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Economics 301
Intermediate Macroeconomics

Labor Supply

Winter 2000

Last updated: January 25, 2000

Note: These notes are preliminary and incomplete and they are not guaranteed to be free of errors. Please let me know if you find typos or other errors. 

The Worker's Labor Supply Decision

Previously, we took the supply of labor as given. That is, we assumed that firms could hire as many workers at the prevailing real wage. Realistically, we have to recognize that workers make a choice regarding how much they work and this labor supply decision interacts with firms' demand for labor to set the real wage and employment level in the economy. The labor supply decision involves the following:

• There is a labor-leisure trade off that individuals face. Workers trade off the benefits from working (more income) and not-working (more leisure time) with the costs of working and not-working.
• The labor-leisure decision problem is an inter-temporal decision problem. Workers consider current and future consumption as well as current and future leisure in the decision on how much to work today.

Income and Substitution Effects

Consider how an increase in the current real wage affects a worker's labor supply. From microeconomics we recognize that there are two offsetting effects:

• Substitution effect of an increase in the real wage, w.
  As w increases, income increases by working more and a worker substitutes work for leisure so labor supply, NS, increases.
• Income effect of an increase in the real wage, w.
  As w increases, working the same number of hours still gives an increase in income so that a worker may decrease the number of hours worked and maintain the previous level of income so labor supply, NS, decreases.

Which effect wins out when w increases is ambiguous since it depends on personal preferences towards current and future consumption and leisure.

Empirical evidence on US aggregate labor supply

In the book Labor Supply by Mark Killingsworth, it is reported that, for US data, temporary increases in real wages, w, tend to increase labor supply, NS, and that permanent increases in w tend to decrease NS. This implies that the substitution effect is stronger for temporary increases in w and that the income effect is stronger for permanent effects.

Factors that Influence Labor Supply

• Current (temporary) real wage, w
  An increase in w increases NS (substitution effect)
• Expected future (permanent) real wage, w^e.
  An increase in w^e decreases NS (income effect).
• Wealth, WL
  An increase in WL decreases NS (income effect).

Aggregate Labor supply

Aggregate labor supply is simply the sum of everyone's individual labor supplies.

Graphical Description of Labor Supply

Increase in the current real wage

An increase in the current real wage, holding everything else fixed, increases labor supply, NS, and this is represented as a movement along the curve.

Increase in the expected future real wage

An increase in the expected future real wage, holding everything else fixed, decreases labor supply which is represented as a leftward shift of the NS curve.

Increase in wealth

An increase in wealth, holding everything else fixed, decreases labor supply which is represented as a leftward shift of the NS curve.