CHAPTER TWO

Labour Supply Theory

2.1. Labour Supply Measurement and the Labour Force Participation
Defination: Labour supply is the term used to describe the human input used in the production process; it is the
term used to describe the supply of factor of production which results from the activity of individuals.
Measurement: The concept and measurement of labour supply is one of the problem areas of labour economics.
However, Labour supply can be measured in a number of ways
1. A head count or “the number of people” is sometimes used to measure labor supply. This approach
considers all people residing in a nation as a labour force. The problem with this approach is that it may
include under age children, over age elderly, hospitalized persons and does not convey the notion of
engagement in economically productive activities, which is implied by the concept of labour supply. The
inclusion in the count people of working age only improves the measurement of labour supply but, this too is
defective.
2. Population of working age approach: In this approach the population all population except children and
the overage are considered as the labor supply of a given country. This approach has also limitation as it
include inactive population too. This is an improvement over the crude head count approach. .
3. Labour force approach: In this approach the most common approche and the population of active labour
force are considered as the labour supply of a given nation. According to the labour force approach or
framework, labour supply is measured by the product of the labour force and its activity rate. By means of a
sample survey or a population census both the labour force and its activity rates are estimated. There are
alternative methods of doing so and the one used recent demographic surveys is that based on the concept of
current economic activity status of the work force. It limitation is that it does not incorporate skill,
education, experiences etc.
4. Manpower Approach: This refers to cognitive skill incorporated in labour. It explain how one engaged in
work

The labour force estimation procedure based on the activity principle involves three steps or stages

i. Step 1. Defining and Measuring the working age population . Conventionally, in most countries the
lower limit is 14 or 15 and upper age limit is 65. However, the recommended international standard do not
set the upper age limit to determine the economically active population. The working population include
every member of the adult population' (population above14 years) is classified in one of three categories:
'employed,' 'unemployed,' or 'not in the labour force
ii. Step 2: Identifying the economically active population of working age i.e. the labour force. Labour
force is individuals in the eligible population who participate in labour market activities either employed or
unemployed. It is the total number of employed and unemployed working-age population. The employed

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 are all persons in the labour force that, during the short reference period, performed “some work” in wage,
or in self-employment. Those in wage-employment are classified as employed if they are at work during
the survey period for pay in cash or in kind; and, although temporarily absent from work during the period
for pay in cash or in kind; and, although temporarily absent from work during the period of counting, have a
formal attachment to their job such as illness, personal responsibilities, bad weather, labour disputes (a
strike or lockout), or on vacation Those in self-employment include persons engaged in some work for
profit or family gain; and, although “with a work attachment to an enterprise” are temporarily at work
(during the reference period or the period of counting). So, part-time workers and self-employed individuals
are included in the employed category. On the hand the unemployed consist of all persons in the group of
working age population who are not currently working but are available for work and say they have actively
looked for work during the reference period, or have been on layoff and expect to be recalled.

Figure 2-1 Labour Force Frame work

Working-Age
Population Population Below
the Specified Age

The Labour Force Population Not

(Currently Active Currently Active
Population)

Unemployed
Employed

In paid Standard Modified

Employment In Self- Definition Definition
Employment

At work for With a job

At work With an “Without work currently “Without work currently
wage or but not at
for profit enterpri available for work” and available for work and (in
salary in work (formal
or family se but “seeking work” (in paid paid or self-employment)
cash or in job
gain in not at or self employment) but not seeking work”
kind
I. T attachment)

iii. Step 3. The identification and measurement of the population that is not in the labour force.
Those not in the labor force” constitute a distinct category of the economically inactive population
(which include the inactive labour force and the under-school age children). The reasons for
inactivity are many and the not economically active labour force includes, students, home-makers,
retired or old-age pensioners, and persons of working age suffering from disablement.

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Note that adults in working age population who are not employed or are not unemployed are not included
in the labour force; for example, full-time students without jobs, house spouses, retired folk, and other
people who say they did not actively look for work during the previous four weeks (such as 'discouraged'
workers) are classified as not in the labour force

2.1.2. Measuring labour Force : Activity Rate (Labour force Participation Rate)

The labour force participation rate is the percentage of the adult population in the labour force. Activity
rate measures the extent of involvement in economic activities, or the participation in the production and
distribution of economic goods and services. The activity status of individuals is determined on the basis
of what they have actually been doing during the short time interval (the reference period) of census
taking. Only if they were engaged in the production and distribution of economic goods and services will
they be counted as economically active, or as a part of the currently active population, or the labour force
(ILO Manual, 1990).
The activity rate (usually expressed as a percentage) is calculated as a ratio of the labour force (which is
the sum of the employed and the unemployed) to the working age population, The working age
population is a socially determined demographic factor and is the sum of three variables: the employed,
the unemployed and the economically inactive of the specified age group..
 Labour force 
Economic Activity Rate or (the labour force participation rate) =  Working Age Population  x 100
 

Labour Force = employed + Unemployed

Working Age Population = employed + unemployed + economically inactive working age population
The population of working age is sometimes referred to as the potential labour force or as the age-eligible
population. This is contrasted with the actual labour force, which is the sum of the employed and
unemployed population of working age. The economic activity rate (or the labour force participation
rate) is then defined as the ratio of the actual to the potential labour force multiplied by 100, i.e.
 Actual Labor force 
Labour force participation rate (economic activity rate)) =  Potential Labor force  x 100
 

The decision to participate in paid labour market activities has influences the size and composition of our
labour force which in turn result impacts the economy

2.1.3. The Limitations of the Estimated Labour Supply Using labour Force Approach
The concept and measurement of labour supply pauses many problems. The labour supply estimate
provided by the activity approach is no exception. It too fails to achieve a wholly satisfactory

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approximation of labour supply. Thus, using labour force as proxy to estimate labour supply of a given
nation has limitations.

First, the concept of labour supply in labour force approach encompasses notions which go beyond the
number of people in the workforce. it does it does not include supply of hours of work in measurement,
effort of individual on the job, labour commitment, productivity of workers etc, is all elements of a
comprehensive measure of labour supply. The particular framework adopted (i.e. the activity approach)
is defective in that it does not include all these considerations.

Second, the second limitation of labour force approach is that labour supply in a given nation consider
only those workers that participate in economic activity, but it is difficult to identify and measure
comprehensively the level of all economic activities included in national income accounting. Such
measurement exclude those sectors that government cannot control such informal sector, smuggling drug
trafficking illicit trade, prostitutes, etc This problem is especially serious in the underdeveloped mainly
subsistent economies where a large portion of the production is non-marketable (i.e. is produced for own
or home consumption), labour markets are largely disorganized, and labour force is largely self or family
- employed, and where a large portion of the population pursue not one “primary job” but multiple jobs.

Third, there are many cases where treatment by a standardized procedure (or criteria set) is not always
possible. The simple method of counting into the labour force individuals “who are able to work and
either are working, temporarily absent from work (with job commitment) or actively seeking work” is not
easy to apply in all cases. There are various types of “begging” (e.g. “pure” begging, begging with
musical accompaniment, begging with service, etc) and categories of “criminal activities “where a
consensus, to include or exclude in activity rate estimates, may be difficult to reach. There are
individuals who may not be “actively seeking work”, but are willing to take one if offered.

Fourth, the reference period is also a factor affecting the (estimated) labour supply. The reference period
can be a day, a weak, a month or even a year and these yield different labour supply estimates. If the
census using short time intervals (reference period) is conducted during slack seasons labour supply
would tend to be underestimated. It would be overestimated if the short reference period (a day or a
week) were in a peak season.

Fifth, the measurement of labour supply is difficult when the frequency of economic status change is
high. If a large proportion of the labour force are in and out of the labour force count too frequently,
labour supply is overestimated and underestimated, respectively.

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Are we to conclude that because the notion of economic activity is spurious in developing economies and
produces unstable and inefficient estimators of labor supply it must therefore to be abandoned? The
labour force approach of estimating labour supply is a popular one and can be refined or improved by
using complementary methods of estimation.
 discouraged' workers (people who would like to work but who have given up actively looking for work
because they believe that no jobs are available

2.2. The Short-Run Theory of Labor Supply

2.2.1. Basic Neoclassical Model of Labor Supply (Income-Leisure Choice Model)

The simple model of individual behavior we construct assumes that individuals work in order to be able to buy
commodities. It also assumes that as a result of their work individuals obtain the commodities they want to buy; it
is as if they were operating in a barter economy swapping their labour directly for commodities. In practice,
however, in a monetary economy individuals work for money and only later do they translate this money into a
demand for commodities?

The decision to work is ultimately the decision about how much to spent time. The individual having
fixed amount of time available must decide how that time is be allocated among labour market activities
and leisure. For any market there three important determinants of demand.
 The opportunity cost of goods( its price)
 Income of consumer
 Preferences

Generally the model is based on the following assumptions

Assumptions

a) Individuals maximize their utility subject to the constraints that confront them in the labour
market. That is maximization of utility is subject to income budget constraints. We therefore need
to know something about an individual’s preferences (what it is that gives him or her satisfaction
or utility) and to distinguish the opportunities for realizing them that exist in the labour market.
b) We shall argue that individuals derive utility from the consumption of commodities and that in
order to buy these commodities they have to obtain an income. Undertaking paid work is one of
the ways of obtaining an income but the size of this income is limited by the opportunities that
confront the individual in the labour market

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 c) There are only two possible uses of time: labor and leisure, Thus, Each individual selects the
combination of hours of work and leisure that maximizes his or her level of satisfaction (utility).
d) Price is fixed

The implication of the above assumptions is that the wage rate, level of income/wealth and preferences
has implication on labor supply of individuals. Basically, we begin with a discussion of preferences, the
utility function and indifference curves, followed by a derivation of the income budget-line constraint and
an analysis of the individual's optimum supply of labour.

Indifference curve analysis is used to determine how labour supply decisions (whether to work and how
much to work) are affected by the wage rate, the amount of non-labour income available to the
individual, and the individual's preferences for work versus leisure (time spent not working). The basic
analytical diagram used in labour supply analysis consists of a set of indifference curves and an income
budget line representing the individual's income opportunities. In labour supply analysis the horizontal
axis for the indifference curve diagram is a bit tricky and the income budget line can be kinky.

(1) An individual’s preferences

An individual’s preferences can be summarized in terms of the objects of choice and the commodities
from which they derive satisfaction and represented by work-leisure indifference curve. Work-leisure
indifference curve shows the various combinations of income and leisure time that will yield the same
level of satisfactions to individual. To simplify our analysis, we sub-divide goods and services into two
categories: consumption [G] goods/services purchased from one's income and 'leisure' [L] time activities
Leisure [L] is broadly defined as all time not working in the labour market. An indifference curve is a set
of leisure-combination choices over which the worker is indifferent. Thus, Workers will have preferences
over a set of consumption-leisure choices.
In a simple theory the
the individual utility function is represented by U=U(G,L) , and
Where
 Goods and services (G,) available to the individual, with the single exception of time. The amount of
goods and services we consume also constitutes a measure of our real income, and hence the term real
income, I, is offer used interchangeably with that of the volume of goods and services, G=I,
 L, is used to describe all hours not spent working, that is leisure time. At this stage in our analysis it
is the generic title for hours spent relaxing as well as hours spent either doing unpaid work (termed
non-market work) or studying or training (i.e. honors devoted to human capital investment). Besides
pure leisure activities (such as vacations and watching TV), L also includes household production

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 (such as gardening and child-care), educational activities (investing in human capital), and personal
time (such as sleeping). Leisure is measured in time units (hours, days, weeks, months, etc.)
 The two goods substitutes each other
G and L are assumed to be subject to 'diminishing marginal utility' (the first derivatives of U are positive
and the second derivatives are negative). The individual obtains utility from consuming additional units
of G or L, but the marginal utility declines as more units are consumed (e.g. eating ice cream cones)
 The utility from leisure includes both the pleasure one derives from the leisure
activity as well as avoiding any disutility associated with work (such as getting
up `early' in the morning, unpleasant physical activity, putting up with a bossy
boss, tension, stress, etc.)
 as shown in Figure 2-1, indifference curves can be used to depict an
individual's preferences for consumption [L] goods and leisure [L] time

Figure 2.1 Indifference Curve

A-abundance of
consumption willing to
give up for leisure
A
B-abundance of leisure willing
to give up for consumption

C C-consumption and leisure

are substitutable
B

0
Leisure

(2). Constraints
The real income that individuals have at their disposal imposes a constraint on their choice. In the simple model
considered here an individual’s expenditure on goods and Services cannot exceed his or her real income, I, that is
G< I.
How many of the objects of choice a given real income can purchase is determined by the price of these objects,
which in our simple model means the price of goods and services, and the price of leisure,

What determines the size of an individual’s real income? The total real income the individual has at his or her
disposal comprises;

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 i) Unearned income (V) perhaps resulting from the yield on wealth or from transfer payments made by
governments,
ii) Income from work. It is the product of the hourly wage rate, W, and the number of hours devoted to work,
H. (i.e. (WH)) .

Thus total real income, I, is given by total nominal income (V + WH) deflated by the price of goods
and services, P:
I= (V+ WH)
Non-labor income may be received in the form of inheritance , lottery winnings, investment income
(interest payments, rent, dividends, profits), alimony payments, welfare benefits, transfer payments,
and/or a spouse's income, lawsuit settlements, or any other income that does not vary with hours worked.
The constraints on individuals’ choices are therefore their real unearned income, the real hourly wage rate they can
earn when working and any constraint on the number of hours they are able to work. The amount of time
individuals have at their disposal in a particular period is limited. Let’s call this total, T, then H cannot exceed T,
that is, H<T. It also follows that the Budget Constraint constraint is given by:
H= T- L
Where, H = hours of work, L = hours of leisure, T = total time available

The above equation states that an hour more devoted to leisure is an hour less worked, and accordingly an hour's
less pay. Thus T in conjunction with P, V and W determine the size of the real income, I, of an individual. They
determine the budget constraints confronting the individual which can now be rewritten as, (which if G = I),
G = [V + W(T – L)]/P.
V = total amount of non-labor income

The equality reflects the assumption that individuals purchase the maximum amount of goods and services
permitted by their income; which can be rewritten as
G =V + WH
Now consider a diagrammatic representation of the budget constraint confronting the individual as in Fig 2.3. As
we move from left to right we enjoy increasing amounts of leisure. However, the amount of leisure time available
is now bounded by T, the time constraint.

I,G

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Imax= Gmax= V + (W)H
p p Slope = -W
P

G1 V
P

Leisure Work
L=O H=O
Fig 2.3 Constraints influencing an individual’s labour supply
If all the time at our disposal is taken as leisure, then T= L, and H = 0, and the only source of income is unearned
income V. V therefore represents the intercept on the vertical axis above point H=O and with V/P the individual
can only purchase goods and services equal to G1. At the other extreme if all the time is devoted to work, then
T=H; and L=O and maximum income (V + H(w) = V + T(w)] is obtained. This gives the intercept above point
L=O. This level of real income has been termed full income for it is the maximum attainable if individually
worked every hour at their disposal. In turn this would enable them to buy goods and services, equal to Gmax .

An increase/decrease in non labour income) would cause the income budget-line to upwards/downwards
in a parallel manner (the slope of the income budget line remains 'w'). The slope of the budget constraint
is negative and is given by the real wage rate; that is given by = -W/p and describes all possible income
levels which can be achieved by giving up leisure hours for work hours. An increase in the wage rate
would cause the budget-line to become steeper and rotate upwards

• The slope of the indifference curve, MRS, is equal to the amount of consumption you would
have to get in order to make you just as happy if you had to give up some leisure.
• The slope of the indifference curve is how much extra consumption you would need to get to
make you just as well off to give up some leisure.
• At any point, you would always willingly give up more leisure if the slope of indifference curve
is less than the real wage.
• You would also willingly give up consumption if the slope of the indifference curve was steeper
than the real wage.

(3). Optimization (The Optimal Position in the Labour Market)

Further Assumptions

 assume that all income [Y] is spent on consumer goods and services (none is saved) and that the
individual maximizes utility subject to an income budget constraint

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  we determine the optimal number of hours to labour supply in the labour market assuming that the
individual assuming that the individual supplies at least one hour of labour (i.e., the individual is in
the labour force).
The individual’s optimum or utility maximizing position can be determined by bringing together the subjective
preferences embodied in the indifference curves and the objective market information contained in each budget
line. That is, by maximizing their utility subject to the budget constraint. Formally this amount to reaching the
highest indifference curve they can subject to the budget constraint. This is illustrated as the point of tangency
between the indifference U and the budget constraint, with slope –W.
Illustration:- The determination of an individual’s hours of work. Of the T = 168 hours that are
available in the week the individual chooses to work H 1=60 hours at W = 10 birr, resulting in T-H 1 =108
hours of leisure, and real income, I1 of 1000 birr. I1 comprises V = 400 birr and H x W= 600 birr.
GRAPH 2.5

In diagrammatic terms, the individual is 'on' a given income budget line and wants to reach the highest
possible indifference curve. In Figure 2-5 assume that the individual has zero non-labour income and
faces the lower diagonal JZ income budget line (the higher kinked income budget line KXZ is used if the
individual has non labour income (unearned income). the tangency point of the highest attainable
indifference curve and the income budget line (point A in Figure 2-5). Therefore, for zero non-labour
income, point A is the 'optimal' utility-maximizing point. at this optimal point A, the individual will
supply Ha hours of labour, 'enjoy' La hours of leisure, and earn income of Ya = wHa

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2.2.1. The Effect of Non-Wage (Unearned) Incomes on Hours of Work
A change in unearned income at a given wage rate will lead to a parallel shift of budget line to the right
provided that leisure is a normal good. The presence of non-labour income allows the individual to reach
a higher indifference curve and the new optimal 'tangency' position. The causes of changes in unearned
income are many and varied. One source of unearned income may take in the form of transfer payments
or supplements to income paid by the government to those in work. For example, many countries pay
some grant toward the maintenance of children. The term Y/P therefore covers a wide range of different
contingencies, but common to all the above cases is the fact that Y/P is independent of hours worked
what happens to hours worked if there is an increase in any one of these elements or the introduction of a
new source of unearned income? Two possibilities are illustrated in fig 2.7, in which individuals A and
B display, respectively, a marked preference for leisure and a marked preference for goods and services.

I.G I.G
Imax=(W1)T+V Imax=(W1)T+V
P P W1 P P W1
P P
Imax=(W1T) P P Imax=(W1)T
I2 P
P I21
V I1 P
L=0 H H2 Y
H=0 P
Person A (corner solution)
Fig 2.7 Changes in unearned income L=0 H1 H2 H=0
Person B
Suppose that initially individual earn zero non labour income, then the budget line be written as I=W(T-L).
Thus, the full income is identical at Imax =( W1/P)(T-L). Now suppose that some has a form of unearned
income, i.e. V/P, is introduced in their income form. This source remains independent of the number of
hours worked. The effect of the introduction of unearned income is shifting the budget outward vertically
without change in wage rate (slope). Now at H=O, I=V/P and at full income when H=T, I max = V/P +
(W1/P)T. As a result of the rise in income both individuals A and B reduce their hours of work and the
points of tangency between the new budget constraint and the higher indifference curves lie to the northeast
of the original point. This reduction in hours at an unchanged wage rate has the effect of shifting the labour
supply curve to the left. Indeed in the extreme case of individual A, this person quits work altogether. The
difference between the behavior of individual A and B is a consequence of the shape of their indifference
maps and the differences in tastes that these reflect. In general therefore, a rise in unearned income leads
unambiguously to reduction in hours worked, provided leisure is a normal good.

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 An increase in non-labour income can lead some 'utility-maximizing' individuals (with strong
preferences for leisure) to leave the labour force. The following factors may lead a 'utility-maximizing'
individual not to participate in the labour force (where labour supply is zero).
 winning a large prize in a lottery, or receiving a large inheritance
 the government offering very generous transfer payments (such as welfare) to an individual
who can only earn a very low wage rate in the labour market
 an increase in a spouse's income, or in family income
Note also a corner solution at zero hours of work will occur when:
 the opportunity cost of time is relatively high, and/or the market wage rate is low
 The absolute value of the slope of the indifference curve at the point corresponding to zero hours of
work is the individual’s “reservation wage” (expressed in real terms). The reservation wage is the
wage rate at which the individual is indifferent between participating and not participating in the
labour force. If the real wage in the labor market exceeds the reservation wage, the individual chooses
to work. On the other hand If the real wage is less than the reservation wage, the individual chooses
to remain out of the labor force and a corner solution occurs

2.2.2. The Effect of a Wage Rate Change On Labour Supply

The effect of a wage rate change on labour supply (or hours of work) is decomposable into a substitution and an
income effect.
Income effect: captures the individual’s reaction to the change in real income occasioned by the change in the
wage rate, holding the relative price of leisure constant. Higher wages increase the labor income for the individual.
In effect, the individual is wealthier and their real income increase. This increase in income enables the individual
to purchase more of all commodities. If leisure is a normal good (demand for leisure is increasing in income), the
increase in potential income associated with an increase in the wage rate will lead to an increase in the
consumption of all goods including leisure and a decline in the supply of labor. In other words, the income effect
of a wage rate changes on leisure is always positive and on hours of work is negative provided that leisure is a
normal good). Using algebraic notation we define the income effect as change in hours of work (ΔH) produced by
a change in income (ΔY), holding wage constant (W)
Income effect =ΔH/ΔY <0, W
Substitution effect: Working in the opposite direction is the substitution effect. The substitution effect is the
change in labour supply attributable to a change in the wage rate holding the level of utility unchanged/
individual’s real income. Putting in different ways, substitution effect change in the mix of L and G resulting from
a change in relative prices, holding utility constant. The opportunity cost of leisure time rises as the wage rate
increases. As leisure time becomes more costly, individuals consume less leisure time and spend more time at

12
work. That is the individual to demand less leisure and work more This is the substitution effect resulting from a
higher wage. This substitution effect is sometimes referred to as a 'compensated' wage effect since the individual
has been compensated to maintain the same utility level (at the new wage rate). As long as the income-leisure
indifference curves are ‘normally’ shaped or convex (i.e. assumption of diminishing MRS holds) , we see that the
substitution effect of wage rate changes on leisure is always negative or on hours of work always positive

The substitution and income effects in the labor supply move in the opposite direction. Thus, an increase in the
wage rate can result in an increase or decrease in labour supply depending on the relative size of the positive
substitution effect and the negative income effect. If the income effect dominates the substitution effect, an
increase in the wage rate will lead to a decrease in the supply of labour. If the substitution effect is stronger than
the income effect, an increase in wages increases labor supply. The relative size of the substitution and income
effects depends on the level of the wage rate and on the individual's preferences for consumption goods G and
leisure L.

Figure 2.5 Income and Substitution Effect

of W1T=YN Wage Increase
-W1
Income

W0T=YN -W0

E’ E1

E0
U1

U0
Net effect
Substitution effect
Income effect
0 l’ l1 l0 T leisure
.

Figure 2-5 can be used to decompose the change in labour supply from an increase in the wage rate into
substitution and income effects. The substitution effect represents that part of the labour supply
adjustment that would occur if the individual remains on the original indifference curve (with the same
utility level) but receives the new wage rate. for an increase in the wage rate from W0 to W1 in Figure 2-5,
the substitution effect is represented by the movement from point E 0t o point E along the Uo indifference
curve, where E is the point on the original Uo indifference curve with slope equal to the new wage rate
W1 (the point of tangency of the original Uo indifference curve and a broken-line which is parallel to the
new budget line with slope W1). an increase in the wage rate from W 0 to W1 has a positive substitution
effect on the supply of labour (point E lies to the left of point E 0). The income effect represents that part

13
of the labour supply adjustment that occurs because of the increase in income (associated with the new
higher wage rate) and move to a higher indifference curve (holding the wage rate constant at the new
higher level W1). The income effect of an increase in the wage rate from W 1 to W2 is represented by the
movement from point E on the Uo indifference curve to point E1 on the U1 indifference curve (both points
on the two indifference curves have the same slope). an increase in the wage rate from W 0 to W1 has a
small negative income effect on the supply of labour (point E1 lies to the right of point E0). the net effect
of an increase in the wage rate from W0 to W1 is an increase in the supply of labour (point E1 lies to the
left of point Eo). the large positive substitution effect (Eo to E) dominates the small negative income
effect (E to E1). an increase in the wage rate from Wb to Wc leads to a much smaller increase in labour
supply.

However, the labour supply of a given nation can also be determined business cycle. This explained in
terms of Added-worker hypothesis and discouraged workers.

Added worker hypothesis is based on the idea that if one family members of household losses job the
other family member will temporary enter in to lobaour force in hope finding employment to offset the
decline in the family income.

Discouraged worker hypothesis: represent the idea that during the recession period some unemployed
worker ( for instance unemployed spouse) become pessimist about finding job with an accaeptable wage
rate and thereby temporary become non-participant

2.3. Derivation of the Backward Bending Labour Supply Curve

An individual’s tastes for leisure and goods may change over time as income grows. It is also possible
that these tastes differ between different segments of the population distinguished according to their
income level. If individuals with low levels of income have a low MRS, then a rise in the wage rate at
low-income levels might lead to an offer of increased hours of work. However as we move up the
income distribution the MRS increases, and beyond some level a rise in the wage rate may result in a
reduction in hours of work. At low incomes the substitution effect might dominate while at high incomes
the income effect might dominate. This possibility is illustrated for a single individual in fig 2.11. Up to
W5/P, the substitution effect dominates and the rise in the wage rate from W1/P to W 5/P results in an
increase supply of hours of work from H 1 to H5. Over this region the labour supply curve is positively
sloped as illustrated in fig 2.11 (b). However, beyond Ws/P further rises in the wage rate result in a

14
decrease in hours worked as the individual purchases more leisure. This is the result of a relative
steepening of the indifference curves; evidence of an increasing MRS, and this produces the backward
sloping segment of the labour supply curve shown in fig 2.11(b). Taken together this change in tastes as
the individual’s income increases, or the change in tastes as we move up the income distribution,
produces the backward bending labour supply curve shown in fig 2.11 (b). Individual tastes are evidently
of crucial importance in determining labour supply.

2.4. Extensions and Applications of the Income-Leisure Choice Model

For many jobs there is a 'standard' work-week (such as 9 to 5 Monday to Friday) in which the number of
hours of work per week is institutionally fixed (e.g. 40 hours). However there are obvious administration
and coordination costs for employers who allow employees to work whatever hours they choose,
whenever they choose. The income-leisure choice model can explain why some people moonlight at a
second job at a wage less than the wage they receive on their first job while other people require an
overtime premium to work more hours. In Ethiopia, “normal hours of work shall not exceed 8 hours a
day or 48 hours a week” (Labour Proclamation No.42/1993, Art 61). The exact amount is usually
recorded in the collective agreements concluded between the workers and employers in private industry
and in public enterprises. In the government sector (which includes the civil service) a standard workday
comprises of 8 hours or of 40 hours per week (Working Days and Hours of Government Offices
Proclamation No. 43/1993 as amended by Proclamation No. 45/1993). It is a common practice in many
countries to set legal limitations for hours of work, and the imposition of such laws restricts the income
leisure choice of individuals. Some may find the eight hours workday a bit long and feel over employed,
while other individuals in similar circumstances find themselves
Figure 2-9a illustrates the effect on the income budget line of a fixed 40 hour work week (L is measured
in hours per week)

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Figure 2-9a

Without a 40 hour per week constraint, the individual can choose any point along the income budget line
between point A and B . A 40 hour per week constraint limits the employee to one point, X . In such
case the employee cannot work less than 40 hours per week, which rules out the AX portion of the
income budget line. Also, the employee will not be paid for more than 40 hours per week, which rules
out the BX portion of the income budget line; if the employee does work more than 40 hours per week,
we assume they receive no additional pay (they would be on the DX line). So, the employee limited to
the shaded rectangle ODXE. Given convex indifference curves, the employee has no choice but to accept
point X when constrained by a fixed 40-hour workweek. However, without this fixed 40 hour per week
constraint, most individuals would not choose point X. The effect of a standard workday on labour
supply is explained the two lower panels of Figure 2-9 which illustrate the two basic possibilities
i. under-employment: in Figure 2-9b, the individual maximizes utility at point J (and would like to
work Lj hours) but is constrained to work only 40 hours. This implies that at 40 hours (point X)
the individual is 'under-employed' (working less hours than desired) and suffers a loss in utility (is
on a lower indifference curve Uo than at point J); the individual has less income and more leisure (less
work) than desired

Figure 2-9b

Over-employment: in Figure 2-9c, the individual maximizes utility at point K (and would like to work Lk
hours) but is constrained to work more hours (40) by the standard workday rule. at 40 hours (point X)
the individual is 'over-employed' (working more hours than desired) and suffers a loss in utility (is on a
lower indifference curve Uo than at point K); the individual has more income but less leisure (more work)
than desired

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Figure 2-9c

A standard workday legislation thus causes the underemployment of some workers ( and the over
employment of others. Those who feel they are over employed tend to compensate themselves for the
loss of leisure by going slow on their work, deteriorating the quality of production, increased
absenteeism, etc. Those that feel underemployed (as a result of the workday legislation), tend to look for
part-time or over-time work to earn complementary incomes..

2.5. Wage Elasticity of Labur Supply

To this point, we have been discussing the extent to which wage changes cause an individual to alter the
hours of work which he or she wishes to supply. stated differently, our discussion has focused on the
wage elasticity of labour supply. More precisely wage elasticity is defined as follows

Es = Percentage change in quantity of labour supplied

Percentage change in the wage rate
Over specific ranges of an individual’s labor supply curve, the elasticity coefficient may be zero
(perfectly inelastic), infinite (perfectly elastic), less than one (relatively inelastic), greater than one
(relatively elastic), or negative (backward bending).

Values of Es Description Results for hours of work

Es =  Perfectly elastic A rise in the wage rate results in an
infinitely large rise in hours worked
> Es>1 Relatively elastic A rise in the wage rate results in a larger
proportions rise in hours of work
Es = 1 Unitary elastic A rise in the wage rate results in an equal
proportions rise in hours worked
0 < Es < 1 Relatively inelastic A rise in the wage rate results in a less
than proportional rise i hours worked
Es = 0 Perfectly inelastic No change in hours worked.

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Given, work-leisure preferences and non-labour income, a change, in wage, rate traces out or locates the
individual’s labour supply curve. The elasticity of this curve for any particular wage change that is, the
sensitivity of hours one wants to work to a change in wage depends upon the relative sizes of the income
and substitution effects. But these movements along an existing individual labour supply curve should
not be confused with shifts in the entire supply curve. These shifts increases or decreases in labour
supply-occur in response to changes in either of two factors: non-labour income and work leisure
preferences. First, changes in non-labour income may shift an individual’s labour supply curve. For
example, receiving a large inheritance, qualifying for a pension, or becoming eligible for welfare benefits
may shift one’s labour supply curve left ward, that is cause a decrease in labour supply or conversely, a
significant decline in dividend income may produce an increase (right ward shift) in labour supply.
Second, a change in a work-leisure preferences (i.e., a person’s indifference map) may cause a shift in the
labour supply curve. For example, an improvement in working conditions, availability of child care, or
large medical bills may change one’s indifference map in ways that increase a person’s labour supply.
Working in the opposite direction, the purchase of a product which requires leisure to enjoy or the
attainment of a culturally acceptable retirement age may alter one’s indifference map such that labour
supply declines

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The Effect of Premium Wages and Straight-time Equvalents on labour Supply

Overtime Premiums for the Over-employed

In Figure 2-11 an 'over-employed' individual is forced to work 40 hours (at point D)
o the highest indifference curve passing through point D crosses below the budget line AB,
indicating that the individual would choose to work less than 40 hours if given the choice;
a higher indifference curve (not shown in Figure 2-11) is tangent to the AD section of the
income budget line

 Figure 2-11

 suppose that the firm occasionally requires people to work more than 40 hours per week, during peak
business periods
 if the firm offered additional hours of overtime at the normal wage W, no 'over-employed' individual
would volunteer to increase their hours beyond 40 (along the BD portion of the budget-line); to do so
would put the individual on a lower indifference curve and result in a decrease in utility (below U o in
Figure 2-11)
o similarly, no person with an indifference curve tangent to the income budget line at point D
would volunteer to increase their hours beyond 40
 overtime premium pay, say 'time-and-one-half' (adding 50% on top of the normal wage), may induce
an 'over-employed' individual to work additional hours
 in Figure 2-11 the normal wage (W) produces the budget line AB
 given that overtime hours begin at point D (40 hours), the income budget line segment for overtime
premium pay is represented by the dashed line GD; the slope of GD is 50% greater than the slope of
BD
 faced with this new kinked income budget-line ADG, the 'over-employed' individual can increase utility
by moving from point D to point H in Figure 2-11 and working (L h – 40) hours of overtime
 by offering overtime premium pay, an employer can induce 'over-employed' individuals to increase the
number of hours of work they are willing to supply
o overtime premium pay will also induce an individual who is not constrained by a fixed
workweek to supply more hours of labour
 given the fixed costs of hiring additional persons (see Chapter 6), a firm may find it profitable to offer
overtime premium pay to entice existing employees into working longer hours

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  provincial governments have passed laws (provincial labour codes) regulating the payment of overtime
pay; requiring firms to pay 'time-and-one-half' for specified overtime hours is not inconsistent with
increasing labour supply behaviour

In general, premium wage rates for overtime work will call forth more hours of work than will a straight-
time wage rate, which yields the same income at the same number of hours as that actually chosen by an
individual paid the overtime premium. Why the difference? The use of premium pay will have a
relatively small income effect because if applies only to hours worked in excess of Hh 1. In comparison
the straight-time equivalent wage will have a much larger income effect because it applies to all hours of
work. In simpler terms, the above figure 2.14 is essentially the labour market analog of price
discrimination in the product market. You might recall from elementary economics that the seller of a
product can obtain more revenue by charging different prices for different quantities of output. In the
present analysis we are simply observing that an employer can obtain a greater amount of labour for a
given outlay by paying different wage rates for different hours of work.

2.14 THE EFFECT OF PREMIUM WAGES AND STRAIGHT-TIME EQUVALENTS ON

LABOUR SUPPLY

Many work situations allow the payment of different wage rates for hours worked, which introduces
choice to the suppliers of labour. It is a common practice among many employers to pay a standard wage
for standard workday and to pay a relatively higher wage rate for overtime work.

Premium wage rate is a payment made for hours worked in excess of the standard workday where as a
straight time equivalent wage rate provides an identical daily or weekly income from the same number of
hours of work.

What impacts does the premium pay provision and a straight time equivalent wage rate have upon the
work-leisure decision? Does it make any difference with respect to work incentives to pay birr 4 per hour
for the first 8 hours of work and birr 6 per hour for an additional 2 hours of overtime or to pay birr 4.40
per hour for each 10 hours of work? Since both payment plans yield the same daily income of birr 44,
one is inclined to conclude it make no difference. But with the aid of Figure 2.14 we find that it does
make a difference
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Fig. 2.14 Premium Wages and Straight time Equivalent

We assume in Figure 2.14 that a worker is initially at the optimum point U 1 where HW is tangent to
indifference curve I1. At U1 the individual chooses to work Hh 1 hours, which we will presume to be the
standard workday. Let us now suppose that the employer offers additional hours of overtime work at
premium pay. This renders the uw segment of HW irrelevant and the budget constraint now become s
HU1P. We observe that the optimum position will move to u 2 on the higher indifference curve I2 and that
the worker will choose to work h1h2 additional hours. Daily earnings will be U2 h2.

Consider now the alternative of a straight time equivalent wage, that is, a standard hourly wage rate,
which will yield the same daily income of U 2h2 for the Hh2 hours of work. The straight time equivalent
wage can be shown by drawing a new budget line HW' through U 2. The budget lines HU1P and HW' will
both yield the same money income of U2h2 for Hh2 hours of work. The important point is that if
confronted with Hw’, the worker will want to move from U2 to a new optimum position at U3 where
fewer hours are worked. Stated differently, at U 2 indifference curve I2 cuts Hw’s from above; that is,
MRSL,Y is greater than the wage rate. This means that the worker subjectively values leisure more highly
at the margin than does the market, and hence, U 2 is no longer the optimum position under a straight
time pay arrangement; our worker will fell over employed when working Hh2 hours on a straight-time
pay plan.
.

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