Question

A friend is arguing that the fact that Urban Meyer gets paid more than any other em-ployee at OSU displays that people have ”backwards” preferences. Use a supply anddemand graph to show your friend that high salaries could be explained by supply andnot demand. Use the term elasticity in your explanation.

Answer 1

The backward preference of an employee is shown in following diagram

In the above diagram, a backward bending labor supply curve is drawn. The backward bending labor supply indicates that after wage rate w*, workers do not want to increase labor hours. Labor supply drops after the wage rate crosses w*.

In the labor market, wage rate initially determined by the mutual interaction between labor demand and supply. Initially, hike in wage rate induces workers to substitute labor for leisure. Therefore, labor hours are increased for overtime in order to get higher pay to meet increasing expenses.

After the wage rate w*, income effect dominates the substitution effect and leisure consumption increases. As wage is sufficiently higher than expense, incentives for working longer hour phased out. Demand for labor does not influence the labor supply at this level of wage. Labor supply elasticity also decreases after the kinked point. Elasticity is measured by the % change in working hours in response to the change in wage rate. Before reaching w*, elasticity is positive and high for a worker as any increase in wage rate induces the worker to raise labor. After w*, labor supply curve becomes downward sloping keeping elasticity of labour supply negative.