Question

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This question is about individual labor supply decisions.

a) According to the life cycle model of labor supply, different types of wage changes can have different effects on labor supply over the life cycle. Explain, the expected effects on labor supply (focusing on both income and substitution effects) following:

i) an evolutionary increase in wages along the expected wage-age profile;

ii) an unexpected increase in wages that shifts the complete wageage profile (i.e. at every age the worker earns a higher wage);

iii) an unexpected increase in the wage rate at one particular point in life, not affecting the expected evolutionary wage rate at any other point in life.

Answer 1

Ans) Changes in the wage rates can cause a change in the supply and demand of labour in the labour market. A rise in it may raise the costs of firms producing a product, thus increasing the selling prices. Due to such an increase, the consumers may demand less for the product, hence the output will decrease. This means that the demand for labour will decrease.

Secondly, the important thing to note is that any rise in the wages makes the labour more expensive in relation to capital, thus forcing firms to substitute capital for labour. Indirectly a demand for labour will decrease.

On the other hand, if the wages are free to adjust in relation to market forces it will move to a point, where the demand for labour equals the supply.