An Analysis on Danish Micro Data - School of Economics and ...

2 Economic theory
Different factors influence the choice of participating in the labour market. The main focus in this
thesis is how health influences employment. The aim of this chapter is to present the theoretical
background of the analysis carried out in this thesis and in particular how labour supply is affected
by mental or physical illness.
First a static model of labour supply is presented. The model is based on microeconomic theory,
more specifically theory from labour economics. Thereafter a model of the demand for health is
introduced in order to give an understanding of how health relates to the individuals’ utility
maximization in general. As an extension to the health economics theory, an introduction is given to
the concept of compliance, since compliance improves the health condition and thereby the
employment status.
2.1 A static model of labour supply 23
The supply of labour can be modelled using a very simple static model. The model originates from
consumer demand theory and has been extended to labour supply theory. Since the model is static,
it only considers one time period and it does not consider interference by the government like taxes
and transfers.
It is assumed that the individual has an endowment of time, L0. He can ‘sell’ his time in the market
by working H hours, or he can ‘consume’ leisure time equal to L. 24 With this in mind he maximizes
his utility function:
U = U ( C,
H,
V , Z)
,
where C stands for consumption of commodities, H stands for hours of work, V stands for observed
characteristics and Z stands for unobserved characteristics. The individual maximizes his utility
function subject to his budget constraint:
PC = WH + I ,
where P represents the unit price of the commodities, W represents the hourly wage rate and I
stands for the non-wage income.
When the individual maximizes the utility function with respect to C and H, he chooses them such
that C > 0 and H ≥ 0.
This gives the possibility for either an interior solution for hours of work,
23 The model is based on Pencavel (1986), Ruhm (1992) and Cahuc & Zylberberg (2004)
24 H + L = L0
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