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Fixed costs of working and the decision to work (2)


Contents:
Introduction
1. Fixed monetary costs of working
2. Fixed time costs of working
3. Estimated fixed costs of working for a typical employee

Conclusion
Endnotes
Bibliography

Introduction
Fixed costs of working are the costs appearing when a person starts working and which do not vary with the number of hours an individual actually works. Fixed costs of working affect a person’s decision to work and the labor supply behavior.
There are two major types of fixed costs of working:
 fixed monetary costs of working;
 fixed time costs of working.
I am going to examine the effect of each type in turn and then to estimate fixed costs of working for a typical employee in monetary terms.

1. Fixed Monetary Costs of Working
Fixed monetary costs of working include fares on public transportation or costs of operating an automobile, cost of child care, cost of clothing, and cost of dining out.
Fixed monetary costs of working and the way they influence the person’s decision to work can be illustrated using the following graph:
Figure 1. (1)


Let us assume that an individual has non-labor income in the amount of aT. If this individual chooses not to work at all, he or she will locate at point a and have a utility level of U1. If the individual chooses to work, he or she will experience the fixed costs of working, shown on the graph as ab. That is why the budget line will start from point b (not from point a as in the case of zero fixed costs of working). It means that in order to start working a person has to spend a fixed sum of money in comparison with the alternative of not working at all.
The absolute slope of the budget line, which represents the wage rate, shows us how large the wage rate needs to be to induce a person to work for pay and how many hours he/she will work at this wage. For example, if a person has a budget line bd, he/she will achieve the highest possible utility level U2 (at point A), working (T – M) hours and earning N amount of income. In this case a person will achieve a higher utility level then in case of not working at all. But if a person has a lower wage rate and thus a budget line be, he/she will achieve the highest possible utility level U1 (at point B). An individual can easily achieve the same utility level by not working at all (at point a). At point C he/she is just indifferent to not working. Any decrease in the wage rate will cause the individual to drop out of the labor force, because utility level U1 will no longer be attainable if he/she works any hours. Thus, the wage represented by the slope of be is a person’s reservation wage, the lowest wage for which he/she will work.
This fixed-cost model provides an explanation for why employees do not work a very small number of hours a week. A person working a very small number of hours will be able to cover the fixed costs of working and earn an extra, but he/she will not do as well in terms of utility as in the case of not working at all. (2)

2. Fixed time costs of working
An individual starting to work for pay will experience not only fixed monetary costs but also fixed time costs. Fixed time costs of working include commuting to work and transporting children to day care.
Let us analyze the influence fixed time costs of working have on person’s decision to work using the following graph:
Figure 2. (3)

We assume that an individual again has non-labor income in the amount of aT. If this individual does not work at all, he/she will locate at point a and have a utility level of U1. If the individual chooses to work, he/she incurs fixed time costs in the amount ab. In this case, the maximum number of hours a day available for work or leisure is no longer T but rather T1. The individual’s budget line thus starts at point b (not at point a as in the case of zero fixed time costs of working).
If an individual’s budget line is bc, he/she will locate at point A and yield utility level U2. But if a person has a lower wage rate (for example his/her budget line is bd), then he/she will achieve the maximum possible utility at point B. At this point, the utility is equal to U1, the utility level a person would attain from not working at all. Any lower wage would clearly induce the individual to drop out of the labor force, as utility level U1 could no longer be attained by working. Thus, if working, this individual will never work less than (T1 – N) hours. So the existence of fixed costs implies that individuals are not willing to work less than some minimum number of hours, termed reservation hours.


3. Estimated fixed costs of working for a typical employee
Fixed costs of working, of course, can be different for different people. They depend on the kind of employment (some employees have a special dress code at work, others do not), location of working place (some people need more time to get to work than others), individual’s tastes and preferences (some people prefer driving a car, others use public transport), situation in the family (some people have children and thus have to pay for child care, some people have relatives who look after their children, and some people do not have children and thus do not have to pay for child care), etc.
I am going to calculate the approximate fixed costs of working for a woman working as a broker in a real estate company in Moscow and having two children. Let us assume that she has monthly non-labor income in the amount of 20000 rubles from renting out a flat.

Table 1. Estimated fixed monetary costs of working for a typical employee (per month).
Cost of operating a car 2500 rubles
Cost of child care (in kindergarten) 1500 x 2 = 3000 rubles
Cost of dining out (the difference between cost of dining out and cost of eating at home) 3000 rubles
Cost of closing 2000 rubles
Total 10500 rubles

Fixed monetary costs of working per day = 10500 : 30 = 350 rubles
Non-labor income per day = 20000 : 30 = 667 rubles
This case is illustrated on the following graph:
Figure 3.

Point a illustrates the case when a woman chooses not to work at all. She achieves a utility level of U1 and receives non-labor income in amount of 667 rubles. Point A shows the real choice of a woman. She now chooses to work 8 hours a day and 8 hours spends on leisure activities. For these 8 hours of work she earns 1500 rubles of income. If, hypothetically, the wage rate falls to the slope of b.l.2, a woman will be indifferent between working for 9 hours a day earning 1100 rubles and not working at all (as in both cases she will achieve the same level of utility). If the wage rate decreases below this level, the woman will drop out of the labor force.

Table 2. Fixed time costs of working for a typical employee (per day).
Cost of commuting to work 2 hours
Cost of transporting children to kindergarten 0,5 hour
Total 2,5 hours

Fixed time costs of working are illustrated on the following graph:
Figure 4.

Point a illustrates the case when a woman chooses not to work at all. She spends 16 hours on leisure and achieves a utility level of U1. Point A shows the real choice of a woman. She now chooses to work 8 hours a day and 8 hours spends on leisure activities. If the wage rate falls to the slope of b.l.2, a woman will be indifferent between points B and a. If the wage rate decreases below this level, the woman will drop out of the labor force.

Conclusion.
Having studied and analyzed theoretical concepts concerning fixed costs of working, I applied them to the case of real employee and calculated both monetary and time fixed costs associated with the process of working for pay. Given example has shown that fixed costs of working amount to the great part of monthly earnings.
Theory says that due to fixed costs of working a person will not work if the wage is lower than reservation wage. Individuals are also not willing to work less than some minimum number of hours, termed reservation hours. We can see the proof of this concept in the given example.

Endnotes:
1) Ehrenberg R. G., Smith R. S. “Modern Labor Economics: Theory and Public Policy”. Addison-Wesley, 2004
2) “Labor Supply with Time and Money Costs of Participation”
The Rand Corporation, R—2044/HEW, October, 1977.
3) Ehrenberg R. G., Smith R. S. “Modern Labor Economics: Theory and Public Policy”. Addison-Wesley, 2004.
Bibliography:
1) Hanoch, G., "Hours and Weeks in the Theory of Labor Supply."
2) Ehrenberg R. G., Smith R. S. “Modern Labor Economics: Theory and Public Policy”. Addison-Wesley, 2004.
3) “Labor Supply with Time and Money Costs of Participation”
The Rand Corporation, R—2044/HEW, October, 1977.
4) http://www.det-sad.com




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