be similar to those we have seen in the goods and services market. We can combine a worker’s budget constraint with his indifference curves to see how the worker would optimize the labor-leisure choice:
Just as a buyer’s budget constraint pivots with a change in the price of one good, a worker’s budget constraint can pivot with a change in the wage. If the wage increases, the curve pivots outwards (U3). If the wage drops, then the curve pivots inwards (U1). Note that the maximum leisure point is fixed, since there are only 24 hours in a day.
In the graph below, you can see the inwards pivot that occurs when the wage level drops: workers cannot afford as many other goods as they could prior to the drop in pay.
When the wage increases, the income effect makes workers feel wealthier and therefore makes them want more of both leisure and consumption. The substitution effect, however, makes leisure relatively expensive (since the worker would have to give up more wages to have free time; think of the wages lost as the price of leisure), so workers will want more consumption and less leisure. Because labor is inversely related to leisure, this means that an increase in wages will cause labor to both increase (substitution effect) and decrease (income effect). Therefore, when wages increase, the combined effect of the substitution and income effect is that workers will choose more consumption; the effect on the level of labor and leisure is uncertain. If we assume that the substitution effect is stronger, then workers will choose to work more and play less, which makes sense, since a higher wage would give workers more incentive to work.
Figure %: Income and Substitution Effects on the Consumption/Leisure Decision
Is this always true, that the substitution effect outweighs the income effect? Some economists believe that it is initially true, at relatively low wage levels. However, as the wage gets progressively higher, they believe that the income effect begins to outweigh the substitution effect, and very high wage-earners will begin to choose leisure over consumption even if their wage increases. (Maybe that’s why corporate bigwigs have the reputation of having too much free time to gallivant around on tropical islands).
Figure %: Backward-bending Labor Supply Curve
An individual’s labor supply curve marks out the number of hours they are willing to work at different wages, the same way that a seller’s supply curve marks out how much they are willing to sell at different prices. How do we find the aggregate labor supply curve? To find aggregate labor supply from many individual supply curves, use horizontal addition to combine all of the work that workers are willing to perform at each wage level, and form the new aggregate labor supply curve.
- What set of circumstances would generate a backward-bending labor supply curve?
Ans. If the substitution effect outweighs the income effect for low wage levels, and the income effect outweighs the substitution effect for high wage levels, there will be a backward-bending labor supply curve.
- Why is there a tradeoff between leisure and consumption, and not between labor and leisure?
Ans. Leisure and consumption are both normal goods, while, for most people, labor is a means to an end rather than a good in and of itself. (Most people, given a choice between labor and leisure, would choose leisure, which wouldn’t give us a very useful budget constraint to worth with). Thus, the tradeoff is between leisure and the things you can buy if you choose labor (consumption). If you choose leisure, you don’t work as much, and so you can’t buy as much. If you choose consumption, you have to work more, and you can’t play as much.
- What happens to labor supply if the wage increases, and the labor supply curve is backward-bending?
Ans. It is uncertain, since we don’t know where we are on the curve. If we are at a point before the bend, then an increase in wages will cause an increase in labor supply. If we are at a point after the bend, then an increase in wages will cause a decrease in labor supply.