11.3 Labor Supply: How to Balance Work and Leisure
Your labor supply is the time you spend working in the market. And work is going to be a big part of your life. Let’s say that you work for 40 years before retiring at age 65, and for 48 weeks per year, you work a regular 40-hour week. Then you’ll spend 76,800 hours, or over 4.6 million minutes, as a labor supplier! Given this, it’s critical that you make smart labor supply choices.
Your Individual Labor Supply: Allocating Your Time Between Labor and Leisure
How much time should you allocate to work? There are only 24 hours in each day. And it’s up to you to decide how best to allocate them. So it’s best to treat time as a scarce resource and make the best choices you can.
The opportunity cost of working is everything you do when you’re not working.
It may not look like leisure, but it’s what he’d give up if he were working.
Every hour that you spend working is one less hour you have available for other things besides paid work. Economists call all this time “leisure” because it includes relaxing, hanging out with friends, or indulging your passions. But it also includes all sorts of unpaid work—like care-giving, taking classes and studying, making meals and cleaning your house—that few people think of as leisure. But we’ll lump them all together (along with sleep!) and call it all leisure, to clearly distinguish that time from time spent in paid work.
The opportunity cost principle tells us that the cost of work is forgoing time spent doing other stuff. The implication is that choosing the number of hours you work is equivalent to choosing your hours of leisure. This is why economists describe labor supply as being about the choice between labor and leisure.
Choose how many hours to work by thinking at the margin.
Deciding how many hours to work is clearly a “how many” choice. The marginal principle suggests that you break this decision up into a series of smaller, or marginal, questions, asking: Should I work one more hour?
This is one of those cases where the marginal principle might seem a bit unrealistic. After all, do you really get to decide whether to work one more hour? Sure, if you are self-employed—say, as a tutor or a babysitter—you often have direct control over your hours, and you can choose whether or not to accept more clients. But many jobs come with a fixed number of hours, such as office jobs that require you to work nine to five, five days per week. Even so, the marginal principle remains useful. For instance, if you want to work more hours you can look for a different job involving longer hours, or you could take on a second job. If you’re paid hourly, you can sometimes take on overtime shifts. In many professions, you’re paid a weekly salary that doesn’t depend on how many hours you work. But even then, you can choose to work longer hours. While the payoff won’t be a larger paycheck this week, your hard work will make it more likely that you’ll get a raise or promotion, which increases your future income.
In short, when you consider all these different margins of adjustment, perhaps it does make sense to say that you choose the hours you work even if you aren’t paid hourly. So the marginal question is relevant: Should you work one more hour?
The Rational Rule for Workers
The cost-benefit principle suggests that you weigh the cost and benefit of working one more hour. The benefit of working one more hour is the wage that you’ll earn; the cost is the hour of leisure you’ll do without. So the answer is: You should work one more hour if the wage is greater than the marginal benefit of leisure. In fact, this is the basis for a very useful rule:
The Rational Rule for Workers: Work one more hour as long as the wage is at least as large as the marginal benefit of another hour of leisure.
If you follow this rule, you’ll keep choosing more work and less leisure until the marginal benefit of one more hour of leisure is equal to the wage. Bottom line: Just as labor demand is all about your marginal revenue product, your labor supply is all about the marginal benefit of leisure.
The Rational Rule for Workers has some interesting implications for the shape of your labor supply curve. To see why, notice that it suggests that labor supply depends on two factors: the wage, and the marginal benefit of leisure. This means that there are two forces in play here. In fact, when the wage rises, there are two different effects, which work in opposite directions.
The substitution effect says that higher wages make work relatively more attractive.
The substitution effect measures how people respond to a change in relative prices. When your wage goes up, the opportunity cost of an hour of leisure goes up. It’s as if leisure becomes more expensive, because you’ll have to give up more money to get an hour of leisure. This is called the substitution effect because higher wages are an incentive to substitute more work for less leisure. The substitution effect is why people work longer hours when their wages rise, and so it leads to an upward-sloping individual labor supply curve, as shown in Panel A of Figure 6.
Figure 6 | Individual Labor Supply Curves
The income effect says higher income makes leisure more attractive.
The income effect measures how people’s choices change when they have more income. You learned in Chapter 2 that your demand for normal goods shifts to the right when your income rises. Because your demand curve is also your marginal benefit curve, this also means that your marginal benefit of normal goods goes up when your income increases. So what does this mean for leisure? For most people, leisure is a normal good, so a rise in income means an increase in the marginal benefit of leisure. Thus a higher wage—which boosts workers’ incomes—will lead them to choose more leisure, which means working fewer hours.
There’s another way of seeing this: A higher wage means that you have more income. What should you buy with your extra income? When your hourly wage rate rises, you don’t need to work as many hours to buy the things you were purchasing before. Rather than spending your pay increase buying more stuff, you might spend it buying more leisure time. The somewhat counterintuitive result is that the income effect provides a reason for workers to cut their hours in response to a wage rise. The income effect leads to a downward-sloping labor supply curve, as shown in Panel B of Figure 6.
Your labor supply curve depends on the balance of income and substitution effects.
Let’s put these pieces together. The Rational Rule for Workers tells you to compare the marginal benefit of another hour of working (which is the wage you would earn) with the cost, which is the marginal benefit of the hour of leisure you would have to forgo. When the wage goes up, there are two effects: A higher wage raises the marginal benefit of working another hour (that’s the substitution effect); and, because leisure is a normal good, it raises the marginal benefit of an extra hour of leisure (that’s the income effect). These two forces push in opposite directions.
How do these two offsetting forces work in practice? If the substitution effect is dominant, then your individual labor supply curve is upward-sloping, as shown in Panel A of Figure 6. If the income effect is dominant, then your individual labor supply curve may be downward-sloping (!), as shown in Panel B. And if the two effects exactly offset each other, then your individual labor supply curve is vertical, as in Panel C. Or if the income effect becomes more important when your wage is higher, then your individual labor supply curve might change from upward-sloping when your wage is low, to vertical to downward-sloping when your wage is high—as shown in Panel D. People may have very differently shaped individual labor supply curves, depending on how they value more money versus more time.
Do the Economics
Let’s discover your individual labor supply curve right now. Start by answering the labor supply survey in Panel A of Figure 7, which asks how many hours you would be willing to work each week if I offered you a different wage. As you respond, think about how income and substitution effects shape your answers. Then plot your responses in Panel B.
Figure 7 | Discover Your Individual Labor Supply Curve
What did you discover? Many students figure that they won’t work at all when the wage is too low. Eventually, when the wage is high enough, they find it worthwhile to work. As the wage rises further, some students decide to work more. But at some point, the wage is so high that some students opt to work fewer hours. Why? Because the higher wage means that they can still pay for the essentials if they work less, and they can use the extra time to increase their chances of succeeding in their studies. This is the income effect at work. If you followed this pattern, you may have sketched a backward-bending labor supply curve, as shown in Panel D of Figure 6.
The price elasticity of labor supply measures workers’ responsiveness to wages.
In Chapter 5 you discovered that the price elasticity of supply measures how responsive sellers are to changes in prices. We can adapt this idea to the labor market where you are supplying hours of your time and the relevant price is your wage. The wage elasticity of labor supply measures how the quantity of labor supplied responds to a change in the wage. Remember that when quantity is relatively unresponsive we describe supply as being inelastic. Few economists agree about the precise estimate of the elasticity of labor supply, but most economists agree that individual labor supply is relatively inelastic. Look back at your own estimates—how many more hours did you say you would work if you could earn $80 an hour? Was it less than twice as many hours as when the wage was $40? If so, your labor supply is relatively inelastic between $40 and $80 an hour. Let’s take a look at the evidence on the shape of labor supply curves.
Interpreting the DATA
Does the individual labor supply curve slope up or down?
The slope of the typical individual labor supply curve remains a matter of debate. Some economists have estimated the price elasticity of labor supply by looking at how people’s working hours change when their after-tax wage changes. If Congress passes an income tax cut, your after-tax wage rises, and people tend to work a little bit more. Most estimates suggest that it takes about a 10% after-tax wage increase to get people to work about 1–3% more. This evidence suggests that the labor supply curve is upward-sloping, but inelastic.
An alternative approach looks at differences in wage rates across people in different occupations. It turns out that the average number of hours worked is roughly the same among workers in high-paying occupations as it is for those in low-paying jobs. This evidence suggests that the labor supply curve is nearly vertical.
Finally, analyzing wage changes over long periods of time yields a different story. Over the past century, wages have risen enormously, and the typical workweek has declined, although by not a lot. This evidence that higher wages led to less work suggests that labor supply is downward-sloping.
While these different types of analyses point to qualitatively different conclusions, they’re quantitatively similar: The common thread to all of these observations is that the effect of changing wages on individual labor supply is relatively small. So the individual labor supply curve is nearly vertical for most people. But remember that some people won’t work at all if the wage is too low. In fact, higher wages raise the likelihood that people will work, which is the issue we’ll now turn to.
The Extensive Margin: Choose Whether or Not to Work
Total labor supply depends not just on how many hours each worker decides to supply, but also on how many people are in the workforce. In fact, only around two-thirds of adults are either working or looking for work, and many of the remaining one-third are homemakers, retirees, or full-time students. So we now shift our focus from the intensive margin (which describes the number of hours each worker supplies—a measure of how intensively existing workers supply their labor) to the extensive margin (which describes the number of people in the workforce—a measure of the extent of work).
To do so, start by putting yourself in the shoes of someone trying to decide whether to join the workforce or not. While the Rational Rule for Workers focuses on how many hours you should work if you decide to work, the decision of whether to work is an either/or question, and so the marginal principle doesn’t apply. Instead, start with the cost-benefit principle, which says to join the workforce if the benefits exceed the costs.
Consider the broad range of opportunity costs and benefits that come from working.
The benefits of working include not only the wage that you’ll earn, but also the nonwage benefits like health insurance that come with the job, along with the fact that today’s work experience might help boost your future earnings.
To see the costs of work, apply the opportunity cost principle, and ask “or what?” This question can be quite illuminating. For those who don’t have a compelling alternative use of their time, this opportunity cost might be quite small. But for parents with young children, the opportunity cost of work is not staying home to raise their kids. For many older people, the opportunity cost is not enjoying their long-awaited retirement. And for students, the opportunity cost might be not taking a full course load. These higher opportunity costs explain why these groups are particularly likely to opt out of the workforce.
The cost of searching for a job, the expense of buying business-appropriate attire, the drudgery of a long commute to and from work, and the difficulty of arranging child care are all fixed costs associated with working. They can lead some people to choose not to work at all, rather than just working a few hours a week.
Higher wages lead more people to enter the labor force.
The higher the wage is, the larger will be the share of the population for whom the benefits of joining the workforce exceed the costs. As a result, higher wages lead more people to decide to supply their labor to the market.
Okay, so far we’ve analyzed your choice of whether or not to work, and, if so, how many hours to work. There’s one more important choice you’ll make: the type of job to have. This choice determines the specific labor market you’ll supply your labor to.
Choosing Your Occupation
Do you remember when you were a kid and people asked you what you wanted to be when you grew up? If you were like many kids, you had a pretty narrow sense of possible occupations. Maybe you wanted to be a teacher, a firefighter, a doctor, or an athlete. In reality, there are actually hundreds of different occupations that you will ultimately choose among. How will you decide?
One of the first factors that you’ll think about when choosing an occupation is your likely earnings. The figure to the left shows the enormous variation in average annual incomes earned across a variety of occupations. You need to know the wages in different occupations so you can make a good choice about which career to pursue.
Apply the cost-benefit principle to figure out the right occupation for you.
The market wage will be a major factor influencing which occupation you choose. This is just the cost-benefit principle at work: The higher the income you’ll earn, the greater the benefit from joining a specific occupation. Thus, wages act as an important signal, directing workers into different occupations. The higher the wage, the more people will join a specific occupation.
But while wages are an important factor in deciding your occupation, they shouldn’t be the only one. Remember that the cost-benefit principle says that you should think broadly about the relevant costs and benefits.
Consider the Benefits
- Do what you love: There is truth in this old adage. After all, your working life will probably take up 40 hours of each week of your life until you retire. If you hate what you do, it will be hard to really give it your all over that much time, not to mention that it’ll probably make you quite unhappy. The trick is to find an occupation that matches your interests. If you love the ocean and find science interesting, then marine biologist might be the job for you. If you love meeting people, you might enjoy sales. If you love crunching numbers, become an analyst. When you love what you are doing, you’re be more likely to succeed. This isn’t just pop psychology—it’s serious economics: When you love your job, the effort required to succeed comes with a lower opportunity cost.
- Ask about benefits: Will you get health insurance, annual leave, housing assistance, or the opportunity for further training? These benefits can make a lower-wage job more attractive—a fact well understood by folks in the military.
- Think about the future: The skills that you are accumulating today will sustain you throughout your professional life. So plan your career around developing skills that will continue to be valuable.
- Follow your comparative advantage: Think about what you’re good at—or what you can do at a lower opportunity cost—relative to other people. That’s the career you’re most likely to succeed in. And that success will lead you to a better wage trajectory.
- Ask about the trajectory: Your starting salary is simply the beginning. In some occupations—such as medicine—there’s low pay and long hours in the first few years on the job. After that, the big money flows. Don’t just ask about your starting salary; find out what folks are earning after a decade of work.
Consider the Costs
- Evaluate the risks: Is this an occupation—such as musician or actor—in which only a few bright stars rise to the top and others earn very little? If so, don’t fall into the trap of overestimating the odds of success.
- Consider the volatility: If bonuses and commissions are a big part of the pay, will you still be able to get by if you have a bad year? Is your job at risk if the economy tanks? If so, can you deal with these risks?
- Don’t forget the hours: While your employer may technically be paying you for a 40-hour week, in some occupations the norm is that folks work much longer hours. Ask a corporate lawyer or management consultant, and you’ll hear they often work 80 or even 100 hours per week. If the marginal benefit you get from extra leisure hours is high, this isn’t the life for you.
Recap: Labor supply decisions involve whether you should work, how much you should work, and what you should do.
You face three key labor supply decisions in your life. First, you have to decide whether to work. Second, you have to decide how many hours to work. And third, you have to decide what kind of work you should do. All of these decisions boil down to applying the cost-benefit principle and considering your opportunity costs. You may also find that the interdependence principle is relevant when the answer to any one of these questions might influence how you answer the other two.
So you now know how people like yourself think about how many hours to work, the decision to work, and what kind of occupation to pursue. Our next task is to put all of this together to think about labor supply in specific occupational labor markets, such as the market for hair stylists.
The Market Labor Supply Curve
In the first half of the chapter, you saw that the market labor demand curve is downward-sloping. What about the market labor supply curve? Market labor supply curves are upward-sloping—meaning that the higher the wage in a particular occupation, the more people there are willing to work in that occupation. There are three reasons that the market labor supply curve is upward-sloping:
Reason one: New people may be induced to enter the workforce. Higher wages convince more people to work, rather than pursue alternatives, such as studying, retiring, or working as a homemaker. A higher wage for hair stylists may induce some people who weren’t working to decide to look for a job as a stylist. For example, a parent who stopped working as a stylist to stay home with their kids might be induced to go back into the labor market if the wage for stylists is high.
Reason two: Existing workers may put in more hours. When wages go up, people already working in that occupation may increase the number of hours they work. You already know that is likely to be a small effect, because while higher wages provide a greater incentive to work (the substitution effect), they also increase the demand for leisure (the income effect). So if the wages of hair stylists go up, on average the hours existing stylists work will go up a small amount.
Reason three: Some people may switch occupations. Remember that wages help shape which occupations people join. So if the wage of hair stylists increases, more people would apply for jobs as a stylist, rather than for jobs in retail or waiting tables. The ready supply of potential new hair stylists at this higher wage is large.
Putting this all together, these three reasons reflect three different types of decisions that people make:
- How many people decide to work,
- How many hours existing workers will put in, and
- Which occupations people choose.
The third decision is important enough to ensure that the market labor supply curve in almost every occupation is upward-sloping. This holds even if individual labor supply curves of existing workers aren’t upward-sloping. Why? Even if a higher wage won’t induce you to work more hours, or even if it won’t induce many more people to work, it will induce others to enter your occupation in order to earn that higher wage. This ensures that the total quantity of hours supplied in the market for hair stylists—or any other occupation—rises with the wage, as suggested by the upward-sloping market labor supply curve shown in Figure 8.
Figure 8 | Market Labor Supply Curve for Hair Stylists
Analyzing Labor Supply Shifts
Let’s now turn to using our deeper understanding of labor supply to forecast how changing economic conditions cause labor supply curves to shift. The key will be the interdependence principle, which reminds us that labor supply decisions are connected to other markets and to government policies. As we work through the four factors that shift labor supply curves, remember that an increase in labor supply shifts the curve to the right, while a decrease in labor supply will shift it to the left.
Labor supply shifter one: Changing wages in other occupations.
The market for hair stylists is connected to the market for workers at skin-care salons. If wages for skin-care specialists rise, some hair stylists will look for work in the skin-care industry instead. Consequently, wage increases in jobs that compete for similar workers reduce the supply of labor, shifting the supply curve to the left. And if wages in these other occupations fall, skin-care workers will become hair stylists instead, increasing the available labor supply of hair stylists (shifting the labor supply curve of hair stylists to the right).
Labor supply shifter two: Changing number of potential workers.
The total number of people in the labor market is a subset of the total number of people in a society. That means that when the population grows, so does potential labor supply. Population can grow because more people are born than are dying—which happens either because of an increase in births or an increase in life expectancy. The population can also grow through immigration. Population growth typically increases labor supply, while a decrease in the population decreases labor supply.
The age distribution of the population also matters. Few children or elderly folks work. People are most likely to work in their 30s and 40s, so growth in the population in this age range boosts labor supply. But a shift in the age distribution toward retirement age—as is currently underway in the United States and other developed countries—leads to a decrease in labor supply, shifting the labor supply curve to the left, since fewer of these folks work.
Labor supply shifter three: Changing benefits of not working.
Remember that the decision to work or not work in the labor market is driven by comparing the wage with the foregone benefits of not working. So anything that changes the benefits of not working will shift the labor supply curve. For instance, a government program that makes college more affordable will lead to a decrease in labor supply among young workers as more of them choose to pursue education. (And after those students graduate with degrees—such as in accounting—it will increase the labor supply of accountants.)
Anything that lowers the cost of child care will increase the labor supply of parents, by reducing their benefit of staying home and providing the care themselves. And if Congress were to reduce Social Security retirement payments to older Americans, then the labor supply of people over age 60 would likely increase.
Similarly, various government support programs aimed at helping people without a job—such as unemployment insurance, disability insurance, food support, and welfare (officially called “Temporary Assistance for Needy Families”)—have an unintended side effect: They increase the opportunity cost of working. As a result, these programs induce some people to work less or not work at all, reducing labor supply. In some countries, these benefits are so generous that taking a job only increases your income by a tiny amount. Government programs in the United States are typically much less generous, so there is less of a work disincentive. The disincentive effects are also muted by the strict rules governing these programs: You can’t get unemployment insurance or welfare unless you are actively training or looking for a job; you can’t get disability insurance unless a doctor certifies a condition; and you can’t get food support unless you have a low income and are working (or are elderly or have a disability).
Labor supply shifter four: Nonwage benefits, subsidies, and income taxes.
So far we’ve described the wage as if it represents the total benefit to working. But in reality, there are other factors to consider, which is why workers focus on their after-tax total compensation, taking account of all nonwage benefits, taxes, and subsidies. For instance, most employers offer nonwage benefits such as health insurance, retirement benefits, paid days off, meals, and subsidized transportation. In addition, working provides you benefits when you retire through Social Security or, if you become unemployed, through unemployment insurance. Some government programs also provide wage subsidies so that the government effectively supplements your paycheck for each extra dollar you earn. These nonwage benefits and subsidies increase the benefit of working another hour. On the flip side, income taxes reduce the benefit of working, because you only get to keep a proportion of each extra dollar you earn. An increase in income tax rates reduces the benefit of working another hour.
Changes in nonwage benefits, subsidies, and income taxes will change the total compensation a worker gets at any given wage, shifting their willingness to work and hence the labor supply curve. At the individual level, whether changes in these factors lead to an increase or decrease in labor supply depends on whether the income or substitution effect dominates. At the aggregate level it’s a bit simpler, as the market labor supply tends to be upward-sloping. Consequently, an increase in nonwage benefits or subsidies, or a decrease in income taxes, will lead to an increase in labor supply, shifting the curve to the right. And a decrease in nonwage benefits, a decrease in subsidies or an increase in income taxes will cause a decrease in labor supply, shifting the curve to the left.