No Such Thing as a Free Lunch: Principles of Economics (Part 152)

Without labor nothing prospers.

Sophocles

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part B)

by

Charles Lamson

The Labor Supply Decision

The size of the labor force in an economy is of obvious importance. A growing labor force is one of the ways in which national income/output can be expanded, and the larger the percentage of people who work is, the higher the potential output per capita.

So far, we have said little about the things that determine the size of the labor force. Of course, demographics are a key; the number of children born in 2020 will go a long way toward determining the potential number of 20 year old workers in 2040. In addition, immigration, both legal and illegal, plays a role.

Also behavior plays a role. Households make decisions about whether to work and how much to work. These decisions are closely tied to consumption decisions, because for most households the bulk of their spending is financed out of wages and salaries.

Households make consumption and labor supply decisions simultaneously. Consumption cannot be considered separately from labor supply, because it is precisely by selling your labor that you earn income to pay for your consumption.

The alternative to supplying your labor in exchange for a wage or salary is leisure or other nonmarket activities. Nonmarket activities include raising a child, going to school, keeping a house, or---in a developing economy---working as a subsistence farmer.

What determines the quantity of labor supplied by a household? Among the list of factors are the wage rate, prices, wealth, and nonlabor income.

The Wage Rate A changing wage rate can affect labor supply, whether the effect is positive or negative is ambiguous. For example, an increase in the wage rate affects a household in two ways. First, work becomes more attractive relative to leisure and other nonmarket activities. Because every hour spent in leisure now requires giving up a higher wage, the opportunity cost of leisure is higher. As a result, you would expect a higher wage would lead to a larger labor supply---a larger workforce. This is called the substitution effect of a wage rate increase.

On the other hand, households who work are clearly better off after a wage rate increase. By working the same number of hours as they did before, they will earn more income. If we assume that leisure is a normal good, people with higher income will spend some of it on leisure by working less. This is the income effect of a wage rate increase.

When wage rates rise, the substitution effect suggests that people will work more, while the income effect suggests that they will work less. The ultimate effect depends on which separate effect is more powerful. The data suggests that the substitution effect seems to win in most cases. That is, higher wage rates usually lead to a larger labor supply, while lower wage rates usually lead to a lower labor supply.

Prices Prices also play a major role in the consumption/labor supply decision. In our discussions of the possible effect of an increase in the wage rate, we have been assuming that the prices of goods and services do not rise at the same time. If the wage rate and all other prices rise simultaneously, the story is different. To make things clear we need to distinguish between the nominal wage rate and the real wage rate.

The nominal wage rate is the wage rate in current dollars. When we adjust the nominal wage rate for changes in the price level, we obtain the real wage rate. The real wage rate measures the amount that wages can buy in terms of goods and services. Workers do not care about their nominal wage---they care about the purchasing power of this wage---the real wage.

Suppose skilled workers in Indianapolis were paid a wage rate of $20 per hour in 2020. Now suppose that their wage rate rose to $22 in 2021, a 10 percent increase. If the prices of goods and services were exactly the same in 2021 as they were in 2020 the real wage rate would have increased by 10 percent. An hour of work in 2021 ($22) buys 10 percent more than an hour of work in 2020 ($20).

What if the prices of all goods and services also increased by 10 percent between 2020 and 2021? The purchasing power of an hour's wages has not changed. The real wage rate has not increased at all. In 2021, $22 bought the same quantity of goods and services that $20 bought in 2020. 

To measure the real wage rate, we adjust the nominal wage rate with a price index. There are several such indexes that we might use, including the Consumer Price Index and the GDP Price Index.

We can now apply what we have learned from the life cycle theory to our wage/price story. Recall the life cycle theory says people look ahead in making their decisions. Translated to real wage rates, this idea says:

Households look at expected future real wage rates as well as the current real wage rate in making their current consumption and labor supply decisions.

Consider medical students who expect their real wage rate will be higher in the future. This expectation obviously has an effect on current decisions about things like how much to buy and whether or not to take a part-time job.

Wealth and Nonlabor Income Life-cycle theory says wealth fluctuates over the life cycle. Households accumulate wealth during their working years to pay off debts accumulated when they were young and to support themselves in retirement. This role of wealth is clear, but the existence of wealth poses another question. Consider two households that are at the same stage in their life cycle and have pretty much the same expectations about future wage rates, prices, and so forth. They expect to live the same length of time, and both plan to leave the same amount to their children. They differ only in their wealth. Because of a past inheritance, household 1 has more wealth than household 2. Which household is likely to have a higher consumption path for the rest of its life? Household 1 is because it has more wealth to spread out over the rest of its life.

Holding everything else constant (including the stage in the life cycle), the more wealth a household has, the more it will consume, both now and in the future.

Now consider a household that has a sudden unexpected increase in wealth, perhaps an inheritance from a distant relative. How will the household consumption pattern be affected? The household will increase its consumption, both now and in the future, as it spends the inheritance over the course of the rest of its life.

An increase in wealth can also be looked on as an increase in nonlabor income. Nonlabor, or nonwage, income is income received from sources other than working---inheritances, interest, dividends, and transfer payments such as welfare payments and Social Security payments. As with wealth:

An unexpected increase in nonlabor income will have a positive effect on household consumption.

What about the effect of an increase in wealth or nonlabor income on labor supply? We already know an increase in income results in an increase in the consumption of normal goods, including leisure. Therefore, an unexpected increase in wealth or nonlabor income results in both an increase in consumption and an increase in leisure. With leisure increasing, labor supply must fall, so:

An unexpected increase in wealth or nonlabor income leads to a decrease in labor supply.

This point should be obvious. If I suddenly win a million dollars in the state lottery or make a killing in the stock market, I will probably work less in the future than I otherwise would have. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 610-611*

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