A-08.024), con bandeja inferior de recogida de aguas de condensación, colocada sobre pre-

Annual income Slope = (1 – 0.6)W b a d c D Full benefit (0.6)20W F C B Slope = W A 20 (32 weeks worked) 38 Leisure (weeks per year)

(14 weeks worked) 52 0 • • ben40208_ch03_074_106.indd 86 ben40208_ch03_074_106.indd 86 03/10/11 9:37 AM03/10/11 9:37 AM

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Specifically, reforms to UI to increase work incentives may be thwarted, in part at least, by the fact that increasing the incentive to work (a supply-side phenomenon) does not guarantee that more people will work if the jobs are not available (a demand-side phenomenon).

In summary, work incentives may be either increased or decreased by UI. Some of those individuals who would, in the absence of a UI system, either be outside the labour force or work fewer weeks than are required to qualify for UI benefits, will increase their weeks worked per year in order to receive UI. In contrast, some of those individuals who would, in the absence of a UI system, work more than the minimum number of weeks required to qualify for UI will reduce their weeks worked per year and increase the number of weeks during which UI ben- efits are received. Both these consequences of UI may increase the unemployment rate—the former because it draws into the labour force individuals with marginal employment attach- ments who devote much of their time to nonmarket activities, and the latter because it reduces employment and increases unemployment of those with strong labour force attachment. The impact of the UI system on unemployment is discussed further in Chapter 18.

Disability Payments and Workers’ Compensation

Income maintenance programs for the disabled also exist in a variety of forms, such as workers’ compensation, disability pension entitlements from public and private pensions, long-term disability insurance (with premiums usually paid from joint contributions from employers and employees), and court awards for personal injury. As indicated in Table 3.1 , expenditures

as weeks of leisure fall below 20. Thus, this parallel component of the budget constraint is the segment from C to B, at 20 weeks of leisure.

After working 32 weeks, available leisure, or time for collecting UI, is reduced. Thus, the returns to work- ing are less than the wage. Between 32 and 52 weeks worked, the return to working is the labour market earnings minus the foregone UI benefits. Since one week’s benefits are equal to 0.6W, the returns to work- ing an additional week over this portion of the budget constraint is W 2 0.6W, or 0.4W. This segment is labelled AB in the figure.

The nature of the work incentive effects of unem- ployment insurance depend on where the individual would be located in the absence of the UI system. Three different possibilities are shown in the figure. For individuals working more than 32 weeks (e.g., at point a on AF), the income and substitution effects work in the same direction to potentially decrease weeks worked (moving to point b on AB). For indi- viduals such as those originally at point c on AF, the unemployment insurance system constitutes a pure income effect, again potentially decreasing work incentives (moving to point d on BC). These adverse work incentive effects are potential because the vast majority of people will not collect UI. Many employees would not leave their job because they may not be

able to return once they have exhausted UI. However, for those with a guaranteed or reasonably certain job—be it seasonal, with family friends, in household activity, or perhaps one of many low-paid, dead-end jobs that cannot attract other workers—there may be an incentive to collect UI. In addition, the incentive would certainly be there for those who have lost their job, perhaps because of a recessionary phase in the business cycle, and hence have no labour market alternatives.

The third possibility illustrated in the figure applies to individuals who would be outside the labour force in the absence of a UI program. These individuals are originally located at point F, reflecting the high value of their time devoted to nonmarket activities. Many such individuals would choose to remain outside the labour force and neither work nor collect UI. Oth- ers, however, would enter the labour force and work a sufficient number of weeks in order to qualify for UI benefits, locating at point C in the figure. In this case, the UI program has increased work incentives by making it attractive for these individuals to devote less time to nonmarket activities and to enter the labour force for relatively brief periods. Similar con- clusions apply to those who would work fewer than 14 weeks in the absence of a UI system (i.e., those who would be located in the segment DF).

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88 PART 1: Labour Supply

on workers’ compensation programs are large, at almost $6 billion a year. Long-term disability programs account for more than $4 billion of the $37 billion a year spent under the Canada/ Quebec Pension Plan. In most cases, of course, the work incentive effects of such income maintenance programs are not of interest, as payment is made precisely because the disability legitimately prevents a person from working, and the person may have little discretion over how much to work. In some cases, however, there may be more discretion over whether to work and, if so, how much to work or when to return to work. In such cases, the work incen- tive effects of disability income maintenance programs become a legitimate policy concern.

Prior to examining the impact of disability compensation, it is informative to examine the effect of the disability or injury itself.

Effect of Disability on Budget Constraint Depending upon its nature, the injury may have a number of different effects on the individual’s budget constraint (i.e., ability to earn income). A partially disabling injury could reduce the amount of time the individual can spend at the job, but not affect the person’s performance and, hence, wage at the job. This is illustrated in Figure 3.7(a) . Without any disabling injury, the worker’s choice set is YH f , given

the market wage rate as illustrated by the slope of the budget constraint. In this particular case, the worker chooses E 0 with corresponding utility of U 0 and hours of work (measured

right to left) of H 0 . The partially disabling injury, for example, could reduce the amount of

time the worker is able to work from H 0 to H p . The worker’s choice set is now limited to E p H f ,

with a corresponding drop in utility to U p . If the injury were completely disabling so that

the person could not work at all, then the person would be constrained to H f , with no labour

market income and utility reduced to U f . This again highlights the misnomer associated with

The effect of a disability can be incorporated into the work decision in a variety of ways. In panel (a), the individ- ual’s potential working time is reduced to a maximum of H P or H F under partial or full disability. In (b), the worker’s opportunity set remains unchanged, but the disutility of work increases. Indiffer- ence curves become steeper at H 0 (from U 0 to U'd ) and desired work falls to H d .

FIGURE 3.7 Effect of Disability

Income 0 0 Leisure Income Leisure Y Eo Ep Uo Up

(a) Reduced worktime, partial and full disability

HO Hp Hf Uf Uo Ud″ Ud′ Ho (b) Increased disutility of labour market versus other activities Hd • • ben40208_ch03_074_106.indd 88 ben40208_ch03_074_106.indd 88 03/10/11 9:37 AM03/10/11 9:37 AM

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the phrase “leisure”—it is a catch-all for all activities outside the labour market, ranging from pure leisure to being unable to work because of disability.

In addition to affecting one’s ability to earn income, a disabling injury may also require medical expenses. This affects the budget constraint, reducing income by the amount of med- ical expenses at each level of hours of work, analogous to a reduction in nonlabour income. Because costs associated with medical expenses shift the budget constraint inward without altering its slope, they will have a pure income effect, unambiguously reducing leisure and increasing hours of work, assuming leisure to be a normal commodity.

A disability that reduced one’s ability to earn wages in the labour market would give rise to conventional income and substitution effects, and hence have an indeterminate effect on hours of work. That is, the returns to work are reduced and, thus, one would work less (sub- stitution effect). But one’s wealth is also decreased, hence reducing one’s ability to purchase commodities including leisure, thereby inducing more work (income effect).

A disability may also have a differential effect on the disutility associated with work or the ability to enjoy non–labour market activities. For example, if the disability gave rise to more pain and suffering associated with labour market activities than with household work, it would rotate the household indifference curve as in Figure 3.7(b) so that the indifference curves Ud' and Ud"

are steeper in the disabled state, Ud', than in the nondisabled state, U 0 . That is, to remain at the

same level of utility, the disabled individual would require more income in return for a given increase in hours of work. For a given market wage rate (as given by the slope of the budget con- straint), this would induce a substitution from labour market to non–labour market activities, reducing work time from H 0 to H d (work being measured from right to left on the diagram).

Obviously, a disability may have a variety of the above effects. They were treated separately here only for expositional purposes. It is a relatively straightforward matter to portray them in various realistic combinations. For example, the disability may reduce the time one is able to work, reduce the wage, impose medical costs, and increase the disutility associated with labour market work as opposed to other activities. In such circumstances, the budget con- straint and utility isoquants will change to reflect each of these effects, and the incentive to work will be affected accordingly.

Effect of Compensation To compensate for the previously discussed type of disabil- ity, various forms of compensation exist, including workers’ compensation, disability pen- sion entitlements from public and private pensions, long-term disability insurance, and court awards. The effect of such compensations upon well-being or utility and work incentives depends upon the form of compensation.

Workers’ compensation, for instance, is designed to support the recipient’s income so it is not reduced by as much as it would be in the absence of the compensation. For example, it may compensate for two-thirds of the loss in one’s former potential income, in which case the worker’s compensation budget constraint appears as the dashed line E 0 Y d H f in Figure 3.8(a) .

That is, as the worker is compelled to reduce work activity (move to the right of E 0 ), income

does not fall by the full drop in take-home pay (as it would along E 0 H f ) but rather falls by the

proportion that it is not supported by workers’ compensation. If workers’ compensation were two-thirds of one’s income loss, then the fall in income would be one-third.

The policy challenge is to design a compensation scheme that compensates those who are legitimately disabled and hence in need of compensation and yet provides an incentive for them to return to work where feasible. The potential for an adverse work incentive effect for those who could legitimately return to work is exhibited by the fact that the workers’ compen- sation budget constraint is like the previously discussed budget constraint under a negative income tax; that is, the additional income enables one to afford to work less (income effect). Further, the reduced opportunity cost of leisure time that comes about because one forgoes disability payments as one increases hours of work (substitution effect) also discourages work activity. Obviously, for those who have no discretion over their ability to engage in more

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90 PART 1: Labour Supply

What is the appropriate level of compensation for a worker who has suffered an injury? Workers’ compensation conventionally compensates someone (for example) by assuming a full disability (H F ) and providing disability ben- efits of two-thirds of the pre- injury income, Y d 5 2/3Y 0 in panel (a). Assuming that benefits are reduced by 1/3W for each hour worked, the new budget set is indi- cated by the dashed line. This may lead the individual to stop working, at E C in panel (b) and obtaining utility U C , which is higher than before the injury (U 0 ). Panel (c) considers the case of an individual who cannot work and also has medical expenses M. The “ideal” compensation would be enough to bring him to U 0 , which is unobservable. More conventionally, a court may award him Y 0 1 M, which yields U y . Thus, ignoring pain and suffering, he would be overcompensated.

FIGURE 3.8 Effect of Compensation

Income Leisure Y0 E0 Income Leisure Income 0 0 0 Leisure E0 U₀ H0 Yd =

(a) Workers’ compensation of two-thirds of lost income

Uc EC U0 Uf Hf (b) No incentive to return to work Y0 E0 Y Uy U0 Hf Ud H0 H0 (c) Restoring income or utility C M Hf • • • • • • • • • 2 3 Y0 ben40208_ch03_074_106.indd 90 ben40208_ch03_074_106.indd 90 03/10/11 9:37 AM03/10/11 9:37 AM

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work activity, the incentive effects are not at issue. For some, however, they may discourage a return to work activity that they are capable of doing.

The availability of the full budget constraint E 0 Y d H f presupposes that such compensation

is available for any combination of partial disabilities that would reduce the person’s work between H 0 and H f . That is, depending upon preferences, workers could locate anywhere along

the segment E 0 Y d . If the compensation were available only if one could prove full disability,

H f , then the worker’s options would be only the points Y d and E 0 . Assuming Y d was above the

indifference curve U 0 as shown in Figure 3.8(a) , then the worker would choose the point Y d .

Figure 3.8(b) illustrates such a situation where the worker receives workers’ compensation for the full disability and has no incentive to return to work, assuming of course that such an option were feasible. The compensation (E c H f ) is such that the worker is better off by not

working and receiving the compensation (point E c ) than by returning to work (point E 0 );

that is, utility under compensation (U c ) is greater than utility under work (U 0 ). Even though

income by working would be greater than income under compensation, it is insufficient to offset the disutility associated with the additional work.

Not providing any compensation, however, risks the effect that individuals who legit- imately cannot return to work have their utility level reduced to U f . Clearly, lowering the

compensation level so that U c is below U 0 would induce a return to work from those who

can legitimately engage in such work; however, it runs the risk of penalizing those who legiti- mately cannot return to work. Also, when one considers the considerable medical costs and pain and suffering that are often associated with disability, it becomes less likely that compen- sating someone for a portion of their lost earnings would make them better off.

Different amounts of compensation are also involved depending upon the position to which the recipient is to be returned. Figure 3.8(c) illustrates the situation where a perma- nently disabling injury prevents the individual from working at all (i.e., forces the individual to locate at H f ) and gives rise to medical costs of H f M. These events reduce the individual’s

well-being from U 0 to U d . A court award to compensate for the individual’s loss of earnings,

YH f , plus medical costs, H f M, would lead to a total award of YM. This would clearly leave

the individual better off than before (U y  > U 0 ) because the individual is not experiencing the

disutility associated with working. If, however, the disability results in pain and suffering, then the individual’s ability to enjoy goods and leisure consumption may be reduced and the individual could be worse off than before, even with the compensation award of YM (and possibly even with some additional compensation for pain and suffering).

If the court wanted to restore an individual to his former level of well-being or utility, U 0 ,

then an award of CM would be appropriate. The problem is assessing the value the individual may attach to not having to work. This is given in the diagram by YC, which is the income reduction the individual would have willingly accepted to reduce work activity from H 0 to H f

(equal to E 0 Y) and to remain indifferent to being at E 0 with utility U 0 . The problem is that YC

is not observed; all that is observed is the person’s income, YH f .

This clearly illustrates the dilemma any court or administrative tribunal would have in arriving at compensation to “restore the person in whole.” Different amounts are involved if this is interpreted to be the previous level of income as opposed to welfare or well-being.

Child Care Subsidy

One of the most hotly debated social programs in recent years has been the provision of day- care or child care subsidies to facilitate the employment of women with children. Analysis of the daycare subsidy requires first investigating how child care costs might affect a parent’s labour supply decision.

Daycare costs can be modelled as a special case of fixed costs associated with working. The assumption in this case is that the cost of child care is incurred only if the person works, and that the cost is independent of hours worked. It is a straightforward exercise to extend the analysis to the case where the cost depends on the actual hours worked.

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92 PART 1: Labour Supply

The effect of the daycare cost on the potential income constraint is illustrated in Figure 3.9(a) . The fixed cost of daycare is analogous to a vertical drop in the individual’s budget constraint immediately upon entering the labour market. That is, immediately upon engaging

Leisure T H0 Hm H1 Y A B M′ R′ E0 Y E R T Leisure M U0 Hm Income Y T E M Cost of daycare Leisure Income 0 0 0 M E U0 (c) The impact on hours worked (b) The impact on participation (a) The impact on

budget constraint U1 Um M′ Income –WRM EM Y – M Y – M Y – M • • •

FIGURE 3.9 The Effect of Child Care Costs on Labour Supply

Daycare costs can be incor- porated into the budget con- straint as a fixed cost, M. If a parent does not work, the consumption opportunity is E, but as soon as the parent works, the budget constraint falls to MB. Effectively, therefore, the hours-income budget line is given by EMB. As seen in panel (b), this results in an increase in the reservation wage from RR 9 to MM 9 . For a parent who works, the adverse income effect will lead to an increase in labour supply, from H 0 to H 1 in panel (c).

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in labour market activities, the individual incurs the fixed costs M  5  EM, which are analogous to a drop in income of EM. (The point M is slightly to the left of the vertical line ET to indicate that the costs are incurred only if one engages in labour market activity; that is, moves to the left of T.) These fixed costs are avoided if one does not work in the labour market but remains at E. In summary, in the absence of child care costs, the person faces income constraint AE, whereas with fixed child care costs, the person faces BME.

We can separately examine the effect of these costs on the individual’s participation and hours decisions. We first look at participation. In the presence of such fixed costs, the indi-