Chapter Review Chapter 7: Labor Markets
- The decision about how to allocate time between work and leisure can be analyzed using the basic ideas of budget constraints and preferences. Individuals face a trade-off along a budget constraint between leisure and income. The amount of income a person can obtain by giving up leisure is determined by the wage rate.
- In labor markets, the substitution and income effects of a change in wages work in opposite directions. An increase in wages makes people better-off, and they wish to enjoy more leisure as well as more consumption; this is the income effect. But an increase in wages raises the opportunity cost of leisure and encourages more work; this is the substitution effect. The overall effect of a rise in wages will depend on whether the substitution or income effect is actually larger.
- An upward-sloping labor supply curve represents a case in which the substitution effect of higher wages outweighs the income effect. A relatively vertical labor supply curve represents a case in which the substitution and income effects of higher wages are nearly equal. A backward-bending labor supply curve represents a case in which the substitution effect dominates at low wages (labor supply increases as the wage increases), but the income effect dominates at high wages (labor supply decreases as the wage increases).
- The basic model of choice between leisure and income also can be used to analyze decisions concerning labor force participation, including when to enter the labor force and when to retire.
- The demand for labor arises from the firm's demand for the factors of production. To maximize profits, the firm will use labor up to the point at which the value of the marginal product of labor equals the wage. This means the marginal product will equal the real wage.
- In this basic competitive model, the real wage adjusts in labor markets to balance supply and demand.
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