Lecture 1 - Labor Markets - Econ 104B Labor Markets...

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Econ 104B Labor Markets
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Allocation of Time Individuals must decide how to allocate the fixed amount of time they have We will initially assume that there are only two uses of an individual’s time engaging in market work at a real hourly wage rate of w leisure (nonwork)
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Allocation of Time Assume that an individual’s utility depends on consumption ( c ) and hours of leisure ( h ) utility = U ( c , h ) In seeking to maximize utility, the individual is bound by two constraints l + h = 24 c = w l
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Allocation of Time Combining the two constraints, we get c = w (24 – h ) c + wh = 24 w An individual has a “full income” of 24 w may spend the full income either by working (for real income and consumption) or by not working (enjoying leisure) the opportunity cost of leisure is w
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Utility Maximization The individual’s problem is to maximize utility subject to the full income constraint Setting up the Lagrangian = U ( c , h ) + λ (24 w c – wh ) The FOCS are / c = U / c - λ = 0 / h = U / h - w λ = 0
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Utility Maximization Dividing the two, we get ) for ( / / c h MRS w c U h U = = To maximize utility, the individual should choose to work that number of hours for which the MRS (of h for c ) is equal to w to be a true maximum, the MRS (of h for c ) must be diminishing
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Income and Substitution Effects Both a substitution effect and an income effect occur when w changes when w rises, the price of leisure rises and the individual will choose less leisure because leisure is a normal good, an increase in w leads to an increase in leisure The income and substitution effects move in opposite directions
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Income and Substitution Effects 1 2 Leisure Consumption A B C The substitution effect is the movement from point A to point C The individual chooses less leisure as a result of the increase in w The income effect is the movement from point C to point B substitution effect > income effect
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Income and Substitution Effects 1 2 Leisure Consumption A B C The substitution effect is the movement from point A to point C The individual chooses more leisure as a result of the increase in w The income effect is the movement from point C to point B substitution effect < income effect
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A Mathematical Analysis of Labor Supply We start by amending the budget constraint to allow for the possibility of nonlabor income c = w l + n Maximization of utility subject to this constraint yields identical results as long as n is unaffected by the labor- leisure choice
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