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DEPARTMENT OF ECONOMICS Chapter Two: Labour Supply Theory

CHAPTER TWO
LABOUR SUPPLY THEORY
Labor supply theory is an economic concept that analyzes the decisions individuals make
regarding the quantity of labor they choose to supply in the market. It seeks to understand the
factors that determine individuals' willingness and ability to work, as well as the trade-offs they
face between work and leisure.
Labour supply is the term used to describe the human input into the production process; it is the
term used to describe the supply of that factor of production which results from the activity of
individuals.
Key elements of labor supply theory include:
1. Substitution Effect: The substitution effect refers to the relationship between wages and
the opportunity cost of leisure. As wages increase, individuals have a greater incentive to
work more hours because the opportunity cost of leisure (foregone wages) becomes
higher. The substitution effect suggests that higher wages lead to an increase in the
quantity of labor supplied.
2. Income Effect: The income effect examines the impact of changes in wages on
individuals' overall income and standard of living. When wages increase, individuals may
choose to work fewer hours because they can maintain or enhance their standard of living
without relying as much on labor income. Conversely, a decrease in wages may result in
individuals working more hours to compensate for the reduced income.
3. Time Constraints: Individuals face time constraints due to the limited number of hours
available in a day. Time spent working is time that cannot be allocated to other activities,
such as leisure, household chores, education, or caring for family members. These time
constraints play a role in individuals' decisions about the quantity of labor they are
willing and able to supply.
4. Non-Wage Factors: Various non-wage factors influence labor supply decisions. These
factors include personal preferences, health considerations, job characteristics, work-life
balance, and availability of alternative activities. For example, individuals may place a
high value on leisure time, leading them to choose fewer working hours even if wages are
high.

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DEPARTMENT OF ECONOMICS Chapter Two: Labour Supply Theory

5. Human Capital: Human capital, which encompasses an individual's skills, education,

training, and experience, is an important determinant of labor supply. Individuals with
higher levels of human capital tend to have higher productivity and may have more job
opportunities, leading to higher wages and a greater willingness to work longer hours.
6. Institutional Factors: Institutional factors, such as labor market regulations, minimum
wage laws, tax policies, and social welfare programs, can affect labor supply decisions.
These factors may influence the net income individuals receive from working, the
availability of part-time or flexible work arrangements, or the eligibility for income
support programs, which can impact the quantity of labor individuals choose to supply.
Labor supply theory provides insights into how individuals respond to changes in wage rates,
income levels, and other factors influencing their labor market participation. It helps economists
and policymakers understand the trade-offs individuals face between work and leisure, the
impact of labor market policies, and the determinants of labor force participation rates.

2.1. Measurement and the Labour force participation

Measurement of labor force participation refers to the process of quantifying and assessing the
extent to which individuals in a given population are actively engaged in the labor market. It
involves identifying and categorizing individuals into specific labor force status categories based
on their employment and unemployment status.
The most common measure of labor force participation is the labor force participation rate,
which is calculated as the percentage of the working-age population (typically individuals aged
15 and older) who are either employed or actively seeking employment. The formula for
calculating the labor force participation rate is as follows:
Labor Force Participation Rate = (Labor Force / Working-Age Population) x 100
Here, the labor force includes both employed individuals and those who are unemployed but
actively seeking work. The working-age population refers to the total number of individuals
within the specified age range.
Labor force participation can be further disaggregated into various subgroups based on
demographic characteristics such as age, gender, education level, and geographic location. This
allows for a more detailed analysis of labor market dynamics and disparities.

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DEPARTMENT OF ECONOMICS Chapter Two: Labour Supply Theory

The measurement of labor force participation is typically conducted through surveys, such as
household surveys or establishment surveys, which gather information from individuals or
businesses regarding employment status. These surveys often employ standardized
questionnaires and sampling techniques to collect representative data.
It's worth noting that labor force participation rate alone does not provide a comprehensive
picture of the labor market. Other labor market indicators, such as employment-to-population
ratio, unemployment rate, and underemployment rate, are also used to provide a more nuanced
understanding of the labor market conditions and dynamics.
Labor force participation is an important measure as it helps policymakers, economists, and
researchers analyze and monitor the utilization of labor resources within an economy. It provides
insights into the level of economic activity, workforce trends, and potential barriers or
opportunities for employment. Additionally, it serves as a key input for various economic models
and policy formulation related to labor market policies, education and training programs, and
social welfare initiatives.

2.2. The Work-Leisure Decision Model

The Work-Leisure Decision Model is a theoretical framework that helps individuals make
decisions about how to allocate their time between work and leisure activities. It recognizes that
individuals have a limited amount of time available and must make choices about how to use that
time effectively. The model takes into account various factors, such as personal preferences,
income, and the trade-offs between work and leisure.
The Work-Leisure Decision Model typically involves several key components:
1. Utility Maximization: The model assumes that individuals seek to maximize their
overall well-being or utility. They make decisions based on their preferences, aiming to
allocate their time in a way that maximizes their satisfaction or happiness.
2. Time Allocation: The model recognizes that individuals have a limited amount of time
available and must allocate it between work and leisure activities. This allocation can
vary depending on personal preferences, cultural factors, and economic constraints.
3. Trade-offs: The model acknowledges that there are trade-offs between work and leisure.
For example, working more hours may lead to higher income but less leisure time, while

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choosing more leisure time may result in lower income or career advancement
opportunities. Individuals must weigh these trade-offs when making decisions.
4. Income Effect: The model recognizes that income plays a significant role in the work-
leisure decision. Higher income can provide individuals with more resources to enjoy
leisure activities or pursue their interests. However, it may also create a desire for higher
consumption, leading individuals to work more to maintain or increase their income.
5. Substitution Effect: The model considers the substitution effect, which refers to the
relationship between the wage rate and the opportunity cost of leisure time. As the wage
rate increases, the opportunity cost of leisure also increases, making individuals more
likely to choose work over leisure.
The Work-Leisure Decision Model helps individuals analyze their preferences, constraints, and
the potential outcomes of different choices. It provides a framework for understanding the factors
that influence the allocation of time between work and leisure and can assist in making informed
decisions to optimize overall well-being.
2.2.1 Workers preference
Worker preferences in the work-leisure decision model can vary significantly from individual to
individual. Preferences are subjective and depend on factors such as personal values, interests,
lifestyle, and cultural background. Here are some common worker preferences that may
influence the allocation of time between work and leisure:

1. Workaholic: Some individuals have a strong preference for work and derive a sense of
fulfillment and satisfaction from their professional endeavors. They may prioritize their
career, willingly work long hours, and sacrifice leisure time to pursue their professional
goals.

2. Balanced Lifestyle: Others may value a balanced lifestyle that allows for a harmonious
combination of work and leisure activities. They seek to maintain a healthy work-life
balance, ensuring that they have enough time for relaxation, hobbies, family, and other
non-work-related pursuits.

3. Leisure Enthusiast: Certain individuals prioritize leisure activities and consider them
essential for their well-being and personal fulfillment. They may place a greater emphasis

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on leisure time and allocate their time accordingly, even if it means working fewer hours
or choosing jobs with more flexibility.

4. Financial Motivation: Some workers are primarily motivated by financial

considerations. They may prioritize work over leisure to maximize their income,
accumulate wealth, or achieve specific financial goals. Their preference for work may be
driven by the desire for financial security, material possessions, or the ability to enjoy
leisure activities that require significant financial resources.

5. Personal Development: For certain individuals, personal growth and development are
key priorities. They may allocate their time between work and leisure based on
opportunities for learning, skill development, and career advancement. They may be
willing to invest more time in work to gain valuable experience or acquire new
knowledge and skills.

6. Health and Well-being: Worker preferences may also be influenced by considerations

of health and well-being. Some individuals prioritize self-care, physical exercise, and
mental rejuvenation. They may allocate sufficient leisure time to engage in activities that
promote their overall well-being, such as exercise, meditation, socializing, or pursuing
hobbies that bring them joy and relaxation.

It's important to note that individual preferences can change over time and can be influenced by
various factors, including personal circumstances, life stages, and evolving priorities. The work-
leisure decision model takes into account these preferences as one of the factors that affect how
individuals allocate their time between work and leisure.

The framework that economists typically use to analyze labor supply behavior is called the
neoclassical model of labor-leisure choice. This model isolates the factors that determine
whether a particular person works and, if so, how many hours she/he chooses to work. By
isolating these key factors, we can tell a simple “story” that explains and helps us understand
many of the stylized facts discussed above. More important, the theory lets us predict how
changes in economic conditions or in government policies will affect work incentives. The
representative person in our model receives satisfaction both from the consumption of goods
(which we denote by C) and from the consumption of leisure (L).

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Obviously, the person consumes many different types of goods during any given period. To
simplify matters, we aggregate the dollar value of all the goods that the person consumes and
define C as the total dollar value of all the goods that the person purchases during the period. For
example, if the person spends $1,000 weekly on food, rent, car payments, movie tickets, and
other items, the variable C would take on the value of $1,000. The variable L gives the number
of hours of leisure that a person consumes during the same time period.

Utility and Indifference Curves The notion that individuals get satisfaction from consuming
goods and leisure is summarized by the utility function:

U = f (C, L) ………………………………………………………………. eq (1).

The utility function transforms the person’s consumption of goods and leisure into an index U
that measures the individual’s level of satisfaction or happiness. This index is called utility. The
higher the level of index U, the happier the person. We make the sensible assumption that buying
more goods or having more leisure hours both increase the person’s utility.

In the jargon of economics, C and L are “goods,” not “bads.” Suppose that a person is consuming
$500 worth of consumption goods and 100 hours of leisure weekly (point Y in Figure 2.1). This
particular consumption basket yields a particular level of utility to the person, say 25,000 utils. It
is easy to imagine that different combinations of consumption goods and hours of leisure might
yield the same level of utility. For example, the person might say that she would be indifferent to
consuming $500 worth of goods and 100 hours of leisure or consuming $400 worth of goods and
125 hours of leisure. Figure 2.1 illustrates the many combinations of C and L that generate this
particular level of utility. The locus of such points is called an indifference curve and all points
along this curve yield 25,000 utils.

Figure 2.1 Indifference Curves Points X and Y lie on the same indifference curve and yield the
same level of utility (25,000 utils); point Z lies on a higher indifference curve and yields more
utility.

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Suppose that the person was instead consuming $450 worth of goods and 150 hours of leisure
(point Z in the figure). This consumption basket would put the person on a higher indifference
curve, yielding 40,000 utils. We can then construct an indifference curve for this level of utility.
In fact, we can construct an indifference curve for every level of utility. As a result, the utility
function can be represented graphically in terms of a family (or a “map”) of indifference curves.

Indifference curves have four important properties:

1. Indifference curves are downward sloping.

We assumed that individuals prefer more of both C and L. If indifference curves were upward
sloping, a consumption basket with more C and more L would yield the same level of utility as a
consumption basket with less C and less L. This clearly contradicts our assumption that the
individual likes both goods and leisure. The only way that we can offer a person a few more
hours of leisure, and still hold utility constant, is to take away some of the goods.

2. Higher indifference curves indicate higher levels of utility.

The consumption bundles lying on the indifference curve that yields 40,000 utils are preferred to
the bundles lying on the curve that yields 25,000 utils. To see this, note that point Z in the figure

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DEPARTMENT OF ECONOMICS Chapter Two: Labour Supply Theory

must yield more utility than point X, simply because the bundle at point Z allows the person to
consume more goods and leisure.

3. Indifference curves do not intersect.

To see why, consider Figure 2.1, where indifference curves are allowed to intersect. Because
points X and Y lie on the same indifference curve, the individual would be indifferent between
the bundles X and Y. Because points Y and Z.

Figure 2.2 Indifference Curves Do Not Intersect Points X and Y yield the same utility because
they are on the same indifference curve; points Y and Z also should yield the same utility.

Point Z, however, is clearly preferable to point X lie on the same indifference curve, the
individual would be indifferent between bundles Y and Z. The person would then be indifferent
between X and Y, and between Y and Z, so that she should also be indifferent between X and Z.
But Z is clearly preferable to X, because Z has more goods and more leisure. Indifference curves
that intersect contradict our assumption that individuals like to consume both goods and leisure.

4. Indifference curves are convex to the origin.

The convexity of indifference curves does not follow from either the definition of indifference
curves or the assumption that both goods and leisure are “goods.” The convexity reflects an
additional assumption about the shape of the utility function. It turns out (see problem 1 at the

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end of the chapter) that indifference curves must be convex to the origin if we are ever to observe
a person sharing her time between work and leisure activities.

The Slope of an Indifference Curve

What happens to a person’s utility as she/he allocates one more hour to leisure or buys an
additional dollar’s worth of goods?

The marginal utility of leisure is defined as the change in utility resulting from an additional hour
devoted to leisure activities, holding constant the amount of goods consumed. We denote the
marginal utility of leisure as MUL.

Similarly, we can define the marginal utility of consumption as the change in utility if the
individual consumes one more dollars’ worth of goods, holding constant the number of hours
devoted to leisure activities. We denote the marginal utility of consumption by MUC.

Because we have assumed that both leisure and the consumption of goods are desirable
activities, the marginal utilities of leisure and consumption must be positive numbers. As we
move along an indifference curve, say from point X to point Y in Figure 2.1, the slope of the
indifference curve measures the rate at which a person is willing to give up some leisure time in
return for additional consumption, while holding utility constant.

Put differently, the slope tells us how many additional dollars’ worth of goods it would take to
“bribe” the person into giving up some leisure time. It can be shown that the slope of an
indifference curve equals:

ճC /ճL = - MUL/ MUC………………………………. eq (2)

The absolute value of the slope of an indifference curve, which is also called the marginal rate of
substitution (MRS) in consumption, is the ratio of marginal utilities. The assumption that
indifference curves are convex to the origin is essentially an assumption about how the marginal
rate of substitution changes as the person moves along an indifference curve.

Convexity implies that the slope of an indifference curve is steeper when the worker is
consuming a lot of goods and little leisure, and that the curve is flatter when the worker is
consuming few goods and a lot of leisure. As a result, the absolute value of the slope of an

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indifference curve declines as the person “rolls down” the curve. The assumption of convexity,
therefore, is equivalent to an assumption of diminishing marginal rate of substitution.

2.2.2 Budget constraint

In the work-leisure decision model, the budget constraint is a significant factor that influences
the allocation of time between work and leisure. The budget constraint represents the limitations
individuals face in terms of the resources available to them, particularly their income or earning
potential.

The budget constraint can be understood in terms of the trade-off between work and leisure.
When individuals choose to allocate more time to work, their income typically increases,
allowing them to have more resources for consumption and leisure activities. Conversely, if they
choose to allocate more time to leisure, their income may decrease, limiting their ability to
engage in certain leisure activities or consume goods and services.

The budget constraint affects the work-leisure decision in the following ways:

1. Income and Leisure Choices: An increase in income may provide individuals with more
financial resources to enjoy leisure activities. They may have the means to pursue
hobbies, travel, or engage in recreational activities. Conversely, a decrease in income
may require individuals to allocate more time to work, reducing their leisure options.

2. Opportunity Cost: The budget constraint introduces the concept of opportunity cost,
which refers to the value of the next best alternative forgone when making a decision.
When individuals choose leisure over work, they are effectively giving up potential
income and the associated benefits that additional work hours might bring.

3. Consumption Choices: The budget constraint also affects individuals' consumption

choices. A higher income allows for greater purchasing power and the ability to enjoy a
wider range of goods and services. When individuals allocate more time to work and
increase their income, they may have more financial resources to allocate towards
consumption, including leisure-related expenses.

4. Work Choices: The budget constraint can influence individuals' choices regarding the
type of work they engage in. Some individuals may prioritize higher-paying jobs to

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increase their income and have more resources for leisure activities. Others may prioritize
jobs with more flexibility or better work-life balance, even if it means accepting lower
wages.

It's important to note that the budget constraint is not solely determined by income but also by
personal financial obligations, such as debt repayments, living expenses, and savings goals.
These obligations further shape individuals' choices regarding work and leisure, as they need to
ensure they meet their financial responsibilities while striving to maximize their overall well-
being.

The work-leisure decision model considers the budget constraint as a core factor alongside
individual preferences, trade-offs, and other considerations when individuals allocate their time
between work and leisure.

The person’s consumption of goods and leisure is constrained by her time and by her income.
Part of the person’s income (such as property income, dividends, and lottery prizes) is
independent of how many hours she/he works. We denote this “non-labor income” by V. Let h
be the number of hours the person will allocate to the labor market during the period and w be
the hourly wage rate. The person’s budget constraint can be written as:

C = wh + V…………………………eq (3).

expenditures on goods (C) must equal the sum of labor earnings (wh) and non-labor income (V).

As we will see, the wage rate plays a central role in the labor supply decision. Initially, we
assume that the wage rate is constant for a particular person, so the person receives the same
hourly wage regardless of how many hours she works. In fact, the “marginal” wage rate (that is,
the wage rate received for the last hour worked) generally depends on how many hours a person
works.

Persons who work over 40 hours per week typically receive an overtime premium, and the wage
rate in part-time jobs is often lower than the wage rate in full-time jobs. For now, we ignore the
possibility that a worker’s marginal wage may depend on how many hours she chooses to work.
Given the assumption of a constant wage rate, it is easy to graph the budget constraint. The
person has two alternative uses for her time: work or leisure.

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The total time allocated to each of these activities must equal the total time available in the
period, say T hours per week, so that T = h + L. We can then rewrite the budget constraint as:

C = w (T - L) + V…………………………eq (4).

Or, C = (wT + V) – wL

This last equation is in the form of a line, and the slope is the negative of the wage rate (or – w).
The budget line is illustrated in Figure 2.3. Point E in the graph indicates that if the person
decides not to work at all and devotes T hours to leisure activities, she/he can still purchase V
dollars’ worth of consumption goods. Point E is the endowment point. If the person is willing
to give up one hour of leisure, she can then move up the budget line and purchase an additional
w dollars’ worth of goods.

In fact, each additional hour of leisure that the person is willing to give up allows her to buy an
additional w dollars’ worth of goods. In other words, each hour of leisure consumed has a price,
and the price is given by the wage rate. If the worker gives up all her leisure activities, she ends
up at the intercept of the budget line and can buy (wT + V) dollars’ worth of goods. The
consumption and leisure bundles that lie below the budget line are available to the worker; the
bundles that lie above the budget line are not. The budget line, therefore, delineates the frontier
of the worker’s opportunity set: the set of all the consumption baskets that a particular worker
can afford to buy.

Figure 2.3 The Budget Line Is the Boundary of the Worker’s Opportunity Set Point E is the
endowment point, telling the person how much she can consume if she does not enter the labor
market. The worker moves up the budget line as she trades off an hour of leisure for additional
consumption. The absolute value of the slope of the budget line is the wage rate.

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Figure 2.3 The Budget Line

2.2.3 The Hours of Work Decision

The hours of work decision is a crucial aspect of the work-leisure decision model and refers to
the choice individuals make regarding the number of hours they dedicate to work. It involves
determining the optimal balance between work and leisure time based on various factors,
including personal preferences, financial considerations, and lifestyle factors.

Several key factors influence the hours of work decision:

1. Personal Preferences: Individual preferences play a significant role in determining the

desired number of working hours. Some individuals may have a strong preference for
work and choose to work longer hours due to intrinsic motivation, career aspirations, or a
desire for personal fulfillment. Others may prioritize leisure time and opt for shorter
working hours to have more time for family, hobbies, or other non-work-related
activities.

2. Financial Considerations: Economic factors, such as income requirements and financial

goals, can influence the hours of work decision. Individuals may choose to work longer
hours to increase their income, meet financial obligations, or achieve specific financial
milestones. Conversely, those with lower income needs or other sources of financial

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security may opt for shorter working hours to prioritize leisure or other non-monetary
aspects of life.

3. Work-Life Balance: The desire for a healthy work-life balance often drives the hours of
work decision. Many individuals strive to allocate their time in a way that allows them to
maintain equilibrium between work responsibilities and personal life. They may seek
flexibility in their working hours, part-time employment, or job arrangements that
accommodate personal commitments and leisure activities.

4. Health and Well-being: Considerations related to physical and mental health can also
impact the hours of work decision. Excessive working hours without sufficient rest and
leisure time can lead to stress, burnout, and health issues. Individuals may prioritize
adequate rest, self-care, and leisure activities to maintain their well-being and
productivity.

5. Industry and Occupation: The characteristics of the industry and occupation in which
individuals work can influence the hours of work decision. Some industries or
occupations, such as healthcare, emergency services, or hospitality, may require irregular
or long working hours due to the nature of the work. In contrast, other sectors may
provide more flexibility and options for individuals to control their working hours.

6. Legal and Institutional Factors: Legal regulations and institutional policies can also
shape the hours of work decision. Labor laws, employment contracts, collective
bargaining agreements, and company policies may impose limitations or offer options
regarding working hours, overtime, and leave entitlements. These factors can impact
individuals' choices and influence their ability to adjust their working hours.

The hours of work decision is influenced by a complex interplay of personal, financial, societal,
and regulatory factors. It is a highly individualized decision that reflects the unique
circumstances and priorities of each person. The work-leisure decision model provides a
framework for individuals to evaluate and make informed choices about their hours of work,
considering the trade-offs and preferences involved.

We make one important assumption about the person’s behavior: she/he wishes to choose the
particular combination of goods and leisure that maximizes her utility. This means that the

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person will choose the level of goods and leisure that lead to the highest possible level of the
utility index U given the limitations imposed by the budget constraint.

Figure 2.4 illustrates the solution to this problem. As drawn, the budget line FE describes the
opportunities available to a worker who has $100 of non-labor income per week, faces a market
wage rate of $10 per hour, and has 110 hours of nonsleeping time to allocate between work and
leisure activities (assuming she sleeps roughly 8 hours per day). Point P gives the optimal bundle
of consumption goods and hours of leisure chosen by the utility-maximizing worker. The highest
indifference curve attainable places her at point P and gives her U* units of utility. At this
solution, the worker consumes 70 hours of leisure per week, works a 40-hour workweek, and
buys $500 worth of goods weekly. The worker would obviously prefer to consume a bundle on
indifference curve U1, which provides a higher level of utility.

For example, the worker would prefer to be at point Y, where she works a 40-hour workweek
and can purchase $1,100 worth of consumption goods. Given her wage and non-labor income,
however, the worker could never afford this consumption bundle. In contrast, the worker could
choose a point such as A, which lies on the budget line, but she would not do so. After all, point
A gives her/his less utility than point P. The optimal consumption of goods and leisure for the
worker, therefore, is given by the point where the budget line is tangent to the indifference curve.
This type of solution is called an interior solution because the worker is not at either corner of the
opportunity set (that is, at point F, working all available hours, or at point E, working no hours
whatsoever).

Figure 2.4 An Interior Solution to the Labor-Leisure Decision. A utility-maximizing worker

chooses the consumption-leisure bundle given by point P, where the indifference curve is tangent
to the budget line.

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Figure 2.4 An Interior Solution to the Labor-Leisure Decision.

2.2.4. The effect of change in non-Labour income on hours of work

A change in non-labor income can have an impact on the hours of work decision. Non-labor
income refers to income derived from sources other than work, such as investments, rental
income, government transfers, or other forms of passive income. When there is a change in non-
labor income, it can affect individuals' incentives and preferences regarding the number of hours
they choose to work.

The effect of a change in non-labor income on hours of work can be summarized as follows:

1. Income Substitution Effect: An increase in non-labor income can create a substitution

effect, whereby individuals may choose to work fewer hours. With additional income
from non-labor sources, individuals have the option to reduce their reliance on labor
income and increase their leisure time. They may choose to work part-time, take more
time off, or pursue activities that provide personal fulfillment outside of paid work.

2. Income Effect: The income effect refers to the impact of a change in income on
individuals' overall consumption and lifestyle choices. An increase in non-labor income

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can provide individuals with greater financial resources, allowing them to maintain or
enhance their standard of living without relying heavily on labor income. In this case,
individuals may choose to work fewer hours or reduce their work intensity to enjoy the
increased financial security or pursue leisure activities that were previously financially
constrained.

3. Work as a Complement to Non-Labor Income: On the other hand, some individuals

may see work as a complement to their non-labor income. They may enjoy their work,
find it personally fulfilling, or view it as a way to enhance their overall well-being and
social engagement. In this case, an increase in non-labor income may not significantly
affect their hours of work, as they continue to derive satisfaction from their job and may
maintain their current working hours or even choose to work more.

It's important to note that the impact of a change in non-labor income on hours of work can vary
across individuals based on their personal circumstances, preferences, and financial goals.
Different individuals may respond differently to changes in non-labor income, depending on
their individual motivations, values, and the relative importance they place on work and leisure.

Moreover, the magnitude of the effect may also depend on the level of non-labor income relative
to labor income. For individuals with substantial non-labor income, the impact on their hours of
work may be more pronounced compared to those who rely heavily on labor income.

In summary, a change in non-labor income can influence the hours of work decision through
income substitution effects, income effects, and individual preferences regarding the role of work
in their lives. Understanding these dynamics can provide insights into how individuals respond to
changes in their financial circumstances and make choices regarding the allocation of their time
between work and leisure.

2.2.5. The effect of change in wage on hours of work

A change in wage can have a significant effect on the hours of work decision. When wages
increase or decrease, individuals may adjust the number of hours they choose to work based on
various economic and personal factors. The effect of a change in wage on hours of work can be
summarized as follows:

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HARAMBEE UNIVERSITY
FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS Chapter Two: Labour Supply Theory

1. Substitution Effect: A change in wage can create a substitution effect, whereby

individuals adjust their labor supply in response to changes in the relative attractiveness
of work compared to leisure. When wages increase, individuals may be motivated to
work more hours to take advantage of the higher earning potential. They may be willing
to substitute leisure time for additional work hours to maximize their income.
Conversely, if wages decrease, individuals may choose to work fewer hours or reduce
their work intensity, seeking alternative activities that provide higher utility relative to the
lower wage rate.

2. Income Effect: The income effect also comes into play when there is a change in wage.
An increase in wage can lead to an increase in overall income, providing individuals with
greater financial resources. This may allow them to maintain or enhance their standard of
living without having to work as many hours. In this case, individuals may choose to
work fewer hours to enjoy more leisure time or pursue activities that contribute to their
well-being outside of work. Conversely, a decrease in wage may reduce overall income,
prompting individuals to increase their work hours to compensate for the income loss.

3. Opportunity Cost of Leisure: The opportunity cost of leisure is another factor that
influences the effect of a change in wage on hours of work. When wages increase, the
opportunity cost of leisure time also increases, as individuals have the potential to earn
more income by working additional hours. This may lead to a higher willingness to
forego leisure time and allocate more hours to work. Conversely, if wages decrease, the
opportunity cost of leisure decreases, making leisure time relatively more attractive
compared to work.

4. Work Intensity and Job Satisfaction: Changes in wage can also impact work intensity
and job satisfaction. In response to a higher wage, individuals may choose to work longer
hours or increase their work intensity to maximize their earnings. On the other hand, a
decrease in wage may lead to reduced work effort or decreased job satisfaction,
potentially resulting in individuals choosing to work fewer hours or seeking alternative
employment opportunities.

It's important to note that the magnitude and direction of the effect of a change in wage on hours
of work can vary across individuals based on their personal circumstances, preferences, and

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HARAMBEE UNIVERSITY
FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS Chapter Two: Labour Supply Theory

financial goals. Different individuals may respond differently to changes in wage rates,
influenced by factors such as income needs, household responsibilities, career aspirations, and
the intrinsic value they place on work and leisure.

Additionally, the elasticity of labor supply can also play a role. Individuals with highly elastic
labor supply may be more responsive to changes in wage rates and adjust their hours of work
accordingly, while those with inelastic labor supply may exhibit less responsiveness to wage
changes.

In summary, a change in wage can lead to adjustments in the hours of work decision through
substitution effects, income effects, the opportunity cost of leisure, and considerations of work
intensity and job satisfaction. These dynamics highlight the intricate relationship between wages
and labor supply, providing insights into how individuals respond to changes in their earning
potential and make choices regarding the allocation of their time between work and leisure.

2.2.6. Reservation Wage (to work or not to work)

The reservation wage refers to the minimum wage or income level that an individual is willing to
accept in order to participate in the labor market and engage in paid employment. It represents
the threshold below which individuals are not willing to work or consider a particular job offer.

The reservation wage is influenced by several factors:

1. Individual Preferences: Personal preferences and individual circumstances play a

significant role in determining the reservation wage. Factors such as lifestyle choices,
desired standard of living, work-life balance, job satisfaction, and non-monetary
considerations can influence the minimum wage level that individuals are willing to
accept.

2. Skills, Experience, and Education: The level of skills, experience, and education
possessed by an individual can impact their reservation wage. Individuals with high-
demand skills, extensive experience, or specialized qualifications may have a higher
reservation wage due to their perceived value in the labor market. On the other hand,
individuals with fewer skills or limited experience may have a lower reservation wage.

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HANDOUT FOR LABOUR [Link]: MW
HARAMBEE UNIVERSITY
FACULTY OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS Chapter Two: Labour Supply Theory

3. Labor Market Conditions: The prevailing labor market conditions, including the
demand for labor and the availability of job opportunities, can influence the reservation
wage. In a tight labor market with strong demand for workers, individuals may have more
bargaining power and be able to negotiate higher wages, resulting in a higher reservation
wage. Conversely, in a weak labor market with limited job prospects, individuals may be
more willing to accept lower wages, leading to a lower reservation wage.

4. Opportunity Costs: The opportunity cost of not working also influences the reservation
wage. Individuals consider the potential income they could earn from alternative
activities, such as pursuing further education, starting a business, or engaging in non-paid
activities. If the potential earnings from these alternatives are higher than what they could
earn from paid employment, individuals may set a higher reservation wage, making them
less likely to accept lower-paying job offers.

5. Social Factors: Social norms, cultural expectations, and the influence of peers and
family can impact the reservation wage. These factors may shape individuals' perceptions
of what constitutes a fair wage or define their minimum income requirements based on
societal standards.

The reservation wage is an important concept in labor economics as it helps explain labor market
dynamics, wage determination, and individuals' decision-making regarding employment. It
serves as a benchmark for individuals when evaluating job offers or considering participation in
the labor market. Employers also consider the reservation wage when setting wage levels and
making hiring decisions.

It's important to note that the reservation wage can vary widely across individuals based on their
unique circumstances and preferences. Additionally, the reservation wage is not a fixed value but
can change over time as individuals' circumstances, skills, and market conditions evolve.

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