Effect of Overtime Wage on the Labour Supply | Microeconomics

The supply of labour depends on the net result of two opposite effects, viz.,

i. Substitution effect and

ii. Income effect.

If the substitution effect of a rise in wage exceeds the income effect the supply curve of labour will be backward bending. In this case as the wage rate increases, the number of hours supplied by a worker could actually fall.

Let us now suppose that the wage rate is a fixed sum per hour for the standard hours of work (say, 40 hours per week) and it is 50% higher for any overtime hours.

Employers normally gain by allowing existing workers work overtime at a higher wage rate rather than hire additional workers when their demand for labour is temporarily higher than normal. By doing this employers can save the costs of hiring and training new workers.

Moreover there are other costs associated with the employment of new workers such as employers’ contribution to provident fund, insurance premium and other types of compensation (such as bonus which are paid only to permanent workers).

These costs can be avoided by inducing existing workers to work overtime rather than by recruiting new workers. Since these costs are employee-related and not hours-related, employers have further incentive to allow existing workers work overtime. In general, unlike the case of paying a higher wage rate, such overtime pay will increase the number of hours worked.

It may be noted that while an increase in wage rate for all hours worked leads to a fall in the supply of labour, an increase in overtime wage beyond some standard hours of work result in an increase in the supply of labour. The reason is that a straight wage increase (i.e., wage increase for all hours worked) generates both income and substitution effects.

And if income effect outweighs substitution effect, the supply of labour falls. But an increase in overtime wage generates only substitution effect and leads to an increase in hours worked (labour supply). This point is illustrated in Fig. 12.5. Here IC­₁, IC₂ and IC₃ are the worker’s indifference curves between work (income) and leisure. We measure income on the vertical axis and hours of work and leisure on the horizontal axis. Hours of work are measured from right to left.

At the initial wage rate AB₁ is the worker’s budget line. The worker is on indifference curve IC₁ and works for N₁ hours. At a higher uniform wage rate AB₂ is the budget line. The worker is now on a higher indifference curve (IC₃), but he reduces the number of hours worked from N₁ to N₃.

With overtime pay the budget line has a kink. It tilts upward after the standard hours of work (i.e., N₁). The kinked budget line is shown as ACD. The worker is still on a higher indifference curve (IC₂), and the number of hours worked increases to N₂.

The number of hours worked does not necessarily increase with overtime pay. If the standard number of hours of work is greater than N₁ the kink is at a point to the left of point C. In this case the number of hours of work need not necessarily increase. It will depend on how far left of point C the kink occurs and how steep the new segment of the budget line is (how high the overtime pay rate is).

And if the standard number of hours is less than N₁ so that the worker puts in overtime even without overtime pay, then the number of extra hours might fall with the introduction of overtime pay rate. But for any worker working just the standard number of hours, overtime pay will always increase the hours of work supplied. The reason, is that a rise in overtime wage generates only substitution effect. It has no income effect.

In order to measure the effect of overtime pay on actual hours worked we have to consider the demand side of the labour market as well. A related point may also be noted here. Much of the government-mandated insurance legislation, which is employee-related rather than hours-related, increases the fixed costs of hiring new employees and provides an incentive for employees to use overtime hours.

The use of overtime hours reduces aggregate employment (in numbers of employees). This is why the government of a country may and often does introduce proposals periodically to increase overtime pay twice the pay rate for standard hours. The basic objective is to increase the marginal cost of using overtime hours and induce employers to hire new employees.