ELM Part 2- Economic modelsManuela Samek

References• Adnett N. (1996) European Labour Markets,

chapter 2.1,2.2; 4.2, 4.3;5.5,5.6;7.2,7.3,7.4

• Blanchard O. (2006) European Unemployment, Economic Policy no.45 Jan.2006

Some questions looking for an answerThe labour market performance of EU countries presents

some problems which need to be addressed:• Why the EU is not able to create enough jobs for its active

population? What factors influence labour demand?• Why participation and employment rates in some

countries are very low especially for women and for the less educated? What factors influence labour supply?

• Why unemployment is so persistent, especially among some groups of the population?

• Why there are differences across countries? What is the role of labour market institutions?

• What policies may be introduced to improve the labour market performance of EU countries?

Economic models try to answer to these questions

Economic models• Economic models of labour supply help to explain labour supply

decisions and differences in participation rates across different groups of the population. They also help explaining the influence of working hours regulation, the taxation and the welfare systems on labour supply decisions;

• Economic models of labour demand explain how firms decide if and how much labour to employ in the productive process. Models of labour demand with adjusting costs consider the relation between employment protection legislation and labour market performance;

• Search and matching models help the analysis of search behavior and the matching of labour demand and supply, in order to derive what variables affect unemployment duration and labour market mismatches;

• Wage determination models help to explain why wages are not flexible and what variables affect wage bargaining and its effects on the wage dynamics and structure.

• Human capital models help to explain why individuals invest in education and training an what are the individual and social returns of this investment.

THE ECONOMIC APPROACH TO THE LABOUR MARKET

Main assumptions of the baseline neoclassical model (1)

• In the labour market buyers (firms, labour demand) and sellers (individuals, labour supply) of labour exchange labour services for pay. Wages are the price of labour services.• Agents (buyers and sellers) are rational: on the basis of their tastes and constraints they try to maximise their objective function. The objective of buyers (firms) is to maximise profits; the objective of sellers (individuals) is to maximise utility. 

Main assumptions of the baseline neoclassical model (2)

• Markets are competitive. There are many sellers and buyers which are price takers: they cannot affect wages or prices which are completely flexible and are set only by the movements of demand and supply. The equilibrium wage and price are those determined by the equality of demand and supply.

•  Individuals and firms are homogenous•  Individuals and firms have a complete information

on labour market conditions•  There are no constraints to labour and firms’

mobility

Labour supply

At the aggregate/macroeconomic level, labour supply is the results of the aggregation of individuals’ decisions relative to:

Labour market participation Fertility decisions and migration flows which define the size of the

working age population

The labour force (LF) function/curve represents the size of the labour force at different levels of the real wage (W/P).

We assume that aggregate participation increases with the real wage.

At the microeconomic /individual level, labour supply is the result of the individual choice between work (which determines consumption possibilities) and leisure (which increases the well being of the individual).

We assume that the individual may freely choose the amount of work

to supply in the labour market.

LABOUR SUPPLY at the individual level (1)

The labour supply function (Ls) represents the behaviour of the sellers of labour. It indicates the amount of work that individuals or households are willing to supply at each wage rate. Labour supply depends on:       Individual tastes and preferences        The real wage rate        Non labour income (which reflects the system of welfare support such as subsidies or unemployment benefits).

LABOUR SUPPLY at the individual level (2)

The individual maximise her/his utility function (which depends on her/his preferences in relation to consumption and leisure and is represented by utility or indifference curves) under an income and time constraint (which depends on the income she/he may get either working or not and the time available)

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max

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LABOUR SUPPLY (3)

• On this basis decision to participate to the labour markets depends on the comparison between the (net of taxes) market real wage and the reservation wage. The individual participate only if the market wage is greater then the reservation wage.

• The reservation wage is the wage below which individuals do not wish to work. The reservation wage depends on non labour income and preferences.

• Changes in non-labour income and tastes shift the position of the supply curve, while changes in the real wage result in movements along the supply curve

Labour supply at the individual level

LABOUR SUPPLY (3)

• Any rise in the real wage (W/P) generates two opposite effects:

a) the increase in the opportunity cost of leisure and home production generates a subsitution of work for leisure, so labour supply increases (substtituion effect)

b) the increase in income will consent to “buy” more leisure and reduces labour supply (income effect)

• In the short run we assume that, given individuals’ preferences and non-labour income, the quantity of labour supplied is a positive function of the real wage (we assume that the substitution effect is higher than the income effect for a relevant range of wages)

Effect of an increase in real wageincome effect > substitution effect

Effect of an increase in real wageincome effect < substitution effect

•  A rise in non labour income (such as unemployment benefits) reduces labour supply, by increasing the reservation wage

• All factors which affect the reservation wage and the market wage affect labour supply: family composition, welfare subsidies, taxes. But also employment and working time regulations affect labour supply, especially in the case of secondary workers (such as married women) .

• In household labour supply models, the secondary worker considers the primary worker’s wage as non labour income. Hence changes in the wage of one component of the household, affect not only his/her labour supply, but also the labour supply of other components.

LABOUR SUPPLY (4)

Effects of subsidies (non labour income) on labour market participation

Individual labour supply curve

The effect of child care subsidies on labour market participation

Estimations of labour supply

• Usually labour supply is estimated using the following regression:

L=0+ 1W+ 2X+ε

• Empirical studies show that usually:– men labour supply is not sensible to changes in real

wages (UNELASTIC) (the income effect compensate the substituion effect)

– Women labour supply is usually sensible to changes in real wages (ELASTIC) (the substituion effect is usually prevalent)

Tab 3.4

Extensions of the basic model

Main extensions of the basic model:– Household models to consider interactions

among households components in labour supply decisions. These models are very useful to explain women labour supply.

– Life cycle models to considier the possibility of changes in preferences and market wages during the life cycle of individuals. Very useful to explain how labour supply changes with age

– Human capital models to consider the possibile interactions among consumption choices, investment in human capital and labour supply

Main predictions of economic models of labour supply

– Labour supply decisions reflect individual and household conditions, preferences, non labour income and market wages.

– The probability to participate to the labour market and hours supplied usually increase when:

o the market wage increases, but over a certain level of hours worked and market wage, further increases in wages may reduce hours worked;

o Non labour income declines;o The costs to be undertaken in order to work decline, especially

for secondary workers– Restrictions on working hours oblige individuals to accept

second best solutions and may reduce the labour supply of secondary workers,

– Taxation and welfare policies affect labour supply differently for the different components of the household