ECON 311: Advanced

Macroeconomics
Module 2: Supply Side. Labour and Leisure

Olga Sudareva1
1 Department of Economics, University of Auckland

Module 2
Outline

1 Recap

2 Applications — Labour and leisure

3 Unifying consumption and labour

4 Labour market equilibrium

5 Efficiency wages

6 Taxes and transfers

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Section 1
Recap
Intertemporal optimisation

• So far we have examined how agents make consumption decisions

across time when they are budget constrained.
• We looked at a simple, two-period model to learn about the
discount factor, the effects of interest and taxes.
• In this lecture, we will apply the same kind of reasoning about
present and future tradeoffs to the supply side to understand
labour-leisure decisions.

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Module reading

Main
• Labour and Leisure: Kurlat, Ch. 7, pp. 127–143 [1]

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Learning outcomes

• Apply general equilibrium framework to understand different

macroeconomic issues such as long run growth, fluctuations,
employment, and inflation.(Capability 3.1 and 3.2)
• Analyse macroeconomic problems and identify possible
solutions.(Capability 1.1, 1.2, 2.2, 4.1, 4.2 and 5.1)
• Use numerical examples in macroeconomic models to predict
outcomes, including different government policy
scenarios.(Capability 3.2 and 4.2)

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Section 2
Applications — Labour and leisure
Some stats

• Heterogeneity
• across countries, and
• over time.
• In NZ, unemployment
reported at 2% in early
1900s; peaked in 1990s
at almost 12%.

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More stats

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More stats

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More stats

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How do we know levels of employment?

• The usual way is to conduct surveys.

• Stats NZ runs a Quarterly Employment Survey of 18,000 participants.
• Individuals are classified into
1 Employed if they have worked in the past 4 weeks;
2 Unemployed if they did not work during the past 4 weeks but actively
looked for a job or will start a job within 4 weeks of their prior job;
3 Out of the labour force if they did not work and did not look for a job
in the past 4 weeks.

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Employment definitions

• From this classification, we obtain:

Labour force = Employed + unemployed.

Labour force
Participation rate = .
Population
Employed (1)
Employment rate = .
Population
Unemployed
Unemployment rate = .
Labour force

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What do the measures mean?

• High unemployment rates are typically viewed as a problem.

• By definition, unemployment means there are people who want to
be employed but have not been able to find work.
• But it does not tell the full story.
• Searching for a job is a productive use of time.
• Many economic models and evidence from the business and
psychology literature show that finding a good match is important.

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What do the measures mean?

• Also important to consider those who are counted as “out of the

labour force” but are simply discouraged workers.
• To avoid the distinction, we could instead focus on the employment
rate, since it considers the population at large.
• Is high employment always a good thing?
• There are many reasons why people may choose not to work (family
care, study, health).

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A model of the labour market

• To understand how shocks and policies affect the macroeconomy, it

is important to have a sense of individuals’ responses to changing
labour market conditions.
• Introduce a worker, Lucy, with preferences

U (c, l) = u(c) + v(l). (2)

• c stands for consumption and l stands for leisure.

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A model of the labour market

10 20

9 19

8 18

17
0.5 1.0 1.5 2.0 0.5 1.0 1.5 2.0

Figure 1: Utility from consumption Figure 2: Utility from leisure

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Model elements

• Lucy has 1 unit of time so the amount of time spent working is

L = 1 − l. (3)

• In this model, we are going to assume the wage rate, w, is

exogenously determined (outside of the model).
• Lucy’s budget constraint for consuming is

c ≤ w(1 − l). (4)

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Model elements

• Lucy has 1 unit of time so the amount of time spent working is

L = 1 − l. (5)

• In this model, we are going to assume the wage rate, w, is

exogenously determined (outside of the model).
• Lucy’s budget constraint for consuming is

c ≤ w(1 − l). (6)

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Worker’s problem

• Lucy solves the following optimisation problem

maxu(c) + v(l)
c,l

s.t. (7)
c ≤ w(1 − l).

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Worker’s problem

Figure 3: Consumption-leisure bundle

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Lagrangian

• The Lagrangian for this problem is

L(c, l, λ) = u(c) + v(l) − λ[c − w(1 − l)] (8)

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First-order conditions

• The first-order conditions are

u 0 (c) − λ = 0 (9)
v 0 (l)
v 0 (l) − λw = 0 ⇔ 0 = w. (10)
u (c)

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Optimality

• Equation (10) describes how Lucy trades off dedicating time to

market work or to leisure activities.
• At the margin, Lucy must be just indifferent between allocating an
extra unit of time to labour or leisure activities.
• In Figure 3, the slope of the indifference curve is the marginal rate of
v 0 (l)
substitution u 0 (c) which, at the optimal allocation, is equal to the
slope of the budget constraint, w.

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Effects of an increase in wages

• Suppose that Lucy gets a promotion .

• How does an increase in w affect Lucy’s optimal labour-leisure
allocation and well-being? This is an important macroeconomic
question that factors into many policy decisions.
• The new budget constraint still crosses (1, 0) but has a steeper
slope.
• As with any price change, this leads to income and substitution
effects.

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Effects of an increase in wages

income effect

substitution effect

Figure 4: Increase in wages.

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Section 3
Unifying consumption and labour
Consumption and work

• So far we have considered consumption-savings and

consumption-leisure as separate problems.
• What happens in the (more realistic) case where we need to decide
how much to save which also affects our labour-leisure trade-offs?
• Let’s revisit Lucy’s problem.

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A dynamic model

• Lucy solves the following problem:

max u(c1 ) + v(l1 ) + β[u(c2 ) + v(l2 )]

c1 ,l1 ,c2 ,l2

s.t. (11)
1 1
c1 + c2 ≤ w1 (1 − l1 ) + w2 (1 − l2 ).
1+r 1+r

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A dynamic model

• There are four decision variables in this problem: consumption in

each period and leisure in each period.

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A dynamic model

• There are four decision variables in this problem: consumption in

each period and leisure in each period.

Q : What is the Lagrangian for this problem?

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A dynamic model

• The first-order conditions are given by

u 0 (c1 ) − λ = 0 (12)
v 0 (l1 ) − λw1 = 0 (13)
1
βu 0 (c2 ) − λ =0 (14)
1+r
1
βv 0 (l2 ) − λw2 =0 (15)
1+r
1 1
c1 + c2 − w1 (1 − `1 ) − w2 (1 − `2 ) = 0 . (16)
1+r 1+r

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A dynamic model

• We can summarise the previous conditions as follows

v 0 (lt )
= wt for t = 1, 2 (17)
u 0 (ct )
u 0 (c1 ) = β(1 + r)u 0 (c2 ). (18)

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A dynamic model

• Equation (17) is equivalent to (10) but generalised over time. Lucy is

indifferent at the margin between devoting a unit of time to leisure
or work, given wage w.
• Equation (18) is the familiar Euler condition: no matter how income is
obtained, Lucy distributes consumption optimally across time.
• While these conditions are similar to the separate cases, analysing
these decisions jointly lets us ask new questions.

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A dynamic model

• Suppose wages rise temporarily. How does Lucy respond?

• Solve for labour supply (L1 = 1 − l1 ) in equation (17).

v 0 (l1 ) = w1 u 0 (c1 )
⇒ l1 = (v 0 )−1 (w1 u 0 (c1 )) (19)
⇒ L1 = 1 − (v 0 )−1 (w1 u 0 (c1 )).

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A dynamic model

• (v 0 )−1 denotes the inverse of v 0 .

• Since the marginal utility of leisure is decreasing, (v 0 )−1 is also a
decreasing function.
• We know from our consumption optimisation that a temporary rise
(w1 rises but w2 does not) affects equation (19) via consumption, c1 ,
which rises more when the wage increase is permanent.

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A dynamic model

• Compared with a permanent rise in wages, a temporary rise will see

a lower c1 which leads to a higher u 0 (c1 ) (from diminishing returns) ⇒
lower (v 0 )−1 (since (v 0 )−1 is a decreasing function) ⇒ lower l1 ⇒
higher L1 .
• Therefore, Lucy’s labour supply rises more in response to a
temporary increase in wages than a permanent rise.

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A dynamic model

• Why? If a wage rise is temporary, Lucy doesn’t feel much richer

so the income effect is weak and the substitution effect dominates.
Lucy sells more time as it becomes temporarily expensive.
• Think about this in terms of Uber’s surge pricing strategy!

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Section 4
Labour market equilibrium
Competitive market

• We know from price theory that in perfectly competitive markets,

firms demand labour up to the point where the marginal product of
labour equals the wage rate.
• The equation
w = FL (K , L), (20)
gives us the labour demand curve.
• The demand curve tells us how much labour the firm is willing to hire.

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Competitive market

• The demand for labour comes from a firm run by Ryan.

• Since F (K , L) is concave in L, the demand curve is downward
sloping.
• For example, if F (K , L) = K α L1−α , then

w = (1 − α)K α L−α
(21)
⇒ L = (1 − α) α Kw − α .
1 1

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Competitive market

• On Lucy’s side (the supplier of labour), we can find the labour supply
curve. Let consumption and leisure payoffs take the following
functional form:
c1−σ
u(c) = 1−σ
(22)
v(l) = − l)
1+
−θ
1+
(1  . (23)

• θ and  are parameters.

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Competitive market

• Marginal utility from consumption and leisure are

u 0 (c) = c −σ (24)
v 0 (l) = θ(1 − l) .
1
 (25)

• Substituting these into (10), we get

θ(1 − l) 
1

= w. (26)
c −σ

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Competitive market

• Substituting for c from the budget constraint, we obtain

θ(1 − l) 
1

= w. (27)
[w(1 − l)]−σ

• Expression (27) defines the relationship between w and the labour

Lucy provides.

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Competitive market

• Equation (27) defines the relationship between Lucy’s willingness to

work and the wage rate.
• The supply curve is upward sloping if σ < 1 (which implies the
substitution effect dominates).
• It is downward sloping if the income effect of wage rises dominates,
leading Lucy to work less when wages rise.
• A downward-sloping labour supply curve is called backward
bending.

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Labour market equilibrium

Labour demand

Labour supply

Figure 5: Wage-working hours determination

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Increase in productivity

• Suppose there is a technological shift (e.g. ChatGPT) that raises the

marginal product of labour, MPL.
• Equation (20) tells us that at any given wage w, Ryan’s firm will want
to hire more workers.
• In the case where the substitution effect dominates, this leads Lucy
to be willing to supply more labour, resulting in a higher proportion
of working hours and a higher equilibrium wage rate.

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Increase in productivity

Figure 6: Effect of an increase in MPL

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Section 5
Efficiency wages
An example

• 5 January 1914: Henry Ford

announces $5 per day
programme, raising minimum
pay from $2.34 to $5.
• The result? Decreased worker
turnover by 35.4%, decreased
absenteeism by 7.5%.
• The reason: The efficiency
wages dramatically increased
the opportunity cost of being
fired.

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Efficiency wages

• Efficiency wages are a level of wages paid to workers above the

minimum wage to retain a skilled and efficient workforce.
• The idea is that workers must be incentivised to remain productive
and highly skilled workers (who are expensive to replace) to not quit.

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Section 6
Taxes and transfers
Adding taxes and transfers

• How will a worker’s decision change in response to a change in tax

policy?
• Let’s keep tax simple:
• τ is the tax rate on worker income.
• T is a transfer that the worker gets from the government.
• The transfer represents unemployment benefits, food assistance,
pensions, etc.

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Adding taxes and transfers

• The worker’s budget constraint is

c ≤ w(1 − l)(1 − τ ) + T . (28)

• Let’s study this from the worker’s perspective, taking τ and T as

given.

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Adding taxes and transfers

• The effect of each of these is illustrated below.

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Adding taxes and transfers

• Taxes lower the slope of the budget constraint: from the worker’s
perspective, the price at which he can sell his time to obtain
consumption is the after-tax wage: w(1 − τ ).
• The effect of higher transfers is a pure income effect. Prices have
not changed but the worker is richer as a result of the transfers,
allowing him to enjoy higher consumption and leisure.

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Adding taxes and transfers

• Therefore, the effect of higher tax rates is just like the effect of lower
wages. Both substitution and income effects come into play.

Q : What is the first order condition for the household’s one-

period labour-leisure optimisation problem?

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Adding taxes and transfers

• Therefore, the effect of higher tax rates is just like the effect of lower
wages. Both substitution and income effects come into play.

Q : What is the first order condition for the household’s one-

period labour-leisure optimisation problem?

A: The worker’s optimal allocation satisfies:

v 0 (l)
= w(1 − τ ). (29)
u 0 (c)

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Section 7
Further reading and TLDR
Extra reading

• Adding taxes and transfers (Kurlat [1] Ch. 7.2 pp. 135-137).
• Labour and search (Kurlat [1] Ch. 7.5 pp. 144-146).

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TLDR

1 The tradeoff individuals face between working and enjoying leisure

time depends on wages and the shape of utility from work and play.
2 An increase in wages causes a reallocation that both increases
individual utility and results in substitution and income effects.
3 A competitive labour market equilibrium results in a wage rate
equal to the marginal product of labour at a supply optimally set
by the household which trades off leisure and work.

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TLDR (math edition)

U
1 Unemployment rate: LF
2 Employment rate: EP
v 0 (lt )
3 Optimal labour allocation: u 0 (ct )
= wt
4 Euler equation: u 0 (ct ) = β(1 + r)u 0 (ct+1 ).

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Section 8
References
References I

[1] Pablo Kurlat. A course in modern macroeconomics. Self-published, Pablo Kurlat,

2020. ISBN: 9781073566716.

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