Chapter 5: Labour Markets and Unemployment
2. Demand and Supply in the Labour Market
Supply for labour: households
Demand for labour: firms
Consumption-leasure trade-off = households value both consumption and leisure. They
balance the two the best they can, given the possibilities available to them.
Indifference curves = combinations of consumption and leasure have the same utility.
The negative slope of the curve shows that there is a trade-off: taking a unit of consumption
requires compensation in the form of more leisure.
Marginal rate of substitution of consumption for leisure = the rate at which a household is
willing to give up consumption for leisure, holding satisfaction constant.
! As a good becomes increasingly scarce, the marginal rate of substitution of other goods for
that particular good increases.
For households with access to a labour market, the price of leisure is the real (consumption)
wage. It is measured as a ratio of an average nominal wage (M) to the consumer price index
(P), the price of goods. If total available time for work is denoted as L and the hourly real
wage is w = W/P, the value of someone’s total time endowment in terms of consumption is
Lw. This endowment can be allocated between C units of consumption and l hours of leisure.
So: Lw = lw + C This equation is someone’s budget constraint.
Highest possible utility achieved in the point where an indifference curve is tangent to the
budget line.
Substitution effect = the relative attractiveness of leisure declines because its relative price
has risen. This would encourage someone to take less leisure, work harder, and consume
more.
Income effect = increase in income would lead to enjoying both more consumption and
more leisure, which means working less. So: working less in response to a wage increase.
The aggregate labour supply remainds the sum of many individual decisions. While individual
labour supply is measured in hours during some period of time, aggregate supply is
measured in person-hours, the total amount of hours supplied by all workers during that
same period.
! The aggregate labour supply curve is less steep than that of individual households for two
reasons:
(1) It represents the summation of a great number of upwardly sloped individual supply
curves.
(2) New workers choose to enter the labour force as wages rise.
2. Demand and Supply in the Labour Market
Supply for labour: households
Demand for labour: firms
Consumption-leasure trade-off = households value both consumption and leisure. They
balance the two the best they can, given the possibilities available to them.
Indifference curves = combinations of consumption and leasure have the same utility.
The negative slope of the curve shows that there is a trade-off: taking a unit of consumption
requires compensation in the form of more leisure.
Marginal rate of substitution of consumption for leisure = the rate at which a household is
willing to give up consumption for leisure, holding satisfaction constant.
! As a good becomes increasingly scarce, the marginal rate of substitution of other goods for
that particular good increases.
For households with access to a labour market, the price of leisure is the real (consumption)
wage. It is measured as a ratio of an average nominal wage (M) to the consumer price index
(P), the price of goods. If total available time for work is denoted as L and the hourly real
wage is w = W/P, the value of someone’s total time endowment in terms of consumption is
Lw. This endowment can be allocated between C units of consumption and l hours of leisure.
So: Lw = lw + C This equation is someone’s budget constraint.
Highest possible utility achieved in the point where an indifference curve is tangent to the
budget line.
Substitution effect = the relative attractiveness of leisure declines because its relative price
has risen. This would encourage someone to take less leisure, work harder, and consume
more.
Income effect = increase in income would lead to enjoying both more consumption and
more leisure, which means working less. So: working less in response to a wage increase.
The aggregate labour supply remainds the sum of many individual decisions. While individual
labour supply is measured in hours during some period of time, aggregate supply is
measured in person-hours, the total amount of hours supplied by all workers during that
same period.
! The aggregate labour supply curve is less steep than that of individual households for two
reasons:
(1) It represents the summation of a great number of upwardly sloped individual supply
curves.
(2) New workers choose to enter the labour force as wages rise.
