Week1 - Labour Supply & Demand

• what is the formula for the unemployment rate

  unemployment rate = unemployed/labour force
• what is the formula for labour force participation

  labour force/participation
• define labour force

  working age group, unemployed and employed
• define participation rate

  percentage of the working age population, employed or actively looking for work
• define the unemployment rate

  percentage of labour force, not in work and actively looking for work
• what is an individuals utility function

  U = f( C,L )
• what do indifference curves show

  combinations of leisure and consumption which derive the same level of utility
• define the marginal rate of substitution

  its given by the slope of the indifference curve and its the amount of leisure you give up for an additional unit of consumption
• what is the formula for MRS

  -(MUL/MUC)
• explain the key determinant of leisure and consumption

  wage rate - price of not working in order to gain leisure and the price of consumption
• what are the two ways that agents earn money, and given this, what would the budget constraint be

  non-labour income (V)

  working hours given the wage rate (hw)

  
  

  budget constraint : C = hw + V
• if there are T hours of leisure and work combines, what equation would that give

  T = h + L
• given the constraint on hours worked and the two ways agents earn money, what would be the full constraint and what would the graph for it look like. explain the main points of the diagram

  C = wT + V - wL

  
  

  -w : slope

  wT + V : intercept

  E : endowment point where consumption is equal to non-labour income when all the time spent in the week is leisure
• how would you solve for an interior solution

  combine the budget constraint and indifference curve to derive the optimal labour supply choice - the point of tangency where the MRS is equal to the slope of the budget constraint, -w
• what happens when there is an increase in non labour income, V

  if income increases we would expect more of leisure and consumption, resulting in a fall in hours worked (only income effect). Thus, the budget constraint shifts upwards and parallel
• what happens when there is an increase in the wage rate

  the budget line rotates upwards as wages increases

  
  

  the effect is ambiguous - if leisure increases then income effect dominates

  if leisure falls then substitution effect dominates
• why may there be ambiguity when it comes to the income and substitution effects

  an increase in the wage leads to a larger income so consumption rises, but you also want to consume more leisure as its a normal good. hours worked falls and the income effect persists.

  
  

  an increase in the wage makes leisure more expensive as you have to give up a larger wage to take on leisure so individuals will substitute towards a relatively cheaper consumption of goods and take less leisure.
• what happens to the income effect when people are not currently working (i.e. when leisure is all they do in the time of the week, T = L)

  there is no income effect
• what is the diagram representing income and substitution effects

  income effect dominates: income effect shifts leisure from a to c. substitution effect shifts leisure from c to b

  
  

  substitution effect dominates: income effects shifts leisure from b to c and substitution effect shifts leisure from c to a
• what can we derive aggregate labour supply curve from

  from individual work-leisure preferences
• what is the reservation wage

  the point where individuals would rather stay at the endowment point than supply labour
• at lower wages, which effect dominates

  substitution effect dominates causing an upward sloping supply curve
• what causes a backward sloping supply curve

  when income effect dominates substitution effect
• draw a consumption-leisure diagram alongside the supply curve

  i. consumption-leisure diagram with different wages depicted on different budget constraints

  
  

  ii. labour supply curve with a backward being section where income effect dominates at higher wages
• what is the formula for labour supply elasticity and what are its measurements

  percentage change in hours worked / percentage change in wage rate
• give and explain the standard estimating equation


  h = ßw + sigmaV + lambdaX + epsilon

  
  

  h : hours worked

  w : wage rate

  V : non-labour income

  X : vector of controls for the ith individual

  ß : key variable of interest

  
  

  ß > 0 : substitution dominates (upward sloping)

  ß < 0 : income dominates (downward sloping)
• what does empirical evidence show about labour supply elasticity


  an elasticity of -0.10 within male prime age workers shows a small inelastic tendency, suggesting that the income effect dominates

  
  

  this suggests that workers don't alter their behaviour much when wages change

  
  

  this may be problematic because for example, government policies aimed at increasing labour supply often rely on effective wage changes

  
  

  however, this data comes from workers who have historically worked 40 hour weeks and have had falling working hours

  
  

  most importantly, this data does not cover women, which have experienced the biggest increase in labour supply
• what effect does income taxation have on the budget constraint


  levying an income tax works like a wage decrease, rotating the constraint downwards

  
  

  this leads to less demand for leisure (income effect) but leisure is cheaper (substitution effect)

  
  

  so if labour supply is upward sloping, increasing income tax reduces labour supply
• what effect of welfare benefits have on the budget constraint


  welfare payments are the equivalent of an increase in non-labour income so there is only an income effect as the relative price of leisure and consumption does not change

  
  

  this can lead to agents leaving the labour market and is more likely to be true for lower wage agents

  
  

  this places a flat section in the budget constraint until all the welfare is exhausted

  
  

  wage rate is effectively zero and a big disincentive to work

  
  

  the income effect leads to more leisure

  
  

  in the flat range if the graph, leisure becomes free and so substitution effect kicks in
• what effect do tax credits have on the budget constraint


  they are targeted at lower income agents and sometimes at particular groups i.e. women with dependents

  
  

  its effectively a working subsidy and hence acts as an increase in income on top of their wage

  
  

  the time is to move agents from non-participation to employment

  
  

  tax credits place kinks in the budget constraint

  
  

  a-b : tax credits are higher than wage rate

  b-c : same slope as the budget constraint - maximum amount of credits

  c-d : phase out range - credit amount reduced at a rate less than the extra amount earned
• what are the effects of EITC on labour supply

  theoretically, it has an ambiguous effect - it may bring people into the labour market as there is no income effect for them but wages effectively increase, or they reduce labour supply
• what empirical evidence is given regarding tax credits in the UK

  Blundell (2005) compares single mothers (eligible) with single women (ineligible) - significant increase in employment (3.5 - 3.8%)
• what empirical evidence is given regarding tax credits in the US

  Eissa & Liebman (1996) - signs of a bigger effect for less educated workers
• considering the firm side, what are the two inputs and what does MP equate to

  the inputs are labour and capital

  
  

  Marginal Product = change in quantity over the change in labour, holding capital constant
• what is the critical assumption towards MP

  marginal product exhibits diminishing marginal returns so as labour rises the marginal product falls
• what is the assumption in competitive labour markets regarding MRP

  MRP = MP*P

  
  

  the return from employing an additional unit of labour (MRP) is its marginal product time the price of the good/service it produces
• to what point will profit maximising firms employ labour

  to the point where marginal return (MRP) equals marginal costs (w)

  
  

  MRP = w

  MP = W/P
• what does it mean when demand is derived

  anything that affects the market will influence the price (P) and hence the demand for labour
• define relative prices

  - (w/r)
• what is MRTS and what is its formula

  the marginal rate of technical substitution

  
  

  MRTS = - (MPL/MPK)