Income and Substitution Effects of a Wage Change: Labor Supply and Demand, Study notes of Market economy

Download Income and Substitution Effects of a Wage Change: Labor Supply and Demand and more Study notes Market economy in PDF only on Docsity! 1 Income-Leisure Choice • Utility increases as you move outward • The 4 assumptions give us smooth well-behaved IDCs Y leisure Assumptions 1. Complete ordering 2. More is better 3. Transitivity 4. DMRS u1 u0 Potential Income Constraint Individuals try to attain the highest possible IDC. However, they are constrained by their potential income constraint. It is a “potential” income constraint because it indicates various amounts of income that can be obtained by giving up leisure and working at the market wage. The “actual” amount of income received depends on the hours you decide to work at the market wage plus your non-wage income (income from other sources). 2 More specifically, the slope of the potential budget constraint depends on the market wage – the higher the market wage the steeper the slope. leisureT Y wT+YN YN Potential income constraint Y=wL+YN Total time = labor + leisure T = L+ l What is the slope of the potential income constraint? But in this case, income depends on the leisure/labor choice: leisure Y ( ) ( ) wlYwTYl p wYwT p YYwTwlpY YlTwpY YwLpY NNN N N −+=⇒−+=⇒+=+ +−= += 1 )( In a standard two good case: where Y* = income *YwlpY =+ YN Slope = -w 5 Income and Substitution Effects The difference between A and B is purely a matter of having more potential income from which you can buy more leisure. If leisure is a normal good then B lies above and to the right of A. The difference between B and C is now a pure (or income compensated) substitution effect, since you are on the same IDC. The only difference is that the relative price of leisure is higher. As a result, you will substitute away from the now more expensive leisure towards work. The SE always increases work effort. In our example, the SE>IE, so a wage increase leads to more work effort and less leisure. Y leisure u1u0 A B C IE SE TE YN 6 It is also possible for the IE>SE. In this case, a wage increase leads to less work effort and more leisure. Y leisure u1u0 A B C IE SE TE YN Deriving the labor supply curve - we will do this in class 7 Labor supply elasticity Labor supply elasticity measures a worker’s responsiveness to wage changes. In other words, it measures the change in hours of work in response to a wage change. L w w L L w w L ww LL w L ** / / % % ∂ ∂ = Δ Δ = Δ Δ = Δ Δ =η The Participation Decision leisureT Y wT+YN YN leisure labor l Equilibrium for a Participant u0 10 What happens to a non-participant if YN rises? leisureT Y wT+YN YN YN’ If leisure is normal, an increase in non-wage income never causes anyone to enter the labor market. You stay out of the market wr w’r u0 u1 What happens to a participant if YN rises? leisureT Y wT+YN YN Case 1 YN’ Exit the market A B u0 u1 11 What happens to a participant if YN rises? leisureT Y wT+YN YN Case 2 YN’ Stay in the market A B u0 u1 Given what we have discussed, what types of people are more likely to work in the labor market and what types of people are less likely to work in the labor market? 12 What if there are fixed costs? • Fixed monetary cost: “Start-up” costs that are independent of the number of hours worked. • What happens to the reservation wage? Y leisure YN YN - M wr wr’ u0 T What if there are fixed costs? • What if you have chosen to work and then a fixed monetary cost is imposed? Y leisure YN YN - M u0 TL0 L1 If you continue to work you work more hours. u1 15 Fixed cost discontinuities in labor supply - we will derive this in class Overtime wages • Labor supply increases by construction if the overtime wage starts at the equilibrium labor supply choice. Y leisure YN u0 T u1 overtime wage 16 Overtime versus the straight-time equivalent • An overtime wage increases work effort by more than an equivalent increase in the wage. Y leisure YN u0 T u1 overtime wage straight-time equivalent wage Fixed Work Days • Fixed work days can lead to underemployment. Y leisure YN u0 Tlf 17 Fixed Work Days • If you are under employed you might be willing to work extra hours for a lower wage (“moonlight”). Y leisure YN u0 T u1 lf moonlighting wage Fixed Work Days • Fixed work days can also lead to over-employment. Y leisure YN u0 Tlf 20 Welfare • You must have no non-wage income to qualify. • Every dollar you earn is taken off your welfare payment. Y leisure YW T Welfare • Case 1: leave work for welfare. Y leisure YW u0 T u1 High welfare payments have a big work disincentive. 21 Welfare • Case 2: keep working. Y leisure YW u0 T How can we get people off welfare? • Reduce the welfare payment • Increase wages • Reduce the 100% implicit tax of welfare 22 Negative Income Tax • Income after taxes and transfers is Y= G+ (1-t)E where G is the basic guarantee Y leisure G T The term negative income tax is used because recipients receive more from the guarantee than they pay out in taxes, even though the implicit tax rate (t) is positive. Negative Income Tax Case 1: Keep working, but work less Y leisure G u1 T u0 Assuming that leisure is normal, the new equilibrium will lie to the right of the old equilibrium because the IE and the SE work in the same direction. But notice that the work disincentive effect is less than for welfare. 25 This is not to say that a wage subsidy is necessarily better. • A wage subsidy does nothing to help unemployables. • A negative income tax targets the poor better (given limited funds for income support payments) because payments depend on income level. We will discuss the major points of the Moffitt paper in class at this point. 26 Earned Income Tax Credit • The earned income tax credit (EITC) is another way to help low-income individuals. • By the late 1990s EITC was the largest cash benefit program in the U.S. granting almost $25 billion per year. Earned Income Tax Credit • In 1996, a single woman with 2 kids could claim a credit of up to 40% of her earnings as long as she earned less than $8890 per year. – The resulting maximum credit is $3556 for a total of $12,446 • The maximum credit is available as long as she earns between $8890-$11,610 for a total between $12,446- $15,166. • Beyond $11610 the credit begins to be phased out. – Each additional $1 earned reduces the credit by $0.2106 until the credit is credit is gone. 27 EITC Y leisure T=16*364=5824 1688.5 272 889 1161 2849.5 Assuming a wage=$10 per hour and 16 hours per day available for work in a year with 364 days. At $10 per hour it takes L=3556/2.106 =1688.5 hours for the subsidy to hit 0. EITC and Labor Supply Y leisureT In general, one would expect employment to increase for this person, but as the IE and SE go in opposite directions, it is also possible that they work less. u0 u1 30 Retirement • Between 1950 and 2000 the labor force participation rate of men aged 55-64 fell from 87% to 67%. • What caused this? Retirement Y Years of retirement 30 Imagine that you are 50 and trying to decide when to retire. Assume that you expect to live until 80. u0 31 Retirement Y Years of retirement 30 How does a wage increase effect your retirement decision? u0 u1 Case 1: Retire sooner IE>SE -- retire sooner Retirement Y Years of retirement 30 u0 u1 Case 2: Retire later IE<SE -- retire later 32 How does a pension benefit increase effect the retirement decision? Y Years of retirement 30 u0 YN u1 YN+P Slope changes because you only get the higher pension during the years you are retired. SE leads to less work IE leads to less work So you retire sooner Social Security • So far we have assumed that a retired person withdraws completely from the labor market. • But many retired people work at least part time. • As of 2000, the Social Security system allows people 65-69 to earn $17,000 with no penalty, but after that they face a 33% tax back rate. • The earnings test does not apply after age 70 35 How does Social Security impact labor supply? Y leisure T $10,000 $116,480 u0 Case 4: Social Security has no impact. Household Production • Much of what we have so far referred to as leisure is really just another form of work. Question: Why do some family members specialize in labor market work and some in household production? 36 Household Production • Consider a married couple. – The only way to get money is to work in the market sector and the only way to get household commodities is to work in the household • Let’s begin by considering a “traditional” family where the husband’s wage is higher. • Let’s also assume that men and women are equally productive at home. Y H Wife H Y Husband H* H* Household Production 37 Assume the following: (a) there are 10 available hours, (b) H*=150, (c) wh = 20, (d) ww = 10 Y H300 Where the household ends up depends on their preferences over H and Y. The opportunity frontier for the couple is: 150 300 200 Wife does both, Husband mkt Wife hp, Husband mkt Wife hp, Husband does both Notice that this production frontier is entirely higher than the last one because of the return to specialization. Y H300 Where the household ends up depends on their preferences over H and Y. What if? (a) hours = 10, (b) Hw*=200, (c) Hh*=100 (c) wh = 20, (d) ww = 10 200 300 200