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Lecture8

# Lecture8 - Lecture#8 Some Applications of Demand Theory...

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Some Applications of Demand Theory Lecture #8 1. Deriving an Individual Worker’s Labour Supply Curve A worker’s supply curve can be determined once they can report how much labour they are willing to offer at each conceivable wage rate. It is reasonable to assume that, at each wage rate, the quantity of labour that the worker is willing to offer is the quantity of labour that maximizes their total utility. It turns out that the worker’s labour supply curve can be “read off” of successive points of equilibria on leisure-income budget lines. I At the initial wage rate, this worker maximizes TU at A by offering L 1 units of labour. BL 2 IC 2 C At a higher wage rate, this worker maximizes TU at C by Leisure Work (L) BL 1 IC 1 L 1 A worker maximizes TU at C by offering L 2 units of labour. L 2

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Some Applications of Demand Theory 1. Deriving an Individual Worker’s Labour Supply Curve We can map the quantities of labour the worker supplies at each wage rate and get their labour supply curve. W S L C w 2 Note that the position of this curve is also determined by shift factors that we are holding constant. For example, if the worker’s preferences for leisure were to change in favour of L A L 2 L 1 w 1 preferences for leisure were to change in favour of leisure (as opposed to work), they would offer less work at each wage rate (i.e. the worker’s labour supply curve would shift to the left). The movement from A to C is a total reaction to a change in the price of labour (wages) and so it involves a substitution effect and an income effect. Here’s the logic. The higher wage rate makes labour more profitable (or leisure more costly!) and so it leads to a substitution of leisure for more labour (give up some leisure to get more labour). However, the higher wage rate also increases the worker’s income per unit of labour which they can use to “buy” more leisure (away from work). We can reasonably (?) assume that leisure is a normal good so part of the extra income will be used to “buy” more leisure. The two effects are opposite, so what is the net effect in this case?
Some Applications of Demand Theory 1. Deriving an Individual Worker’s Labour Supply Curve SE: sub leisure for more work Work w SE: sub leisure for more work Leisure IE: purchase more leisure Leisure Leisure a bit Work Note: In this analysis, we are assuming that the SE dominates the IE so that the net effect is to reduce leisure more due to the SE than we increase leisure due to the IE. This leads to a net increase (TE) in work due to an increase in the wage rate. Does this always happen at every wage? NO !!! 2 Backward bending Labour Supply Curves 2. Backward - bending Labour Supply Curves Some workers find that as the wage rate goes up and they offer more labour, the time spent on leisure becomes more and more valuable to them. At very high wage rates leisure becomes more scarce and very valuable so that the IE may

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