Labor Supply Research Paper

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For economists, “labor supply” usually means the hours of work, usually per week, offered for pay or profit. This definition  therefore excludes unpaid  household work and voluntary work. Usually, the question of labor-force participation (the question of whether a person is working or looking for work) is treated separately. Research on both the theoretical and applied labor supply exploded in the 1980s and 1990s, with the work ranging from models of individual behavior in a static one-period model to dynamic multi-period models for a household. Simple theoretical models that gave a backward-bending supply curve  (where  labor  supply  first  increased and  then decreased with wage rates, for which little evidence exists) have given way to empirical labor-supply curves that are usually (but not always) positively sloped with respect to the wage rate. Beginning in the late twentieth century, much of the focus of research has been on labor supply as a whole, not  on  particular firms, industries, or  occupations.

The concept of “labor supply” is defined for economies with a well-developed labor market; that is, a market where wage labor is employed. The concept of labor supply in less developed countries (LDCs) is less clearly defined, because culture, history, and institutions affect labor  supply.  In  some  LDCs,  women  are  not involved in the formal labor market, and the labor activities that  women perform may be limited by tradition, either for religious or cultural reasons. Because precapitalist conditions exist in LDCs, labor in these nations is often tied to a particular feudal lord, and the worker does not  have the  freedom to  move from one employer to another, or from one location to another.

In LDCs, as the economy develops, labor moves from the agricultural sector to the industrial sector. W. Arthur Lewis, in his seminal 1954 paper “Economic Development with Unlimited Supplies of Labour,” put forward a dual-economy model in  which the  surplus agricultural labor (defined as labor with  a zero marginal product) moved to  the  industrial  (modern)  sector, providing a nearly infinite supply of labor at a constant wage. This provided a boost to economic development because the industrial sector could expand with a “surplus” (i.e., a profit) being created with cheap labor. The rapid growth of the Chinese economy in the first decade of the twentyfirst century provides an example of how surplus labor from agriculture can provide a boost to economic growth.

In general, there are important  differences in labor supply for males and females. Biology, history, and society have led to women spending more time in housework, child rearing, and various other domestic duties. For various reasons, including discrimination, society appears to have accepted a gender segregation of roles in the labor market. For example, women work in the textile industry while men work in mining, and women work as primary school teachers while men work as lawyers. Fortunately, many of these stereotypes are breaking down slowly, at least in most Western countries.

The labor supply in a particular economy can increase through  population  growth (natural  increase), immigration, an increase in people employed or looking for work, and through workers offering longer hours of work in each period. Although the labor supply of different educational or skill levels is considered in many models, the issue of the efficiency of labor services (i.e., how hard and diligently a person works) is usually ignored.

In most models of labor supply, the determination of the hours of work is derived from an assumption of utility-maximizing individuals who face given wage rates and prices and a time constraint. In  all these models, it is assumed that there is a disutility from work—that is, it is assumed that people do not like working. There is a good deal of evidence, however, from psychologists, sociologists, and industrial relations experts that work provides an individual with a set of contacts, imposes a time structure on the waking day, provides social status and identity, and  enforces activity (see Jahoda  1982).  Further,  an unemployed person often suffers from a level of despair that may lead to mental illness.

Standard neoclassical models are set up  to analyze competitive capitalist economies with a well-developed wage-labor market.  The  utility  function,  which  is unchanging over the life cycle, depends on leisure and consumption goods. An increase in the wage rate leads to a substitution effect (leisure becomes expensive) and an income effect (a person can purchase more leisure and goods). If leisure is a normal good, then these two effects work in opposite directions. The net effect of a wage rate change is therefore ambiguous. The introduction  of income taxes and social security payments make the analysis more complex, since the budget constraint becomes nonlinear.

In a novel extension to the concept of labor supply, George Becker argued in a 1965 paper that individuals choose “commodities” that are produced by combining consumer goods with the individual’s time. Hence, a consumer good that is purchased, such as meat, also needs time (e.g., cooking time, washing-up time) to form the “commodity” called dinner. The  time used in cooking thus has an “opportunity cost.” Alternatively, the “dinner” can be purchased in a restaurant with less time spent in obtaining it. The choice of cooking at home or eating out depends on the opportunity costs of time. For a professional person, the opportunity costs of cooking a meal are generally too high. This approach is especially useful in analyzing nonmarket work done (mainly) by women.

In an early model, labor supply was dependent on current wages and (expected) future wages, such that people would offer to work less in the current period if future wages were expected to  be  higher.  Robert  Lucas and Leonard Rapping deal with the intertemporal substitution of labor in  “Real Wages, Employment,  and  Inflation” (1969). In advanced models, labor supply is dependent on the planned time path of consumption goods and leisure, along with a choice of saving and wealth accumulation over an  entire lifetime. A critical assumption in  these dynamic models is of a utility function that is not affected by  habits  or  learning  (intertemporal  separability over time), as this could make the wage rates depend on individual’s behavior (see Card 1994). There are significant differences in the labor supply of males and females due to cultural and  institutional  factors. Typically, the  female labor supply is significantly affected by the number of preschool children in the family.

Expanded models of labor supply allow for joint household decision making, with bargaining between husband and wife (see Vermeulen 2002). The aggregate supply of hours depends on the number of people who are willing to work (given wage offers and their reservation wage) and the hours offered per person. Individuals are assumed to  work out  a “reservation wage,” meaning a wage below which they are not willing to work because the opportunity cost of leisure is too high. This reservation wage is obviously influenced by an individual’s age, education, experience, family commitments, social security benefits, and wealth status. Changes in the minimum wage are likely to lead to a change in the distribution of reservation wages, because the idea of “fair wages” will also change (see Falk, Fehr, and Zehnder 2005). Changes in reservation wages can also affect the aggregate supply of labor.

It is generally assumed that the individual can work as many hours at a given wage as she or he desires (either within  a firm, choosing different offers from different firms, or with multiple jobs). It is also usually assumed that there are no institutional constraints (e.g., a specified work week for a full-time person), and that the nonavailability of work (i.e., involuntary unemployment) is not a factor. Most estimates of labor supply are based on people who are working. This creates a selection bias, because it excludes those who want to work but cannot find work or have refused the wage offered to them. However, an individual can influence his or her wage through an appropriate investment in human capital, such as acquiring new skills or  additional  education.  In  some labor  markets (especially for highly skilled labor) an individual may be able to bargain for a package of wages, hours, and other perquisites.

Some empirical regularities have been seen in OECD (Organisation for Economic Co-operation and Development) countries in the post-war period. These include an increase in the number of women working, a decrease in the number of older males working, a fall in the average number of hours worked, and educated people working longer hours. Most of the research on this subject has focused on an econometric estimation of labor supply for males, females, and households. Econometric estimation has moved progressively  from time-series data to cross-section data to panel data. Most estimates of labor supply find  a  small  positive link  between  wages and  hours worked—known as “elasticity,” the percentage increase in labor supply as a result of a one percent change in the wage rate—although there is a large element of “unexplained” variance. A major interest has been the extent to which welfare benefits and changes in tax rates affect the labor supply. Policy changes in these and other areas could affect people’s  decision whether  or  not  to  seek work. Again, because most labor-supply models are based on data on working people, the possibility of selection bias must be considered.

Labor supply is also important from a policy perspective. How people respond to changes in tax rates, social security payments, and  other  institutional  features like minimum wages are all relevant. Much of the evidence is based on simple models of single-person (or “unitary”) households, and is thus subject to debate. The evidence on many of these issues is very controversial, especially the impact  of  minimum   wage on  employment.  And  as Richard Blundell and Thomas Macurdy point out, there is little evidence to support the view that welfare programs have a disincentive effect on the labor supply.

Even though there have been significant advances in the theoretical modeling of labor supply, and in econometric estimation techniques, there are still large gaps in our understanding of the impact of policy changes on labor supply. Models need to be extended to households in which people decide simultaneously whether to work and how many hours to work over a longer period, including their saving behavior, and with some allowance made for the existence of demand-constrained choices. The existence of persistent unemployment in most OECD economies suggests that a basic underlying assumption of labor supply models is unrealistic, namely that workers can choose whether to work and how many hours to work.

Bibliography:

  1. Becker, G 1965. A Theory of the Allocation of Time. Economic Journal 75 (299): 493–517.
  2. Blau, Francine , and Marianne A. Ferber. 1992. The Economics of Women, Men, and Work. 2nd ed. Englewood Cliffs, NJ: Prentice-Hall.
  3. Blundell, Richard, and Thomas Macurdy. Labor Supply: A Review of Alternative Approaches. In Handbook of Labor Economics, Vol. 3A, eds. Orley C. Ashenfelter and David Card. Amsterdam: North Holland.
  4. Card, D 1994. Intertemporal Labor Supply: An Assessment. In Advances in Econometrics, ed. Christopher Sims. Cambridge, U.K.: Cambridge University Press.
  5. Card, David, and Alan Krueger. 1995. Myth and Measurement: The New Economics of the Minimum Wage. Princeton, NJ: Princeton University Press.
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  7. Falk, Armin, Ernst Fehr, and Christian Zehnder. 2005. The Behavioral Effects of Minimum W IZA Discussion Paper No. 1625. Bonn, Germany: Institute for the Study of Labor.
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  18. Vermeulen, Fr 2002. Collective Household Models: Principles and Main Results. Journal of Economic Surveys. 16 (4): 533–564.

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