2025 Midterm 2 review COMM 220 Analysis of Markets
Concordia University
COMM 220 Midterm 2 Review:
Chapter 6: Supply of Labor to the Economy
Labor force participation rates (LFPR) - measure the willingness to work
Hours of work - controlled by supply and demand
Employers set hours of work expected of employees
Employees exercise their preferences via
Part-time or full-time work
More than once job
Selection of occupation and employers
Labor is most abundant and most important factor of production
A person’s discretionary time (16 hours) can be spent either
Working for pay to generate income for consumption (Y)
Leisure (L)
Demand for a good or service is determined by
Opportunity cost of the good (market price)
One’s level of wealth
One’s set of preferences
Opportunity cost of leisure
One’s wage rate = the extra earnings from an extra hour of work
Effects of increase in wages/income on leisure/work preferences can be categorized as
Income effect
Income rises⬆, desired work hours will fall⬇, demand for leisure hours rises⬆
Substitution effect
Wage rate rises⬆, opportunity cost of leisure rises⬆, work incentives rise⬆
Income and substitution effects separately
An income effect: received an inheritance or won the lottery
A substitution effect: raising gasoline tax but offsetting it by lowering social security tax
Normally both effects are present, often working in opposite directions
Actual labor response = sum of the income and substitution effects
If income effect dominates: labor supply curve negatively sloped: as W⬆, H⬇
If substitution effect dominates: labor supply curve positively sloped: as W⬆, H⬆
Individual labor supply curve depends on wage and bends backwards
, Analysis of the labor/leisure choice:
Uses indifference curves and budget constraints
An indifference curve connects various combinations of income and leisure that yield the
same level of utility
Preferences: U = f (Y,L)
Higher U means higher level of utility
∆Y*MUY + ∆L*MUL = 0
– ∆Y/∆L = MUL/MUY
∆Y/∆L = – MUL/MUY = MRSY,L
Characteristics of an indifference curve
-The northeastern curve is preferred to any curve to the southwest
-Indifference curves do not intersect
-Indifference curves are negatively sloped
-Indifference curves are convex
-Different people have different sets of indifference curves
Income (Y) and wage (W) constraints
The budget constraint shows the combinations of leisure and income that are possible
Y = total income = Y = WH + V
Slope of budget constraint = wage rate = ∆Y/∆H
∆Y/∆H = w or ∆Y/∆L = – w
A utility maximizer will choose the combination of income and leisure at the tangency of
the budget constraint to the highest indifference curve
Individuals who face the same budget constraint, but who have different preferences for
leisure, will make different choices about hours of work
Lower value of leisure – tangency to the left of point N (middle)
Higher value of leisure – tangency to the right of point N (middle)
An individual who has a strong preference for leisure would have no tangency point
The income effect: nonlabor incomes shift the budget constraint upward, holding W constant
Income and substitution effects with a wage increase
Workers would be wealthier and face a higher opportunity cost of leisure
Substitution effect > income effect: W⬆, H⬆
Which effect is stronger?
It depends on the slopes of the indifference curve and the budget constraint
The reservation wage is the wage below which a person will not work in the labor market
Empirical findings on the income and substitution effects:
Labour supply theory suggests that desired hours of work depends on:
Wealth, the wage rate, and leisure-income preferences
Overall, the observed substitution effects are positive while the observed income
effects are negative
Concordia University
COMM 220 Midterm 2 Review:
Chapter 6: Supply of Labor to the Economy
Labor force participation rates (LFPR) - measure the willingness to work
Hours of work - controlled by supply and demand
Employers set hours of work expected of employees
Employees exercise their preferences via
Part-time or full-time work
More than once job
Selection of occupation and employers
Labor is most abundant and most important factor of production
A person’s discretionary time (16 hours) can be spent either
Working for pay to generate income for consumption (Y)
Leisure (L)
Demand for a good or service is determined by
Opportunity cost of the good (market price)
One’s level of wealth
One’s set of preferences
Opportunity cost of leisure
One’s wage rate = the extra earnings from an extra hour of work
Effects of increase in wages/income on leisure/work preferences can be categorized as
Income effect
Income rises⬆, desired work hours will fall⬇, demand for leisure hours rises⬆
Substitution effect
Wage rate rises⬆, opportunity cost of leisure rises⬆, work incentives rise⬆
Income and substitution effects separately
An income effect: received an inheritance or won the lottery
A substitution effect: raising gasoline tax but offsetting it by lowering social security tax
Normally both effects are present, often working in opposite directions
Actual labor response = sum of the income and substitution effects
If income effect dominates: labor supply curve negatively sloped: as W⬆, H⬇
If substitution effect dominates: labor supply curve positively sloped: as W⬆, H⬆
Individual labor supply curve depends on wage and bends backwards
, Analysis of the labor/leisure choice:
Uses indifference curves and budget constraints
An indifference curve connects various combinations of income and leisure that yield the
same level of utility
Preferences: U = f (Y,L)
Higher U means higher level of utility
∆Y*MUY + ∆L*MUL = 0
– ∆Y/∆L = MUL/MUY
∆Y/∆L = – MUL/MUY = MRSY,L
Characteristics of an indifference curve
-The northeastern curve is preferred to any curve to the southwest
-Indifference curves do not intersect
-Indifference curves are negatively sloped
-Indifference curves are convex
-Different people have different sets of indifference curves
Income (Y) and wage (W) constraints
The budget constraint shows the combinations of leisure and income that are possible
Y = total income = Y = WH + V
Slope of budget constraint = wage rate = ∆Y/∆H
∆Y/∆H = w or ∆Y/∆L = – w
A utility maximizer will choose the combination of income and leisure at the tangency of
the budget constraint to the highest indifference curve
Individuals who face the same budget constraint, but who have different preferences for
leisure, will make different choices about hours of work
Lower value of leisure – tangency to the left of point N (middle)
Higher value of leisure – tangency to the right of point N (middle)
An individual who has a strong preference for leisure would have no tangency point
The income effect: nonlabor incomes shift the budget constraint upward, holding W constant
Income and substitution effects with a wage increase
Workers would be wealthier and face a higher opportunity cost of leisure
Substitution effect > income effect: W⬆, H⬆
Which effect is stronger?
It depends on the slopes of the indifference curve and the budget constraint
The reservation wage is the wage below which a person will not work in the labor market
Empirical findings on the income and substitution effects:
Labour supply theory suggests that desired hours of work depends on:
Wealth, the wage rate, and leisure-income preferences
Overall, the observed substitution effects are positive while the observed income
effects are negative
