Labor Supply

We assume that the individual will try to maximize their utility, within a fixed number of hours (24 hours a day). This means, there is a trade off (opportunity cost) between how many hours a person works and the hours spent on leisure.

The opportunity cost involved in working - forgone hours of leisure - give a backward bending supply of labor curve for the individual (see Figure 1).

The key to understanding the principle is the concept of utility. For example, if the consumer is in equilibrium, then the utility they get purchasing goods with the income they earn in the last hour will equal the utility they would gain from the last hour leisure time. (i.e. the Marginal Utilities per dollar spent on each of the activities are equal, exactly at the consumption optimum).

If the wage rate increased from W1 to W2 then due to a higher income the individual would have a greater utility, hence, they would be willing to increase their hours worked per day to L2. Over this section of the curve the substitution effect is positive, the income effect is negative, but the substitution effect is greater than the income effect. Therefore, the increase in the real wage rate will cause an increase in the number of hours worked.

However, if the wage rate increased from W2 to W3, then the number of hours worked per day would fall from L2 to L3. This is because the income effect is greater than the substitution effect.

The processes involved in the decision to work more or less hours is termed the income and substitution effects. The higher wage means that the individual could work fewer hours to maintain the same consumption patterns of goods and services. Therefore, the income effect would mean that an individual would work fewer hours. However, the substitution effect is that the higher wage will mean the utility gained from the last hour work is greater than the utility gained from an hour of leisure. This is because the higher wage means the individual can purchase more goods. Consequently, the individual will substitute work for leisure until the utilities equal (i.e the consumer is back in equilibrium between work and leisure).

An interesting issue is that individuals have different characteristics and utilities. Hence the degree of trade off between the utility of an hour worked and the utility of an hour of leisure will be different. This implies that the elasticity of substitution between leisure and consumption will vary. It is likely that the low income households will tend to be less responsive to wage changes than higher income groups due to the high substitution effect.