Individual Labour Supply
How to compute the reservation wage
It is equal to the Marginal Rate of Substitution between consumption and leisure at the endowment point.
The endowment point is such that the agent spends all their time as leisure.
We plug L=T and C=T (non labour income) into the MRS
What is the marginal rate of substitution between consumption and leisure?
It is the slope of the IC's -> -MU_L/MU_C
It describes how many hours of leisure the agent is willing to give up for an extra unit of consumption.
What is the effect on labour supply of an increase in non-labour income? (ceteris paribus)
Decrease in hours worked
What are the empirical challenges to estimate income effect?
Measurement error -> recall bias
Endogeneity -> changes in non-labour income are not random
Selection -> people with high non-labour income systematically differ from those without
Which methods do applied econometrics use to identify causal effects?
Randomised controlled trials
Natural experiments
Explain the two effects that a change in the wage rate has on an individual’s labour supply decision in the neoclassical model.
The income effect gives the change in the consumption bundle induced by the additional income resulting from the wage increase. Since both consumption and leisure are normal goods with DECREASING MU, the individual will consume more of both.
The substitution effect illustrates what happens to the worker’s consumption bundle as the wage increases, holding utility constant. It isolates the impact of the increase of the OPORTUNIRY COST from leisure on hours of work, holding utility constant.
What is the impact of a change in the wage rate on an individual’s labour supply decision if they are currently outside the labour force?
If the indivudual is outside of the LF, it means that the current wage rate is lower than their reservation wage, which is the minimum wage the individual requires to join the LF.
If the new wage rate is greater than the reservation wage, the opportunity cost from leisure will increase for the individual, making them joining the LF. There would be only a substitution effect, because as the individual does not participate in the LF, the increase in the wage rate will not make them any wealthier until they join the LF.
What is the impact of a cash grant from the government that is paid out to people whenever they are outside the labour force on high and low paid individuals’ decision to work?
High paid -> stay
Low paid -> leave the LF -> increase in reservation wage, only income effect