Supply of Labor in Perfect Competition: Study with Video Lessons, Practice Problems & Examples

The supply of labor is influenced by individual decisions to work, which involves sacrificing leisure time. The reservation wage represents the minimum wage an individual is willing to accept. As wages increase, the supply of labor typically rises; however, at high wage levels, individuals may prioritize leisure over work due to the income effect outweighing the substitution effect. This can lead to a backward-bending supply curve, where increased wages result in decreased labor supply as leisure becomes more valued than additional income.

Supply of Labor in Perfect Competition

Alright. So we've discussed the demand for labor, now let's consider the supply of labor. So the supply of labor, you're going to see it's very similar to the supply for a good, most of the time when we talk about it, especially when we think market wide. So when we talk about the supply of labor, now we're thinking about individuals. Remember, it's the individuals who are supplying the labor to a firm. So what are the ideas here that go into it? When we decide to work, as an individual, when we decide to work, we give up our leisure time, right? We give up the time that we would spend not working. And when we talk about leisure in economics, it's going to include everything that's not work itself. So this isn't just days you spend relaxing on the beach; this is time you spend exercising, time you spend with your family, and time you spend walking your dog. Everything you do that's not work, well, that's leisure. So you're essentially giving up that leisure time to work. Every hour that you're working is an hour you don't spend having leisure time. Cool?

So one more topic here is the reservation wage. The reservation wage is the lowest wage someone is willing to take to work. You could imagine that if the wages were low enough, you'd say, "You know what, screw it, I'm not going to work, I'll just figure out another way to do this." So there's going to be some wage that's going to be the lowest minimum that they would take to work, and then any wage above that, they would work. So what we're going to see, especially on the market supply, is that as wages increase, the supply of labor increases, right? And this makes sense, right? As you make more money, you're going to want to work more to make more money, that you're going to be more willing to work at higher wages to make more money. So that's the idea here is that as the wages go up, you are going to supply more labor, and we're going to end up in a situation like we see here.

Okay, so this is going to be the supply of labor, and we see it looks very similar to supply when we were studying product supply, right? It's just an upward-sloping curve. Nothing crazy here, right? When we have, let's say, this low wage right here, I'll put, "low wage." Well, there's going to be this quantity supplied right here. Right? "Quantity low." And then if the wage gets high up here, well, people are going to be more willing to work, and there will be a much higher quantity of labor over here. Right? "Quantity high." This is the high quantity when there's a high wage. Cool?

And one last thing here, this bottom point right here, well, this is going to be that reservation wage we talked about, right? Notice how it's not touching the very bottom because you would at least want this much money before you worked. So that would be the reservation wage, and here we're basically talking about the market supply, we're talking about supply on a grand scale. Alright? So why don't we, in the next video, let's break down the individual supply curve and see how we could actually have some interesting things happening in there. Alright, let's do that now.

Individual Supply Curve of Labor (Backward-Bending Supply Curve)

Alright, so now let's think about the supply curve on the individual level. Okay, so on the individual level, remember this is just you and me supplying our labor to the market, what we're going to see is that it's actually possible, and you got a little spoiler at the bottom, it's possible for the supply curve to bend backwards. Okay. It's going to turn back around just like you see on that graph at the bottom, okay? So let's think about how this could happen.

Think about it. As your wages increase, as you're making more and more money per hour, the wages are increasing, well, a person's going to be earning more money, right? That's simple enough. A person earns more money as the wage increases, but think about as you reach a high enough wage where you're making enough money per hour, well, you might start to value your leisure time more than work. Right? You could be making enough money from the work you're doing that you'd say, hey, actually at this point maybe I value more leisure time than I do work because I'm already making a high enough salary, right. So once you reach a high enough wage, you might value that leisure more than the work and this is where the substitution effect and income effect come into play.

Alright, so substitution effect, the first thing that happens when you reach a high wage, well the increased wages, it's going to raise the opportunity cost of leisure time, right? Because now if you wanted to take an hour off, you're going to have to give up that higher wage than when you were making less money. So now once you're making a high wage, the opportunity cost goes up, alright? So it makes it a little more difficult to want to not work because you're thinking, hey, I could be making $50 an hour, $100 an hour, you could be making some big amount of money that you're giving up to have leisure time.

But the other side of the coin is the income effect because increased wages will give the consumer more purchasing power, right? When you have more money, you have more purchasing power. You have more money to purchase. Remember when we talked about normal goods and inferior goods? These had to do with the income level. When the consumer's income went up, they bought more normal goods and less inferior goods. Good, when you have more money you want more leisure, right? You're going to want more leisure as your as your income goes up. Well, the wages increase, leisure is a normal good, so the quantity demanded of leisure is going to go up. We're going to see an increase in the demand for leisure right, and that's just how we saw when we studied supply and demand and normal goods.

Okay, so think about that. As the wages go up, you're going to reach a point where the income effect outweighs the substitution effect, okay? So there's going to be levels of income, so let's go down here to the graph, where the substitution effect is stronger than the income effect. That substitution effect all along here, all the way up to this point, that substitution effect is having a stronger hold, right? Where the wage is going up and you are considering that opportunity cost, so you are going to spend more and more time at work because of those higher wages, right? So once you reach this level, say that's $100 an hour. That was your breaking point right there. Now you're making $100 an hour, they start offering you more than that and you're like man I'm making a ton of money already, it'd be better if I spent some time you know buying a boat and sailing around the world, whatever it is, you're going to want to spend that time on leisure instead. And that's what ends up happening, it starts going backwards again, right? So we still have our reservation wage down here, the lowest we take and then it's going to keep increasing, right? The supply curve increases just like we're used to up to a point and then once you reach that threshold, it's going to turn back around because you're going to supply less labor and take more leisure time, right? So up here, this last part where it's turning back around, that's where the income effect is outweighing the substitution effect. At that point, you're valuing that leisure time more than you're valuing the, extra time at work. Cool? So that's a pretty interesting thing. We haven't seen anything like this before where the curve actually bends back the other way. This is a very special case when we think of the trade-off between leisure and work. Cool? Alright. So let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the reservation wage in the context of labor supply?

The reservation wage is the minimum wage an individual is willing to accept to work. It represents the lowest amount of money for which a person would be willing to give up their leisure time to engage in labor. If the offered wage is below this threshold, the individual would prefer to remain unemployed or find alternative ways to sustain themselves. The concept is crucial in understanding labor supply because it sets a baseline for the minimum compensation required to attract workers into the labor market.

How does the supply of labor change as wages increase?

As wages increase, the supply of labor typically rises. This is because higher wages make work more attractive compared to leisure, leading individuals to offer more labor hours. The supply curve for labor is generally upward sloping, indicating that higher wages result in a higher quantity of labor supplied. However, at very high wage levels, the supply curve can bend backward due to the income effect, where individuals prioritize leisure over additional income, reducing the labor supplied.

What causes the labor supply curve to bend backward?

The labor supply curve bends backward due to the interplay between the substitution effect and the income effect. Initially, as wages increase, the substitution effect dominates, making work more attractive than leisure. However, at high wage levels, the income effect becomes stronger. Individuals earn enough to value leisure more than additional work, leading to a decrease in labor supply. This results in a backward-bending supply curve, where further wage increases lead to less labor being supplied.

What is the substitution effect in the context of labor supply?

The substitution effect in labor supply refers to the change in labor supply when wages increase, making work more attractive relative to leisure. As wages rise, the opportunity cost of leisure increases, encouraging individuals to work more hours. This effect leads to an upward-sloping labor supply curve, as higher wages incentivize more labor supply. However, this effect can be countered by the income effect at very high wage levels.

What is the income effect in the context of labor supply?

The income effect in labor supply occurs when higher wages increase an individual's purchasing power, allowing them to afford more leisure. As wages rise, individuals may choose to work fewer hours because they can maintain their desired standard of living with less work. This effect can lead to a backward-bending labor supply curve at high wage levels, where further wage increases result in a decrease in labor supply as individuals prioritize leisure over additional income.