[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Review and Practice
SUMMARY
1. 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.
2. 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.
3. 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).
4. 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.
5. 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.
6. In this basic competitive model, the real wage adjusts in
labor markets to balance supply and demand.
KEY TERMS
nominal wage
real wage
labor force participation decision
reservation wage
factor demand
value of the marginal product of labor
real product wage
REVIEW QUESTIONS
1. How do people make choices about the amount of time
to work, given their personal tastes and real wages in
the market?
2. How will the income effect of a fall in wages affect hours
worked? How will the substitution effect of a fall in
wages affect hours worked?
3. What does the labor supply curve look like if the income
effect dominates the substitution effect? What will it
look like if the substitution effect dominates the income
effect?
4. How does a technological change that makes workers
more productive affect the demand for labor at a given
wage and price?
5. How does an increase in the price of a firm’s output
affect the firm’s demand for labor at a given wage?
6. Why is the labor demand curve downward sloping?
PROBLEMS
1. Imagine that a wealthy relative dies and leaves you an
inheritance in a trust fund that will provide you with
$20,000 per year for the rest of your life. Draw a diagram
to illustrate this shift in your budget constraint
between leisure and consumption. After considering the
ideas of income and substitution effects, decide whether
this inheritance will cause you to work more or less.
2. Most individuals do not take a second job (moonlight),
even if they can get one—say, as a taxi driver—even
though their “basic job” may require them to work only
37 hours a week. Most moonlighting jobs pay less per
hour than the worker’s basic job. Draw a typical
worker’s budget constraint. Explain why the budget
186 ∂ CHAPTER 8 LABOR MARKETS