Welfare and the Supply of Labour.
There are lots of definitions of Economics as a subject or of what it means to be an Economist. One of the simplest definitions is that Economics is just the study of the effect of incentives on human behaviour.
One of the questions we look at is what makes us work and, more pertinent these days, how welfare payments or income taxes might impact the number of hours we chose to work. There is much talk of a universal basic income — but if I can receive money for doing nothing, why work? The same question applies to welfare payments too and of course to income taxes. If you are going to increase the rate of tax I pay on my earnings, will I work more or less?
The reason we work is of course to earn money with which to do the things we actually want to do. Work can be seen as an inferior good: like economy or own brand bread, as soon as I can afford to I will buy less/work less and move on to the things that give me more pleasure.
In the USA Biden has announced historic reforms to welfare with a move to give more benefits to the poorest and raise taxes on the richer sections of society. https://edition.cnn.com/2021/05/16/politics/biden-welfare-queen-blake/index.html
But what will this do to the incentive to get out there and get a job?
When choosing how many hours an individual will wish to work each day, we can consider that a person can do two things with their 24 hours in a day: they can work or they can have leisure. Imagine a person with 24 hours of leisure. If they give up an hour of leisure then they can start to work and get a wage. The more hours of leisure they give up, the greater their total wage per day. The rate at which an hour of leisure translates into money income is the wage rate. We can picture this trade-off between leisure and wage as a Budget Constraint, as shown below. The Budget Line MT shows all possible combinations of work and leisure an individual might enjoy in a given day. For example at point C they will work TL1 hours and have OL1 leisure and will gain an income of M1.
We can model worker choices between wages and leisure in terms of an Indifference curve, where a given indifference curve shows combinations between wages and leisure that yield the same level of happiness or utility. The higher the indifference curve the greater the total happiness. Hence a worker will want to occupy that point on their Budget Line at which they achieve their highest Indifference Curve. So, in the following diagram, we see three Indifference curves, each representing, as one goes up from the origin, higher levels of utility. The highest curve the individual can reach with a given Budget Line MT is Indifference Curve IC2 at point E, with TL1 work and OM1 wages. This is their optimal labour supply point. The individual will want to work TL1 hours each day.
What is the effect on this decision of the introduction of welfare benefits? Benefits which, even if a person does not work at all, and spends the whole day in leisure, they will still get some basic income. Let us imagine that a person with no job still has a basic income. Some maybe interest on savings or support from family members, and the rest is state unemployment benefit. In the below diagram we see that with no job and 24 hours of leisure the person receives BC of basic income. Of this we assume that AC is unemployment benefit.
This level of non-work income enables the individual to gain Indifference Curve I2. The effect of this is to make the individual think very hard about getting a job. If they do enter the labour market and get a job we assume their unemployment benefit ends completely. In this case, they will lose AC of income and this will drag them down from their initial indifference curve of I2. So the question is: will it be worth them giving up AC in return from the wages paid by a job? This will only be rational for the person if, by working, they can end up on a higher Indifference Curve than I2, for then they will be happier employed than unemployed. In the diagram, we can see that if DA is the budget constraint for wages and leisure the worker will not want to work at all. Having given up AC of income benefit, they will only get back to that initial income at point E on the Budget Line — but to restore their pre-work income they have to work for H1B hours a day. They will be giving up a lot of leisure just to maintain their income. Clearly this is not rational, and indeed point E places them on a lower indifference curve, I1. They will be less happy working than being unemployed.
This is called a poverty trap: given the leisure-wage trade off represented by Budget Line DA the person is better off being unemployed than taking a job. To overcome this, a higher wage rate must be paid, one which compensates for reduced leisure time by higher earnings. In the above diagram this is shown by Budget Line FA. Given this budget line, the previously unemployed person can take a job, lose unemployment benefit, but still be better off by trading in leisure for work to end up at point G. At point G they are on a higher Indifference Curve I3. They now have a higher level of happiness working than not.
So what will be the effect of a policy, such as Biden’s, to increase welfare payments independent of work? The basic effect will be to reduce labour supply as some individuals find it more beneficial not to work than to work. In itself, therefore, a generous unemployment payment system will reduce the supply of labour and increase the number of people out of work.
On the other hand, if the labour market tightens and causes wage rates to rise, then more people will be tempted to give up unemployment cheques and free time in return for money incomes they value more highly. Biden wants to raise wages for blue colour workers. If he can do so then he may have the best of both worlds: better benefits for the unemployed and a higher supply of labour. If he can’t he may end up with a growing welfare bill and rising numbers of workers who feel it’s just not in their interests to work.
By Dr Ian St John and Kirti Shah
