Income Leisure Choice Theory 1.

Basic Model: i) Prefs, ii) Constraints, and iii) U Max and Comp Stats 2. Behind the Basic Model: Income and Subs Effects - for products purchased from firms - for factors of production sold to firms 3. Evidence on Basic Model Note: remember the context LS~=~POP~TIMES~{EMP} OVER {POP}~TIMES~{HOURS} OVER {EMP}~TIMES~{EFFORT/SKILL} OVER {HOUR}

1. Basic Income-Leisure Choice Theory (Hours of Work) Intro: one of the most important decisions made by any individual is how to between activities in the market and all other activities activities in the market yield $$, but perhaps also some intrinsic satisfaction activities in home or outside market also produce satisfaction, either because they are directly rewarding (reading novel, sitting in front of fireplace, going skiing) or because they produce useful and enjoyable things (dinners, raise children, fix roof, etc.) This requires $$. but only a fixed amount of time is available, both to generate $$ in the market and to spend at home (again, the scarcity issue) so, how to allocate time between these uses? Answer to this question is thought of as labour supply but is actually much broader than that. to start thinking about how this decision is made, it might be helpful to consider a case with simple circumstances. consider, a single parent (multiple hh's - more than one parent?- more complicated) with kids (including family allowance) Can work at temporary clerical or labourer jobs for $5/hour and can get as much work as wants at this rate. Needs to decide how much work to accept. This woman gets some util. from time at home, and needs $ to run household what is the best tradeoff? begin by assuming the woman cares about 2 things: - time left over for other stuff - income also, assume that: - no fixed costs of working - pays no taxes on the $5 earned * we will consider changing these assumptions later. Order of Analysis 1. Preferences 2. Constraints 3. Optimal Choices 4. Comp. Statistics 5. Understanding Comp. Stats: Income vs. Subs. Effects (a) Characterize preferences (using indiff. curves) Properties of ICs 1. downward sloping: |slope| = MRS = MUl / MUy 2. |slope| (MRS) diminishes as move right allocate time

3. a whole family of ICs exists; every

bundle has an IC through it utility

4. ICs further from origin higher levels of

h = time working (in market) y = income w = wage (eg. $5) G = other income (eg. child support from spouse) Thus: y=wh+G

both y and l are good - prefer more of both slope tells us the amount of income youre willing to give up to have 1 more hour to yourself fact that slope diminishes means that the more leisure you already have (the less income you have), the less income youll give up to have even more leisure

Finally, express h in terms of l. On a weekly basis: h=T-l

For y, l:
Budget Constraints: y = w (T - l )+ G y = (wT + G) - w l

(b) Characterize Budget constraints

y y

person WITH sick children at home

person WITHOUT sick children at home

what are the combinations of y and l that you can achieve given wages, child support payments, etc.?

 if w=$5, T=168 then wT=840. Feasible set looks like:

G + 840 income if worked 24 hrs/day 7 days/wk slope = - w = opp. cost of an hour of income ($5)

note: in general | slope of budget constraint | = w (wage rate)

(c) Utility Maximization Individuals best policy: Characteristic of best policy: unless individual is at a corner (doesnt work at all) LINE`slope~of~I.C.`LINE~=~MRS~=~{{M} U SUB l} OVER {{M} U SUB y}~=~w~=~LINE`slope~of~B.C.`LINE

Tangency Solution y y

Corner Solution

# hours at home

l # hours worked chooses not to work at all

Individual #1

Individual #2

U-max rule... (d) Comp Statics (i) Effects of other income, G (eg. court settlement gives more alimony) - BC: y = ( wT + G) - l

- G raises y intercept raises income at l=24 (h=0) leaves slope unchanged

w3 w2 w1 w0 G

What you typically expect:

G
24

24

y, l both normal goods (pos. sloped ICC) if both y, l normal, other income, then work less
y
$1008 + G slope = -5 $840 + G slope = - 6

(ii) increase in wages consider a higher wage, $6/hour. What does this do to B.C.? recall: y=(wT+G)-wL - both intercept and | slope | rise Old B.C.: y = 5 ( 168 - l ) + G = 840 - 5 l + G New B.C.: y = 6 ( 169 - l ) + G = 1008 - 6 l + G

24

Y-intercept and slope has increased but

income at zero hours work (l=24) is unchanged at G

two cases, even if leisure normal: case 1: raise wages continuously, starting at w=0 PCC; Price offer curve, PCL, etc. if ICs have negative slope, always pick zero hours of work at w=0.

W w3 w2 w1 w0 labour supply curve for case 1

wR
h= 24 - l

as wage available rises, works more

w3 w2

PCC
w1 w0 G

decrease in time worked as w

24

case 2: again, raise wages continuously, start at w=0

both responses are perfectly natural;

depends on tastes as wage available rises, works less. Does this make sense? - Sure. w makes worker better off takes home more income, spends more time with kids Income and Subs Effects 1) Decomp for purchased goods 2) Decomp for goods sold (eg. labour)

 To understand intuitive reasons for this, recall theory of income and subs. effects of a price , which helps us understand effects of p by decomposing into two components - income and subs. [ Assume in all cases that goods are normal ] 1) Consider first, not labour (a factor of prod. that you sell), but the more usual case of a good you purchase, like bananas.
income

what happens when price of bananas slope of b.c. increases opp. cost of a banana subs effect b.c. closer to origin, worse off - inc. effect
all other goods
leisure

[ note: do inc / subs same way as text. may be different from how you are used to]

decomposition: if bananas normal E0 E2 : total effect reduce U to new level without changing opp costs E0 E1 : inc effect well-being to new level without changing opp costs E1 E2 : subs effect change opp costs without changing util.

bananas

For any normal good which is purchased by

an individual, income and subs. effects of price
E2
s u b

EO
s c .

changes reinforce each other, both tending to x when px 2) Now consider labour (or better, time), a good that you sell
bananas

i n

E1

What happens when its price, wage? [ assuming leisure a normal good]

|slope| of b.c. increases (steeper),opp cost of an hour of leisure - subs effect b.c. further from origin; better off - income effect

$
now, can have either or LS. Do decomposition of both cases:

E2
inc

subs

case a:w = LS E0 E2 : total effect [ leisure ] work more E0 E1 : inc effect [ leisure ] work less change well-being without changing opp costs

E1 E0

leisure
being

E1 E2 : subs effect [ leisure ] work more change opp costs without changing well here, inc. and subs are in opposite directions, and SUBS outweighs INC

E2

subs

For normal goods which you sell, inc. and

subs. effects work in opposite directions; when

E1
inc

px:

E0

inc effect sell less subs effect sell more case b:

leisure

w = LS

E0 E2 : total effect [ leisure, work ] E0 E1 : inc effect [ leisure, work ] E1 E2 : subs effect [ leisure, work ] now, INC outweighs SUBS

for~purchased~goods~:~~~~~{dx} OVER {dp}~~~~=~~~~{dx} OVER {dp} LINE SUB {dU~=~0}~~~~-~~~~x`{dx} OVER {dY}

for~labour~supply~:~~~~~{dh} OVER {dw}~~~~=~~~~{dh} OVER {dw} LINE SUB {dU~=~0}~~~~+~~~~h`{dh} OVER {dY} even when leisure is a normal good, income effect of a wage can outweigh subs effect and cause total LS to

Final notes on income and subs effect 1) Relation is summarized in Slutsky equation for labour supply:

total effect

subs effect (-)

inc. effect (+)

total effect

pure subs effect (+)

pure inc effect ( - ) [ if leisure normal]

because importance of income effect depends on initial hours of work, h : i) household L response to wage most likely in individuals with high initial hours ii) decision to work at all (LFP) always responds positively to wages indeed, when h=0, no inc effect and dh/dw cannot be < 0: initial h = 0, w = h [ cant go below 0 ] initial h large, w = h

2) Although L is different from most goods because it is something we sell, its not different to any other good households sell. The conclusions about effects of labour supply apply to anything that households are involved with and sell. examples: savings peasant rice farmers; natives and furs blood organs (India) Hours of Work and Tests of Theory normally, given income sell less

 hundreds done, most involving married women but other groups studied too Basic Idea: in a sample of 1000's of working, married women, regress hours of work on wages and non-wage income (including income of husband) do women who receive higher wages, work more? i.e.~est~:~~~~h~~=~~a~+~b CDOT w~+~c CDOT G~+~d CDOT Kids,~etc~(`age,~marital~status~)~+~E

theory predicts nothing specific about b, c, etc directly but: {dh} OVER {dw} Positive pure subs. effect of w on h, i.e., LINE SUB {dU`=`0}~>~0

Now, from (1): Slutsky~equations`:~~~~~~~~~~~~{dh} OVER {dw}`LINE SUB {dU`=`0}~~=~~{dh} OVER {dw}~~-~~h `CDOT` {dh} OVER {dY}~~>~~0# ~~~~~~~~~~~=~~b~~-~~h`CDOT`c~~>~~0

typical results:

b>0 c<0

w = LS G = LS

Trends in Hours of Work and Labour Force Participation I. Hours:a) Trends (Sunter and Morissette) b) Explanations II. LFP a) Data and Measurement b) Trends (Bassett) c) Articles examining LS explanation in US (Smith-Ward, Juhn) d) Canadian data; other explanations

Weekly hours of work - Trends 1. Standard Weekly Hours longest available time series on hours is this strong decline throughout 20th century, from 1900 to about 1960 stable since then possible explanations: - increasing real wages; bbls - legislation [ these explain the decline to 1960] - real wage growth stopped after 1973 - hours reduced via longer education, earlier retirement instead (longer lifetime) - increase in non-wage benefits instead of leisure (including paid vacations) [these explain the stabilization after 1960] 2. Actual weekly hours good data in Canada mainly since 1970's only; a little earlier in the US overall mean hours at main jobs quite steady (except for youth?) latest trend is some polarization but source of this is not well-understood possible reasons for polarization: - increase in voluntary part-time work, especially among youth - increase in demand for highly skilled workers (and longer hours)