07 December 2007

“S” for Labor Supply

Our moderator, Jan Jablonski, seems to say: assumptions, stupid!

In international economics there is always a moment when we go into a murky waters of international comparison. There are several traps that we should be aware of. One of the greatest sins of an economist is to uncritically employ the analytical apparatus which was previously invented. In other words, there is a high probability of a mistake of some sort if one uncritically uses analytical tools developed for the US and applies them to i.e. Cambodia. What is the most fragile part? As usual it is assumptions. One needs to check if they hold to a reasonable extent. The problem seems to be vital especially in the field of international comparison, given the tremendous variety between economies around the world. This brings us to the actual topic of this short text which is the differences in labor supply among countries that find themselves in different stages of development.

Why labor supply? It is the area in which making a mistake in a simple copying market model with its usual parameters might bring a serious mistake. Usually labor market is assumed to work as any other market. A negative slope of a demand function does not need a particular explanation. Positive slope of a labour supply has its nice explanation. When wage raises the cost of not working also rises and substitution effect (being stronger than income effect) guarantees that the amount of hours of labour supplied rises. Alternatively, when wage falls there is less incentive to work (you don’t work if they pay you hardly anything) and labor supply falls. Thus we have a usual supply and demand cross on a diagram. There is a nuance often put in microeconomic textbooks, namely the backward sloping supply curve. From some high level of wage on, the income effect dominates the substitution effect and the amount of hours supplied to the market actually drops when wage rises. The story behind it is that if you are already rich (high wage) the additional increase in wage will remind you about the beautiful world outside your working place and you’ll decide to spend more time on leisure still enjoying a high wage.

On an aggregated level the labor supply curve often boils down to positively sloped straight line as only few people actually are “too rich for work”. This might well be good approximation for western economies in general. What happens if we travel with this framework to some developing country? Will it still be reasonable?

Let’s go down the wage axis and think what happens to the labor supply. If you earn only a little, let’s say enough to meet the subsistence level and suddenly your wage falls, there is a high chance you wish to continue your existence, so you supply more labor. By doing so you restore your income back to the subsistence level. Why wasn’t it a case in a previous setup? Well, the (usually implicit) assumption was that non-labor income guarantees subsistence level. It is a reasonable assumption in developed countries where non-labor income consists mainly of capital income, but also unemployment and other social benefits. It might be simply a mistake to assume the same for a developing country. Fristly, because of the low level of capital accumulation the capital income might be too low to guarantee a subsistence level. Secondly, a developing country might be simply too poor to maintain an extensive social security system.

What happens to our supply curve if we remove the assumption about the sufficient level of non labor income? Obviously it is getting a negative slope – lowering the hourly wage results in more labour supplied to the market. In this case the negative income effect dominates the substitution effect. What is important is that additional assumption might be very handy. If you have both supply and demand curves with a negative slope you might start worrying about stability of such model. It would be most embarrassing if, in the case of the excess of labour supply, the downward pressure on wages would bring even higher excess of labour supply. You need to assume that when wage falls, the amount of hours of labor demanded rises faster than the amount of hours of labor supplied to the market. In other words you need a slope of the supply curve to be higher (in absolute terms, as they are both negative) than the slope of a demand curve or alternatively: the supply curve needs to be steeper than a demand curve.

Interestingly the cases discussed previously are not exclusive. Putting all the pieces together we get a labor supply curve (Ls on the graph) which has something like an S-shape. The part between point A and B on a graph is a standard representation of a labor supply curve. The part above the point B represents the discouraging effects of a rising wage on hours of labor supplied. The part below point A would represent the increase in hours of labor supplied due to decrease in income below the subsistence level. Which part of the supply curve is applicable to a particular case is a matter of assumptions you can allow.

A real life example often brought forward is the case of female labor force participation. The data investigation for Mexico confirmed a negative relationship between wages and labor supply for this group on low levels of income. The relationship turns positive when the income rises.

What might be the general conclusion? It is trivial, but also crucial: to be aware of assumptions that are required in order to proceed with the analysis. Otherwise one might arrive with conclusions very far from reality.

Author: Jan Jablonski


Licona Gonzalo Hernández Reshaping the Labor Supply Curve for the Poor, LACEA Annual Meeting, Rio de Janeiro, Brazil, 2000, lacea.org.

Krueger Anne O., The Implications of a Backward Bending Labor Supply Curve, The Review of Economic Studies, Vol. 29, No. 4. (Oct., 1962), pp. 327-328.

Dessing Maryke, Labor supply, the family and poverty: the S-shaped labor supply curve, Journal of Economic Behavior & Organization, Vol. 49 (2002) 433–458.

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