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CHAPTER THREE LITERATURE REVIEW
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prevailing market wage rate and non-labour income (reservation wage). An increase in the market wage rate is associated with two basic effects; the income and substitution effects. If income is held constant, an increase in wage rate raises the opportunity cost of leisure so that individuals will prefer to substitute more work hours for leisure.
Hence, labour supply increases. This is called the substitution effect. On the other hand, increase in wage rate also increases an individual‟s income and thus affords the individual the luxury of purchase of more leisure time. This reduces work hours supplied and is called the income effect (Stoep, 2008). Given that both effects stem from a rise in wage rate, the final outcome of the effect of an increase in wage rate on work hours depends on which effect dominates the other. Where the substitution effect dominates the income effect, the individual increases work time relative to leisure time. Similarly, dominance of income effect over the substitution effect reduces work time and raises leisure hours. Hence, the traditional neoclassical theory of labour suggests that labour supply is not necessarily a monotonic function of wages. The supply of labour hours for market work increases at a low wage rate and subsequently diminishes when wage is sufficiently high. The income and substitution effects are further enunciated in figure 3.1.
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Figure 3.1: Impact of Wage Change (Income and Substitution Effects) on Labour Supply.
Source: Durnel (2010)
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In figure 3.1, assuming an initial wage rate EF with utility maximised at point P, an increase in wage rate will rotate the budget line from EF to EG and make it become steeper with a new maximum utility at point R. The movement from P to R occurs in two steps. The first step shows the income effect where the increase in labour income shifts the budget line EF to a new budget line DD. The income effect can be analysed at point Q where the new budget line DD is tangential to the individual indifference curve U1, keeping wage constant. It is examined by the movement from OP to OR. The substitution effect is also analysed keeping income constant; this is shown by the movement from Q to R along the indifference curve U1. Dominance of the income effect over the individual‟s preferences implies that an increase in wage rate motivates individuals‟ demand for more leisure implying a decrease in work hours. This is shown in Figure 3.1A with an increase in leisure time from OP to OR (large income effect) and small movement from Q to R (small substitution effect). On the other hand, dominance of the substitution effect over individual‟s preferences implies increase in work hours and subsequent reduction in leisure hours. This is observed in Figure 3.1B with decrees in leisure time from OP to OR (small income effect) and larger movement from Q-R (large substitution effect) (Borjas, 2008).
The traditional neoclassical theory provides clear explanation of work hours based on the labour leisure trade off. It can also be used to determine whether an individual chooses to participate in the labour force or not (that is supply more than zero work hours or supply zero work hours) (Stoep, 2008).
One of the major criticisms of the traditional neoclassical theory of labour supply is that it does not recognise other ways by which an individual spends his/her time aside leisure and work time. Individuals can choose to spend their time in non-market activities such as home consumption and production of goods and services (Stoep, 2008). Non-market time involves household consumption such as; eating, sleeping, entertainment, cleaning, cooking and investing in health. Hence, the model does not add household production to labour supply decisions (Huffman, 2010). Huffman (2010) had earlier shown the framework that corrects for this weakness of the neoclassical model of labour supply with the inclusion of household production into the utility function of the individual. Assuming an individual in the household consumes and obtains utility from leisure (L) and two purchased goods; X1 (food) and
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X2 (non-food goods and services), the utility function; assumed to be strictly concave is:
U = U (L, X1, X2; τ) (3.1)
Where τ is a taste parameter that influences the transformation of leisure and purchased goods into utility.
Assume that the individual receives time endowment for a given period which could be a year or a day and this time is allocated between leisure (L) and market work hours, h.
T= L + h (3.2)
Hence, market work hours becomes
h = T –L (3.2a)
Where the individual earns wage income (W) per hour (h) and also receives income (V), which comprises interest payments on assets, dividends on portfolio investment and unanticipated gifts and total income earned by the individual (IC) is allocated to purchasing X1 and X2, then, IC is such that:
IC = W·h + V = P1X1 + P2X2 (3.3) Where P1 and P2 are the prices of goods X1 and X2. Substituting for market time or wage work hours (3.2a) into equation 3.3 yields the full income constraint (F) similar to Becker‟s (1965)1 full income constraint;
F = W (T-L) + V = P1X1 + P2X2 (3.4) F = W T - W L + V = P1X1 + P2X2 (3.4a) Rearranging equation 3.4a yields
F = W T + V = W L + P1X1 + P2X2. (3.4b) The expression in equation 3.4b shows that full income received is spent on leisure, purchases of food and non-food goods and services.
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The individual chooses L, X1 and X2 that maximize equation (3.1) subject to equation (3.4b). With the lagariange multiplier λ, the first-order conditions for the individual‟s decision problem are:
L: UL = λW (3.5a)
Xi: Xi U = λPi, i = 1, 2 (3.5b)
λ: W·T + V − W·L − P1X1 + P2X2 = 0 (3.5c) Equations (3.5a) to (3.5c) can be solved jointly to obtain the general form of the individual‟s demand functions for leisure, food, as well as non-food goods and services:
(3.5a) L* = DL (W, P1, P2, V, τ) (3.5b-3.5c) X*i = Xi D (W, P1, P2, V, τ) i = 1, 2.4
The demands for leisure, food and non-food purchases as shown, are determined by the opportunity cost of time or the price of leisure which is the wage rate (W), the price of food purchases (P1), the price of non-food purchases (P2), income from assets and gifts (V ) and tastes (τ).
Given the optimal choice of leisure and the time constraint (3.2), the general form of the labour supply equation can be obtained as:
h* = T - L* = Sh (W, P1, P2, V, τ) (3.6) Hence, hours of work or labour supply is determined by exactly the same set of variables as those that determine the demand for leisure and non-market time spent in food, and non-food purchases. This indicates that leisure may not be the sole alternative to labour time in market activities(Huffman, 2010).
Another weakness of the traditional neoclassical theory is that, it ignores the influence of other household members such as the presence of young children; on labour supply decisions of individuals in the household. Other factors that influence labour supply such as age, education, gender and marital status are also not considered in the model.
Most studies examining the labour supply decision of individuals show that these
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variables have significant effects on work time. (Stern, 1989; Bridges and Lawson, 2008; Machio, 2012; Contreras et al 2010; Fadayomi and Ogunrinola, 2013).