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CHAPTER 16
Justice Department). Testifying for the government was a prominent economist
(MIT professor Franklin Fisher). Testifying for Microsoft was an equally prominent economist (MIT professor Richard Schmalensee). At stake was the future
of one of the world’s most valuable companies (Microsoft) in one of the economy’s fastest growing industries (computer software).
A central issue in the Microsoft case involved tying—in particular, whether
Microsoft should be allowed to integrate its Internet browser into its Windows
operating system. The government claimed that Microsoft was bundling these
two products together to expand the market power it had in the market for
computer operating systems into an unrelated market (for Internet browsers).
Allowing Microsoft to incorporate such products into its operating system, the
government argued, would deter new software companies such as Netscape
from entering the market and offering new products.
Microsoft responded by pointing out that putting new features into old
products is a natural part of technological progress. Cars today include stereos
and air-conditioners, which were once sold separately, and cameras come with
built-in flashes. The same is true with operating systems. Over time, Microsoft
has added many features to Windows that were previously stand-alone products. This has made computers more reliable and easier to use because consumers can be confident that the pieces work together. The integration of
Internet technology, Microsoft argued, was the natural next step.
One point of disagreement concerned the extent of Microsoft’s market
power. Noting that more than 80 percent of new personal computers used a
Microsoft operating system, the government argued that the company had substantial monopoly power, which it was trying to expand. Microsoft replied that
the software market is always changing and that Microsoft’s Windows was
constantly being challenged by competitors, such as the Apple Mac and Linux
operating systems. It also argued that the low price it charged for Windows—
about $50, or only 3 percent of the price of a typical computer—was evidence
that its market power was severely limited.
As this book was going to press, the final outcome of the Microsoft case was
yet to be resolved. In November 1999 the trial judge issued a ruling in which he
found that Microsoft had great monopoly power and that it had illegally abused
that power. But many questions were still unanswered. Would the trial court’s
decision hold up on appeal? If so, what remedy would the government seek?
Would it try to regulate future design changes in the Windows operating system? Would it try to break up Microsoft into a group of smaller, more competitive companies? The answers to these questions will shape the software
industry for years to come.
Q U I C K Q U I Z : What kind of agreement is illegal for businesses to make?
◆ Why are the antitrust laws controversial?
CONCLUSION
Oligopolies would like to act like monopolies, but self-interest drives them closer
to competition. Thus, oligopolies can end up looking either more like monopolies
or more like competitive markets, depending on the number of firms in the
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O L I G O P O LY
371
“ME? A MONOPOLIST? NOW JUST WAIT A
MINUTE . . .”
372
PA R T F I V E
F I R M B E H AV I O R A N D T H E O R G A N I Z AT I O N O F I N D U S T R Y
oligopoly and how cooperative the firms are. The story of the prisoners’ dilemma
shows why oligopolies can fail to maintain cooperation, even when cooperation is
in their best interest.
Policymakers regulate the behavior of oligopolists through the antitrust laws.
The proper scope of these laws is the subject of ongoing controversy. Although
price fixing among competing firms clearly reduces economic welfare and should
be illegal, some business practices that appear to reduce competition may have legitimate if subtle purposes. As a result, policymakers need to be careful when they
use the substantial powers of the antitrust laws to place limits on firm behavior.
Summary
◆
◆
Oligopolists maximize their total profits by forming a
cartel and acting like a monopolist. Yet, if oligopolists
make decisions about production levels individually, the
result is a greater quantity and a lower price than under
the monopoly outcome. The larger the number of firms
in the oligopoly, the closer the quantity and price will be
to the levels that would prevail under competition.
of the prisoners’ dilemma applies in many situations,
including arms races, advertising, common-resource
problems, and oligopolies.
◆
The prisoners’ dilemma shows that self-interest can
prevent people from maintaining cooperation, even
when cooperation is in their mutual interest. The logic
Policymakers use the antitrust laws to prevent
oligopolies from engaging in behavior that reduces
competition. The application of these laws can be
controversial, because some behavior that may seem to
reduce competition may in fact have legitimate business
purposes.
Key Concepts
oligopoly, p. 350
monopolistic competition, p. 350
collusion, p. 353
prisoners’ dilemma, p. 359
dominant strategy, p. 360
cartel, p. 353
Nash equilibrium, p. 355
game theory, p. 358
Questions for Review
1.
If a group of sellers could form a cartel, what quantity
and price would they try to set?
5.
What is the prisoners’ dilemma, and what does it have
to do with oligopoly?
2.
Compare the quantity and price of an oligopoly to those
of a monopoly.
6.
Give two examples other than oligopoly to show how
the prisoners’ dilemma helps to explain behavior.
3.
Compare the quantity and price of an oligopoly to those
of a competitive market.
7.
What kinds of behavior do the antitrust laws prohibit?
8.
What is resale price maintenance, and why is it
controversial?
4.
How does the number of firms in an oligopoly affect the
outcome in its market?
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CHAPTER 16
O L I G O P O LY
373
Problems and Applications
1. The New York Times (Nov. 30, 1993) reported that “the
inability of OPEC to agree last week to cut production
has sent the oil market into turmoil . . . [leading to] the
lowest price for domestic crude oil since June 1990.”
a. Why were the members of OPEC trying to agree to
cut production?
b. Why do you suppose OPEC was unable to agree on
cutting production? Why did the oil market go into
“turmoil” as a result?
c. The newspaper also noted OPEC’s view “that
producing nations outside the organization, like
Norway and Britain, should do their share and cut
production.” What does the phrase “do their share”
suggest about OPEC’s desired relationship with
Norway and Britain?
2. A large share of the world supply of diamonds comes
from Russia and South Africa. Suppose that the
marginal cost of mining diamonds is constant at $1,000
per diamond, and the demand for diamonds is
described by the following schedule:
PRICE
QUANTITY
$8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
5,000
6,000
7,000
8,000
9,000
10,000
11,000
12,000
ideas apply to companies that are oligopolists in the
market for the inputs they buy.
a. If sellers who are oligopolists try to increase the
price of goods they sell, what is the goal of buyers
who are oligopolists?
b. Major league baseball team owners have an
oligopoly in the market for baseball players. What
is the owners’ goal regarding players’ salaries?
Why is this goal difficult to achieve?
c. Baseball players went on strike in 1994 because
they would not accept the salary cap that the
owners wanted to impose. If the owners were
already colluding over salaries, why did the owners
feel the need for a salary cap?
4. Describe several activities in your life in which game
theory could be useful. What is the common link among
these activities?
5. Consider trade relations between the United States and
Mexico. Assume that the leaders of the two countries
believe the payoffs to alternative trade policies are as
follows:
United States' Decision
Low Tariffs
b.
c.
d.
If there were many suppliers of diamonds, what
would be the price and quantity?
If there were only one supplier of diamonds, what
would be the price and quantity?
If Russia and South Africa formed a cartel, what
would be the price and quantity? If the countries
split the market evenly, what would be South
Africa’s production and profit? What would
happen to South Africa’s profit if it increased its
production by 1,000 while Russia stuck to the cartel
agreement?
Use your answer to part (c) to explain why cartel
agreements are often not successful.
3. This chapter discusses companies that are oligopolists in
the market for the goods they sell. Many of the same
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U.S. gains
$30 billion
Low
Tariffs
Mexico gains
$25 billion
Mexico's
Decision
Mexico gains
$10 billion
U.S. gains
$10 billion
U.S. gains
$20 billion
High
Tarrifs
Mexico gains
$30 billion
a.
High Tariffs
U.S. gains
$25 billion
a.
b.
c.
d.
Mexico gains
$20 billion
What is the dominant strategy for the United
States? For Mexico? Explain.
Define Nash equilibrium. What is the Nash
equilibrium for trade policy?
In 1993 the U.S. Congress ratified the North
American Free Trade Agreement (NAFTA), in
which the United States and Mexico agreed to
reduce trade barriers simultaneously. Do the
perceived payoffs as shown here justify this
approach to trade policy?
Based on your understanding of the gains from
trade (discussed in Chapters 3 and 9), do you think
that these payoffs actually reflect a nation’s welfare
under the four possible outcomes?
374
PA R T F I V E
F I R M B E H AV I O R A N D T H E O R G A N I Z AT I O N O F I N D U S T R Y
6. Suppose that you and a classmate are assigned a project
on which you will receive one combined grade. You
each want to receive a good grade, but you also want to
do as little work as possible. The decision box and
payoffs are as follows:
Your Decision
Work
You get A grade,
no fun
Shirk
You get B grade,
fun
Work
Classmate's
Decision
Classmate gets
A grade, no fun
You get B grade,
no fun
Classmate gets B
grade, no fun
You get D grade,
fun
Shirk
Classmate gets
B grade, fun
Classmate gets
D grade, fun
Assume that having fun is your normal state, but
having no fun is as unpleasant as receiving a grade that
is two letters lower.
a. Write out the decision box that combines the letter
grade and the amount of fun you have into a single
payoff for each outcome.
b. If neither you nor your classmate knows how much
work the other person is doing, what is the likely
outcome? Does it matter whether you are likely to
work with this person again? Explain your answer.
9. Farmer Jones and Farmer Smith graze their cattle on
the same field. If there are 20 cows grazing in the
field, each cow produces $4,000 of milk over its
lifetime. If there are more cows in the field, then each
cow can eat less grass, and its milk production falls.
With 30 cows on the field, each produces $3,000 of milk;
with 40 cows, each produces $2,000 of milk. Cows cost
$1,000 apiece.
a. Assume that Farmer Jones and Farmer Smith can
each purchase either 10 or 20 cows, but that neither
knows how many the other is buying when she
makes her purchase. Calculate the payoffs of each
outcome.
b. What is the likely outcome of this game? What
would be the best outcome? Explain.
c. There used to be more common fields than there are
today. Why? (For more discussion of this topic,
reread Chapter 11.)
10. Little Kona is a small coffee company that is considering
entering a market dominated by Big Brew. Each
company’s profit depends on whether Little Kona
enters and whether Big Brew sets a high price or a low
price:
Big Brew
7. The chapter states that the ban on cigarette advertising
on television in 1971 increased the profits of cigarette
companies. Could the ban still be good public policy?
Explain your answer.
8. A case study in the chapter describes a phone
conversation between the presidents of American
Airlines and Braniff Airways. Let’s analyze the game
between the two companies. Suppose that each
company can charge either a high price for tickets or a
low price. If one company charges $100, it earns low
profits if the other company charges $100 also, and high
profits if the other company charges $200. On the other
hand, if the company charges $200, it earns very low
profits if the other company charges $100, and medium
profits if the other company charges $200 also.
a. Draw the decision box for this game.
b. What is the Nash equilibrium in this game?
Explain.
c. Is there an outcome that would be better than
the Nash equilibrium for both airlines? How
could it be achieved? Who would lose if it were
achieved?
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High Price
Low Price
Brew makes
$3 million
Brew makes
$1 million
Enter
Kona makes
$2 million
Little
Kona
Kona loses
$1 million
Brew makes
$7 million
Don't
Enter
Kona makes
zero
Brew makes
$2 million
Kona makes
zero
Big Brew threatens Little Kona by saying, “If you enter,
we’re going to set a low price, so you had better stay
out.” Do you think Little Kona should believe the
threat? Why or why not? What do you think Little Kona
should do?
11. Jeff and Steve are playing tennis. Every point comes
down to whether Steve guesses correctly whether
Jeff will hit the ball to Steve’s left or right. The
outcomes are:
CHAPTER 16
Steve Guesses
Left
Right
Steve loses
point
Steve wins
point
Left
Jeff wins
point
Jeff loses
point
Jeff
Hits
Right
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Steve loses
point
Jeff wins
point
Steve wins
point
Jeff loses
point
O L I G O P O LY
375
Does either player have a dominant strategy? If Jeff
chooses a particular strategy (Left or Right) and sticks
with it, what will Steve do? So, can you think of a better
strategy for Jeff to follow?
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IN THIS CHAPTER
YOU WILL . . .
Analyze competition
among firms that
sell dif ferentiated
products
Compare the
outcome under
monopolistic
competition and
under per fect
competition
MONOPOLISTIC
COMPETITION
You walk into a bookstore to buy a book to read during your next vacation. On the
store’s shelves you find a John Grisham mystery, a Stephen King thriller, a Danielle
Steel romance, a Frank McCourt memoir, and many other choices. When you pick
out a book and buy it, what kind of market are you participating in?
On the one hand, the market for books seems competitive. As you look over
the shelves at your bookstore, you find many authors and many publishers vying
for your attention. A buyer in this market has thousands of competing products
from which to choose. And because anyone can enter the industry by writing and
publishing a book, the book business is not very profitable. For every highly paid
novelist, there are hundreds of struggling ones.
On the other hand, the market for books seems monopolistic. Because each
book is unique, publishers have some latitude in choosing what price to charge.
The sellers in this market are price makers rather than price takers. And, indeed,
the price of books greatly exceeds marginal cost. The price of a typical hardcover
377
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Consider the
desirability of
outcomes in
monopolistically
competitive
markets
Examine the debate
over the ef fects of
adver tising
Examine the debate
over the role of
brand names
378
PA R T F I V E
F I R M B E H AV I O R A N D T H E O R G A N I Z AT I O N O F I N D U S T R Y
monopolistic competition
a market structure in which many
firms sell products that are similar
but not identical
novel, for instance, is about $25, whereas the cost of printing one additional copy
of the novel is less than $5.
In this chapter we examine markets that have some features of competition and some features of monopoly. This market structure is called monopolistic
competition. Monopolistic competition describes a market with the following
attributes:
◆
◆
◆
Many sellers: There are many firms competing for the same group of
customers.
Product differentiation: Each firm produces a product that is at least slightly
different from those of other firms. Thus, rather than being a price taker, each
firm faces a downward-sloping demand curve.
Free entry: Firms can enter (or exit) the market without restriction. Thus,
the number of firms in the market adjusts until economic profits are driven
to zero.
A moment’s thought reveals a long list of markets with these attributes: books,
CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, and
so on.
Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of competition and monopoly. But oligopoly and monopolistic competition are quite different. Oligopoly departs from the perfectly
competitive ideal of Chapter 14 because there are only a few sellers in the market.
The small number of sellers makes rigorous competition less likely, and it makes
strategic interactions among them vitally important. By contrast, under monopolistic competition, there are many sellers, each of which is small compared to the
market. A monopolistically competitive market departs from the perfectly competitive ideal because each of the sellers offers a somewhat different product.
C O M P E T I T I O N W I T H D I F F E R E N T I AT E D P R O D U C T S
To understand monopolistically competitive markets, we first consider the decisions facing an individual firm. We then examine what happens in the long
run as firms enter and exit the industry. Next, we compare the equilibrium under monopolistic competition to the equilibrium under perfect competition that
we examined in Chapter 14. Finally, we consider whether the outcome in a monopolistically competitive market is desirable from the standpoint of society as a
whole.
T H E M O N O P O L I S T I C A L LY C O M P E T I T I V E
FIRM IN THE SHORT RUN
Each firm in a monopolistically competitive market is, in many ways, like a monopoly. Because its product is different from those offered by other firms, it faces a
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CHAPTER 17
(a) Firm Makes Profit
MONOPOLISTIC COMPETITION
(b) Firm Makes Losses
Price
Price
MC
MC
ATC
Average
total cost
Price
Price
Average
total cost
Demand
Profit
MR
0
ATC
Losses
Profitmaximizing
quantity
MR
Quantity
0
Lossminimizing
quantity
M ONOPOLISTIC C OMPETITORS IN THE S HORT R UN . Monopolistic competitors, like
monopolists, maximize profit by producing the quantity at which marginal revenue
equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is
above average total cost. The firm in panel (b) makes losses because, at this quantity, price
is less than average total cost.
downward-sloping demand curve. (By contrast, a perfectly competitive firm faces
a horizontal demand curve at the market price.) Thus, the monopolistically competitive firm follows a monopolist’s rule for profit maximization: It chooses the
quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price consistent with that quantity.
Figure 17-1 shows the cost, demand, and marginal-revenue curves for two
typical firms, each in a different monopolistically competitive industry. In both
panels of this figure, the profit-maximizing quantity is found at the intersection of
the marginal-revenue and marginal-cost curves. The two panels in this figure
show different outcomes for the firm’s profit. In panel (a), price exceeds average
total cost, so the firm makes a profit. In panel (b), price is below average total cost.
In this case, the firm is unable to make a positive profit, so the best the firm can do
is to minimize its losses.
All this should seem familiar. A monopolistically competitive firm chooses its
quantity and price just as a monopoly does. In the short run, these two types of
market structure are similar.
THE LONG-RUN EQUILIBRIUM
The situations depicted in Figure 17-1 do not last long. When firms are making profits, as in panel (a), new firms have an incentive to enter the market. This
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Demand
Quantity
Figure 17-1
379
380
PA R T F I V E
F I R M B E H AV I O R A N D T H E O R G A N I Z AT I O N O F I N D U S T R Y
entry increases the number of products from which customers can choose and,
therefore, reduces the demand faced by each firm already in the market. In other
words, profit encourages entry, and entry shifts the demand curves faced by the
incumbent firms to the left. As the demand for incumbent firms’ products falls,
these firms experience declining profit.
Conversely, when firms are making losses, as in panel (b), firms in the market
have an incentive to exit. As firms exit, customers have fewer products from which
to choose. This decrease in the number of firms expands the demand faced by
those firms that stay in the market. In other words, losses encourage exit, and exit
shifts the demand curves of the remaining firms to the right. As the demand for
the remaining firms’ products rises, these firms experience rising profit (that is, declining losses).
This process of entry and exit continues until the firms in the market are making exactly zero economic profit. Figure 17-2 depicts the long-run equilibrium.
Once the market reaches this equilibrium, new firms have no incentive to enter,
and existing firms have no incentive to exit.
Notice that the demand curve in this figure just barely touches the averagetotal-cost curve. Mathematically, we say the two curves are tangent to each other.
These two curves must be tangent once entry and exit have driven profit to zero.
Because profit per unit sold is the difference between price (found on the demand
curve) and average total cost, the maximum profit is zero only if these two curves
touch each other without crossing.
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CHAPTER 17
MONOPOLISTIC COMPETITION
381
Figure 17-2
Price
MC
ATC
P = ATC
Demand
MR
0
Profit-maximizing
quantity
Quantity
To sum up, two characteristics describe the long-run equilibrium in a monopolistically competitive market:
◆
◆
As in a monopoly market, price exceeds marginal cost. This conclusion arises
because profit maximization requires marginal revenue to equal marginal
cost and because the downward sloping demand curve makes marginal
revenue less than the price.
As in a competitive market, price equals average total cost. This conclusion
arises because free entry and exit drive economic profit to zero.
The second characteristic shows how monopolistic competition differs from monopoly. Because a monopoly is the sole seller of a product without close substitutes, it can earn positive economic profit, even in the long run. By contrast,
because there is free entry into a monopolistically competitive market, the economic profit of a firm in this type of market is driven to zero.
MONOPOLISTIC VERSUS PERFECT COMPETITION
Figure 17-3 compares the long-run equilibrium under monopolistic competition to
the long-run equilibrium under perfect competition. (Chapter 14 discussed the
equilibrium with perfect competition.) There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the markup.
E x c e s s C a p a c i t y As we have just seen, entry and exit drive each firm in a
monopolistically competitive market to a point of tangency between its demand
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A M ONOPOLISTIC C OMPETITOR
IN THE L ONG R UN . In a
monopolistically competitive
market, if firms are making
profit, new firms enter, and the
demand curves for the incumbent
firms shift to the left. Similarly, if
firms are making losses, old firms
exit, and the demand curves of
the remaining firms shift to the
right. Because of these shifts in
demand, a monopolistically
competitive firm eventually finds
itself in the long-run equilibrium
shown here. In this long-run
equilibrium, price equals average
total cost, and the firm earns zero
profit.
382
PA R T F I V E
F I R M B E H AV I O R A N D T H E O R G A N I Z AT I O N O F I N D U S T R Y
(b) Perfectly Competitive Firm
(a) Monopolistically Competitive Firm
Price
Price
MC
MC
ATC
ATC
Markup
P
P = MC
P = MR
(demand
curve)
Marginal
cost
MR
0
Quantity
produced
Efficient
scale
Demand
Quantity
0
Quantity produced =
Efficient scale
Quantity
Excess capacity
Figure 17-3
M ONOPOLISTIC VERSUS P ERFECT C OMPETITION . Panel (a) shows the long-run
equilibrium in a monopolistically competitive market, and panel (b) shows the long-run
equilibrium in a perfectly competitive market. Two differences are notable. (1) The
perfectly competitive firm produces at the efficient scale, where average total cost is
minimized. By contrast, the monopolistically competitive firm produces at less than the
efficient scale. (2) Price equals marginal cost under perfect competition, but price is above
marginal cost under monopolistic competition.
and average-total-cost curves. Panel (a) of Figure 17-3 shows that the quantity of
output at this point is smaller than the quantity that minimizes average total cost.
Thus, under monopolistic competition, firms produce on the downward-sloping
portion of their average-total-cost curves. In this way, monopolistic competition
contrasts starkly with perfect competition. As panel (b) of Figure 17-3 shows, free
entry in competitive markets drives firms to produce at the minimum of average
total cost.
The quantity that minimizes average total cost is called the efficient scale of the
firm. In the long run, perfectly competitive firms produce at the efficient scale,
whereas monopolistically competitive firms produce below this level. Firms are
said to have excess capacity under monopolistic competition. In other words, a monopolistically competitive firm, unlike a perfectly competitive firm, could increase
the quantity it produces and lower the average total cost of production.
Markup over Marginal Cost
A second difference between perfect competition and monopolistic competition is the relationship between price and marginal cost. For a competitive firm, such as that shown in panel (b) of Figure 17-3,
price equals marginal cost. For a monopolistically competitive firm, such as that
shown in panel (a), price exceeds marginal cost, because the firm always has some
market power.
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CHAPTER 17
MONOPOLISTIC COMPETITION
How is this markup over marginal cost consistent with free entry and zero
profit? The zero-profit condition ensures only that price equals average total
cost. It does not ensure that price equals marginal cost. Indeed, in the long-run
equilibrium, monopolistically competitive firms operate on the declining portion of their average-total-cost curves, so marginal cost is below average total cost. Thus, for price to equal average total cost, price must be above marginal
cost.
In this relationship between price and marginal cost, we see a key behavioral
difference between perfect competitors and monopolistic competitors. Imagine
that you were to ask a firm the following question: “Would you like to see another
customer come through your door ready to buy from you at your current price?”
A perfectly competitive firm would answer that it didn’t care. Because price exactly equals marginal cost, the profit from an extra unit sold is zero. By contrast, a
monopolistically competitive firm is always eager to get another customer. Because its price exceeds marginal cost, an extra unit sold at the posted price means
more profit. According to an old quip, monopolistically competitive markets are
those in which sellers send Christmas cards to the buyers.
MONOPOLISTIC COMPETITION AND
T H E W E L FA R E O F S O C I E T Y
Is the outcome in a monopolistically competitive market desirable from the standpoint of society as a whole? Can policymakers improve on the market outcome?
There are no simple answers to these questions.
One source of inefficiency is the markup of price over marginal cost. Because
of the markup, some consumers who value the good at more than the marginal
cost of production (but less than the price) will be deterred from buying it. Thus, a
monopolistically competitive market has the normal deadweight loss of monopoly
pricing. We first saw this type of inefficiency when we discussed monopoly in
Chapter 15.
Although this outcome is clearly undesirable compared to the first-best outcome of price equal to marginal cost, there is no easy way for policymakers to fix
the problem. To enforce marginal-cost pricing, policymakers would need to regulate all firms that produce differentiated products. Because such products are so
common in the economy, the administrative burden of such regulation would be
overwhelming.
Moreover, regulating monopolistic competitors would entail all the problems
of regulating natural monopolies. In particular, because monopolistic competitors
are making zero profits already, requiring them to lower their prices to equal marginal cost would cause them to make losses. To keep these firms in business, the
government would need to help them cover these losses. Rather than raising taxes
to pay for these subsidies, policymakers may decide it is better to live with the
inefficiency of monopolistic pricing.
Another way in which monopolistic competition may be socially inefficient is
that the number of firms in the market may not be the “ideal” one. That is, there
may be too much or too little entry. One way to think about this problem is in
terms of the externalities associated with entry. Whenever a new firm considers entering the market with a new product, it considers only the profit it would make.
Yet its entry would also have two external effects:
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383
384
PA R T F I V E
F I R M B E H AV I O R A N D T H E O R G A N I Z AT I O N O F I N D U S T R Y
◆
◆
The product-variety externality: Because consumers get some consumer surplus
from the introduction of a new product, entry of a new firm conveys a
positive externality on consumers.
The business-stealing externality: Because other firms lose customers and
profits from the entry of a new competitor, entry of a new firm imposes a
negative externality on existing firms.
Thus, in a monopolistically competitive market, there are both positive and negative externalities associated with the entry of new firms. Depending on which externality is larger, a monopolistically competitive market could have either too few
or too many products.
Both of these externalities are closely related to the conditions for monopolistic competition. The product-variety externality arises because a new firm would
offer a product different from those of the existing firms. The business-stealing externality arises because firms post a price above marginal cost and, therefore, are
always eager to sell additional units. Conversely, because perfectly competitive
firms produce identical goods and charge a price equal to marginal cost, neither of
these externalities exists under perfect competition.
In the end, we can conclude only that monopolistically competitive markets
do not have all the desirable welfare properties of perfectly competitive markets.
That is, the invisible hand does not ensure that total surplus is maximized under
monopolistic competition. Yet because the inefficiencies are subtle, hard to measure, and hard to fix, there is no easy way for public policy to improve the market
outcome.
Q U I C K Q U I Z : List the three key attributes of monopolistic competition.
◆ Draw and explain a diagram to show the long-run equilibrium in a
monopolistically competitive market. How does this equilibrium differ from
that in a perfectly competitive market?
FYI
Is Excess
Capacity a
Social Problem?
As we have seen, monopolistically competitive firms produce
a quantity of output below the
level that minimizes average total cost. By contrast, firms in
per fectly competitive markets
are driven to produce at the
quantity that minimizes average
total cost. This comparison between perfect and monopolistic
competition has led some
economists in the past to argue that the excess capacity of
monopolistic competitors was a source of inefficiency.
Today economists understand that the excess capacity of monopolistic competitors is not directly relevant for
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evaluating economic welfare. There is no reason that society should want all firms to produce at the minimum of
average total cost. For example, consider a publishing firm.
Producing a novel might take a fixed cost of $50,000 (the
author’s time) and variable costs of $5 per book (the cost of
printing). In this case, the average total cost of a book declines as the number of books increases because the fixed
cost gets spread over more and more units. The average total cost is minimized by printing an infinite number of books.
But in no sense is infinity the right number of books for society to produce.
In short, monopolistic competitors do have excess capacity, but this fact tells us little about the desirability of the
market outcome.
CHAPTER 17
MONOPOLISTIC COMPETITION
ADVERTISING
It is nearly impossible to go through a typical day in a modern economy without
being bombarded with advertising. Whether you are reading a newspaper, watching television, or driving down the highway, some firm will try to convince you to
buy its product. Such behavior is a natural feature of monopolistic competition.
When firms sell differentiated products and charge prices above marginal cost,
each firm has an incentive to advertise in order to attract more buyers to its particular product.
The amount of advertising varies substantially across products. Firms that sell
highly differentiated consumer goods, such as over-the-counter drugs, perfumes,
soft drinks, razor blades, breakfast cereals, and dog food, typically spend between
10 and 20 percent of revenue for advertising. Firms that sell industrial products,
such as drill presses and communications satellites, typically spend very little on
advertising. And firms that sell homogeneous products, such as wheat, peanuts, or
crude oil, spend nothing at all. For the economy as a whole, spending on advertising comprises about 2 percent of total firm revenue, or more than $100 billion.
Advertising takes many forms. About one-half of advertising spending is for
space in newspapers and magazines, and about one-third is for commercials on
television and radio. The rest is spent on various other ways of reaching customers, such as direct mail, billboards, and the Goodyear blimp.
T H E D E B AT E O V E R A D V E R T I S I N G
Is society wasting the resources it devotes to advertising? Or does advertising
serve a valuable purpose? Assessing the social value of advertising is difficult and
often generates heated argument among economists. Let’s consider both sides of
the debate.
The Critique of Adver tising
Critics of advertising argue that firms advertise in order to manipulate people’s tastes. Much advertising is psychological
rather than informational. Consider, for example, the typical television commercial
for some brand of soft drink. The commercial most likely does not tell the viewer
about the product’s price or quality. Instead, it might show a group of happy people at a party on a beach on a beautiful sunny day. In their hands are cans of the
soft drink. The goal of the commercial is to convey a subconscious (if not subtle)
message: “You too can have many friends and be happy, if only you drink our
product.” Critics of advertising argue that such a commercial creates a desire that
otherwise might not exist.
Critics also argue that advertising impedes competition. Advertising often
tries to convince consumers that products are more different than they truly are.
By increasing the perception of product differentiation and fostering brand loyalty,
advertising makes buyers less concerned with price differences among similar
goods. With a less elastic demand curve, each firm charges a larger markup over
marginal cost.
The Defense of Adver tising
Defenders of advertising argue that firms
use advertising to provide information to customers. Advertising conveys the
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prices of the goods being offered for sale, the existence of new products, and the
locations of retail outlets. This information allows customers to make better
choices about what to buy and, thus, enhances the ability of markets to allocate resources efficiently.
Defenders also argue that advertising fosters competition. Because advertising
allows customers to be more fully informed about all the firms in the market, customers can more easily take advantage of price differences. Thus, each firm has
less market power. In addition, advertising allows new firms to enter more easily,
because it gives entrants a means to attract customers from existing firms.
Over time, policymakers have come to accept the view that advertising can
make markets more competitive. One important example is the regulation of certain professions, such as lawyers, doctors, and pharmacists. In the past, these
groups succeeded in getting state governments to prohibit advertising in their
fields on the grounds that advertising was “unprofessional.” In recent years, however, the courts have concluded that the primary effect of these restrictions on advertising was to curtail competition. They have, therefore, overturned many of the
laws that prohibit advertising by members of these professions.
CASE STUDY
ADVERTISING AND THE PRICE OF EYEGLASSES
What effect does advertising have on the price of a good? On the one hand, advertising might make consumers view products as being more different than
they otherwise would. If so, it would make markets less competitive and firms’
demand curves less elastic, and this would lead firms to charge higher prices.
On the other hand, advertising might make it easier for consumers to find the
firms offering the best prices. In this case, it would make markets more competitive and firms’ demand curves more elastic, and this would lead to lower
prices.
In an article published in the Journal of Law and Economics in 1972, economist
Lee Benham tested these two views of advertising. In the United States during
the 1960s, the various state governments had vastly different rules about advertising by optometrists. Some states allowed advertising for eyeglasses and eye
examinations. Many states, however, prohibited it. For example, the Florida law
read as follows:
It is unlawful for any person, firm, or corporation to . . . advertise either
directly or indirectly by any means whatsoever any definite or indefinite price
or credit terms on prescriptive or corrective lens, frames, complete
prescriptive or corrective glasses, or any optometric service. . . . This section is
passed in the interest of public health, safety, and welfare, and its provisions
shall be liberally construed to carry out its objects and purposes.
Professional optometrists enthusiastically endorsed these restrictions on
advertising.
Benham used the differences in state law as a natural experiment to test
the two views of advertising. The results were striking. In those states that prohibited advertising, the average price paid for a pair of eyeglasses was $33.
(This number is not as low as it seems, for this price is from 1963, when all
prices were much lower than they are today. To convert 1963 prices into today’s dollars, you can multiply them by 5.) In those states that did not restrict
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advertising, the average price was $26. Thus, advertising reduced average
prices by more than 20 percent. In the market for eyeglasses, and probably in
many other markets as well, advertising fosters competition and leads to lower
prices for consumers.
ADVERTISING AS A SIGNAL OF QUALITY
Many types of advertising contain little apparent information about the product
being advertised. Consider a firm introducing a new breakfast cereal. A typical advertisement might have some highly paid actor eating the cereal and exclaiming
how wonderful it tastes. How much information does the advertisement really
provide?
The answer is: more than you might think. Defenders of advertising argue that
even advertising that appears to contain little hard information may in fact tell
consumers something about product quality. The willingness of the firm to spend
a large amount of money on advertising can itself be a signal to consumers about
the quality of the product being offered.
Consider the problem facing two firms—Post and Kellogg. Each company has
just come up with a recipe for a new cereal, which it would sell for $3 a box. To
keep things simple, let’s assume that the marginal cost of making cereal is zero, so
the $3 is all profit. Each company knows that if it spends $10 million on advertising, it will get 1 million consumers to try its new cereal. And each company knows
that if consumers like the cereal, they will buy it not once but many times.
First consider Post’s decision. Based on market research, Post knows that its
cereal is only mediocre. Although advertising would sell one box to each of 1 million consumers, the consumers would quickly learn that the cereal is not very
good and stop buying it. Post decides it is not worth paying $10 million in advertising to get only $3 million in sales. So it does not bother to advertise. It sends its
cooks back to the drawing board to find another recipe.
Kellogg, on the other hand, knows that its cereal is great. Each person who
tries it will buy a box a month for the next year. Thus, the $10 million in advertising will bring in $36 million in sales. Advertising is profitable here because Kellogg
has a good product that consumers will buy repeatedly. Thus, Kellogg chooses to
advertise.
Now that we have considered the behavior of the two firms, let’s consider the
behavior of consumers. We began by asserting that consumers are inclined to try a
new cereal that they see advertised. But is this behavior rational? Should a consumer try a new cereal just because the seller has chosen to advertise it?
In fact, it may be completely rational for consumers to try new products that
they see advertised. In our story, consumers decide to try Kellogg’s new cereal because Kellogg advertises. Kellogg chooses to advertise because it knows that its cereal is quite good, while Post chooses not to advertise because it knows that its
cereal is only mediocre. By its willingness to spend money on advertising, Kellogg
signals to consumers the quality of its cereal. Each consumer thinks, quite sensibly,
“Boy, if the Kellogg Company is willing to spend so much money advertising this
new cereal, it must be really good.”
What is most surprising about this theory of advertising is that the content of
the advertisement is irrelevant. Kellogg signals the quality of its product by its
willingness to spend money on advertising. What the advertisements say is not as
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important as the fact that consumers know ads are expensive. By contrast, cheap
advertising cannot be effective at signaling quality to consumers. In our example,
if an advertising campaign cost less than $3 million, both Post and Kellogg would
use it to market their new cereals. Because both good and mediocre cereals would
be advertised, consumers could not infer the quality of a new cereal from the
fact that it is advertised. Over time, consumers would learn to ignore such cheap
advertising.
This theory can explain why firms pay famous actors large amounts of money
to make advertisements that, on the surface, appear to convey no information at
all. The information is not in the advertisement’s content, but simply in its existence and expense.
BRAND NAMES
Advertising is closely related to the existence of brand names. In many markets,
there are two types of firms. Some firms sell products with widely recognized
brand names, while other firms sell generic substitutes. For example, in a typical
drugstore, you can find Bayer aspirin on the shelf next to a generic aspirin. In a
typical grocery store, you can find Pepsi next to less familiar colas. Most often, the
firm with the brand name spends more on advertising and charges a higher price
for its product.
Just as there is disagreement about the economics of advertising, there is disagreement about the economics of brand names. Let’s consider both sides of the
debate.
Critics of brand names argue that brand names cause consumers to perceive
differences that do not really exist. In many cases, the generic good is almost indistinguishable from the brand-name good. Consumers’ willingness to pay more
for the brand-name good, these critics assert, is a form of irrationality fostered by
advertising. Economist Edward Chamberlin, one of the early developers of the
theory of monopolistic competition, concluded from this argument that brand
names were bad for the economy. He proposed that the government discourage
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their use by refusing to enforce the exclusive trademarks that companies use to
identify their products.
More recently, economists have defended brand names as a useful way for
consumers to ensure that the goods they buy are of high quality. There are two related arguments. First, brand names provide consumers information about quality
when quality cannot be easily judged in advance of purchase. Second, brand
names give firms an incentive to maintain high quality, because firms have a financial stake in maintaining the reputation of their brand names.
To see how these arguments work in practice, consider a famous brand name:
McDonald’s hamburgers. Imagine that you are driving through an unfamiliar
town and want to stop for lunch. You see a McDonald’s and a local restaurant next
to it. Which do you choose? The local restaurant may in fact offer better food at
lower prices, but you have no way of knowing that. By contrast, McDonald’s offers a consistent product across many cities. Its brand name is useful to you as a
way of judging the quality of what you are about to buy.
The McDonald’s brand name also ensures that the company has an incentive
to maintain quality. For example, if some customers were to become ill from bad
food sold at a McDonald’s, the news would be disastrous for the company.
McDonald’s would lose much of the valuable reputation that it has built up with
years of expensive advertising. As a result, it would lose sales and profit not just in
the outlet that sold the bad food but in its many outlets throughout the country.
By contrast, if some customers were to become ill from bad food at a local restaurant, that restaurant might have to close down, but the lost profits would be
much smaller. Hence, McDonald’s has a greater incentive to ensure that its food
is safe.
The debate over brand names thus centers on the question of whether consumers are rational in preferring brand names over generic substitutes. Critics of
brand names argue that brand names are the result of an irrational consumer response to advertising. Defenders of brand names argue that consumers have good
reason to pay more for brand-name products because they can be more confident
in the quality of these products.
CASE STUDY
BRAND NAMES UNDER COMMUNISM
Defenders of brand names get some support for their view from experiences in
the former Soviet Union. When the Soviet Union adhered to the principles of
communism, central planners in the government replaced the invisible hand of
the marketplace. Yet, just like consumers living in an economy with free markets, Soviet central planners learned that brand names were useful in helping to
ensure product quality.
In an article published in the Journal of Political Economy in 1960, Marshall
Goldman, an expert on the Soviet economy, described the Soviet experience:
In the Soviet Union, production goals have been set almost solely in
quantitative or value terms, with the result that, in order to meet the plan,
quality is often sacrificed. . . . Among the methods adopted by the Soviets to
deal with this problem, one is of particular interest to us—intentional product
differentiation. . . . In order to distinguish one firm from similar firms in the
same industry or ministry, each firm has its own name. Whenever it is
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IN THE NEWS
TV Networks as
Brand Names
BRAND NAMES CONVEY INFORMATION TO
consumers about the goods that firms
are offering. Establishing a brand
name—and ensuring that it conveys
the right information—is an important
strategy for many businesses, including
TV networks.
A TV Season When
Image Is Everything
BY STUART ELLIOTT
A marketing blitz to promote fall television programming, estimated at a record $400 million to $500 million, has
been inundating America with a barrage
of branding.
Branding is a shorthand term along
Madison Avenue for attempts to create
or burnish an identity or image, just as
Coca-Cola seeks to distinguish itself
from Pepsi-Cola. For the 1996–97
prime-time broadcast television season,
which officially began this week, viewers
have been swamped by the torrent of
teasing practically since the 1995–96
season ended in May.
At the center of those efforts is the
most ambitious push ever by the broadcast networks to brand themselves and
many of the blocks of programming they
offer—a marked departure from the
past, when they would promote only
specific shows.
“The perception was that people
watched shows, not networks,” said
Bob Bibb, who with Lewis Goldstein
jointly heads marketing for WB, a fledgling network owned by Time Warner, Inc.,
and based in Burbank, California.
“But that was when there were only
three networks, three choices,” Mr. Bibb
added, “and it was easy to find the
shows you liked.”
WB has been presenting a sassy
singing cartoon character named Michigan J. Frog as its “spokesphibian,” personifying the entire lineup of the
“Dubba-dubba-WB”—as he insists upon
calling the network.
“It’s not a frog, it’s an attitude,” Mr.
Bibb said, “a consistency from show to
show.”
In television, an intrinsic part of
branding is selecting shows that seem
related and might appeal to a certain audience segment. It means “developing
AN
ATTITUDE , NOT JUST A FROG
an overall packaging of the network to
build a relationship with viewers, so they
will come to expect certain things from
us,” said Alan Cohen, executive vice
president for the ABC-TV unit of the
Walt Disney Company in New York.
That, he said, means defining the
network so that “when you’re watching
ABC, you’ll know you’re watching
ABC”—and to accomplish it in a way
that appeals to the primary ABC audience of youngish urbanites and families
with children.
SOURCE: The New York Times, September 20, 1996,
p. D1.
physically possible, it is obligatory that the firm identify itself on the good or
packaging with a “production mark.”
Goldman quotes the analysis of a Soviet marketing expert:
This [trademark] makes it easy to establish the actual producer of the product
in case it is necessary to call him to account for the poor quality of his goods.
For this reason, it is one of the most effective weapons in the battle for the
quality of products. . . . The trademark makes it possible for the consumer to
select the good which he likes. . . . This forces other firms to undertake
measures to improve the quality of their own product in harmony with the
demands of the consumer.
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391
Goldman notes that “these arguments are clear enough and sound as if they
might have been written by a bourgeois apologist.”
Q U I C K Q U I Z : How might advertising make markets less competitive?
How might it make markets more competitive? ◆ Give the arguments for
and against brand names.
CONCLUSION
Monopolistic competition is true to its name: It is a hybrid of monopoly and competition. Like a monopoly, each monopolistic competitor faces a downwardsloping demand curve and, as a result, charges a price above marginal cost. As in
a competitive market, however, there are many firms, and entry and exit drive the
profit of each monopolistic competitor toward zero. Because monopolistically
competitive firms produce differentiated products, each firm advertises in order to
attract customers to its own brand. To some extent, advertising manipulates consumers’ tastes, promotes irrational brand loyalty, and impedes competition. To a
larger extent, advertising provides information, establishes brand names of reliable quality, and fosters competition.
The theory of monopolistic competition seems to describe many markets in
the economy. It is somewhat disappointing, therefore, that the theory does not
yield simple and compelling advice for public policy. From the standpoint of the
economic theorist, the allocation of resources in monopolistically competitive markets is not perfect. Yet, from the standpoint of a practical policymaker, there may
be little that can be done to improve it.
Summary
◆
A monopolistically competitive market is characterized
by three attributes: many firms, differentiated products,
and free entry.
◆
The equilibrium in a monopolistically competitive
market differs from that in a perfectly competitive
market in two related ways. First, each firm has excess
capacity. That is, it operates on the downward-sloping
portion of the average-total-cost curve. Second, each
firm charges a price above marginal cost.
◆
Monopolistic competition does not have all the
desirable properties of perfect competition. There is the
standard deadweight loss of monopoly caused by the
markup of price over marginal cost. In addition, the
number of firms (and thus the variety of products) can
be too large or too small. In practice, the ability of
policymakers to correct these inefficiencies is limited.
◆
The product differentiation inherent in monopolistic
competition leads to the use of advertising and brand
names. Critics of advertising and brand names argue
that firms use them to take advantage of consumer
irrationality and to reduce competition. Defenders of
advertising and brand names argue that firms use them
to inform consumers and to compete more vigorously
on price and product quality.
Key Concepts
monopolistic competition, p. 378
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Questions for Review
1.
Describe the three attributes of monopolistic
competition. How is monopolistic competition like
monopoly? How is it like perfect competition?
2.
Draw a diagram depicting a firm in a monopolistically
competitive market that is making profits. Now show
what happens to this firm as new firms enter the
industry.
3.
Draw a diagram of the long-run equilibrium in a
monopolistically competitive market. How is price
related to average total cost? How is price related to
marginal cost?
4.
Does a monopolistic competitor produce too much or
too little output compared to the most efficient level?
What practical considerations make it difficult for
policymakers to solve this problem?
5.
How might advertising reduce economic well-being?
How might advertising increase economic well-being?
6.
How might advertising with no apparent informational
content in fact convey information to consumers?
7.
Explain two benefits that might arise from the existence
of brand names.
Problems and Applications
1. Classify the following markets as perfectly competitive,
monopolistic, or monopolistically competitive, and
explain your answers.
a. wooden #2 pencils
b. bottled water
c. copper
d. local telephone service
e. peanut butter
f. lipstick
2. What feature of the product being sold distinguishes a
monopolistically competitive firm from a monopolistic
firm?
3. The chapter states that monopolistically competitive
firms could increase the quantity they produce and
lower the average total cost of production. Why don’t
they do so?
4. Sparkle is one firm of many in the market for
toothpaste, which is in long-run equilibrium.
DO FIRMS:
Make differentiated products?
Have excess capacity?
Advertise?
Pick Q so that MR ⫽ MC?
Pick Q so that P ⫽ MC?
Earn economic profits in long-run equilibrium?
Face a downward-sloping demand curve?
Have MR less than price?
Face the entry of other firms?
Exit in the long run if profits are less than zero?
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a.
b.
c.
d.
Draw a diagram showing Sparkle’s demand curve,
marginal-revenue curve, average-total-cost curve,
and marginal-cost curve. Label Sparkle’s profitmaximizing output and price.
What is Sparkle’s profit? Explain.
On your diagram, show the consumer surplus
derived from the purchase of Sparkle toothpaste.
Also show the deadweight loss relative to the
efficient level of output.
If the government forced Sparkle to produce
the efficient level of output, what would happen
to the firm? What would happen to Sparkle’s
customers?
5. Do monopolistically competitive markets typically have
the optimal number of products? Explain.
6. Complete the table below by filling in YES, NO, or
MAYBE for each type of market structure.
PERFECT
COMPETITION
MONOPOLISTIC
COMPETITION
MONOPOLY
CHAPTER 17
7. The chapter says that monopolistically competitive
firms may send Christmas cards to their customers.
What do they accomplish by this? Explain in words and
with a diagram.
8. If you were thinking of entering the ice-cream business,
would you try to make ice cream that is just like one of
the existing brands? Explain your decision using the
ideas of this chapter.
9. Describe three commercials that you have seen on TV.
In what ways, if any, were each of these commercials
socially useful? In what ways were they socially
wasteful? Did the commercials affect the likelihood of
your buying the product, and why?
10. For each of the following pairs of firms, explain which
firm would be more likely to engage in advertising.
a. a family-owned farm or a family-owned restaurant
b. a manufacturer of forklifts or a manufacturer
of cars
c. a company that invented a very reliable watch or a
company that invented a less reliable watch that
costs the same amount to make
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MONOPOLISTIC COMPETITION
393
11. Twenty years ago the market for chicken was perfectly
competitive. Then Frank Perdue began marketing
chicken under his name.
a. How do you suppose Perdue created a brand name
for chicken? What did he gain from doing so?
b. What did society gain from having brand-name
chicken? What did society lose?
12. The makers of Tylenol pain reliever do a lot of
advertising and have very loyal customers. In contrast,
the makers of generic acetaminophen do no advertising,
and their customers shop only for the lowest price.
Assume that the marginal costs of Tylenol and generic
acetaminophen are the same and constant.
a. Draw a diagram showing Tylenol’s demand,
marginal-revenue, and marginal-cost curves. Label
Tylenol’s price and markup over marginal cost.
b. Repeat part (a) for a producer of generic
acetaminophen. How do the diagrams differ?
Which company has the bigger markup? Explain.
c. Which company has the bigger incentive for careful
quality control? Why?
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IN THIS CHAPTER
YOU WILL . . .
Analyze the labor
demand of
competitive, profitmaximizing firms
Consider the
household decisions
that lie behind
labor supply
THE
MARKETS
FACTORS
OF
FOR
THE
PRODUCTION
When you finish school, your income will be determined largely by what kind of
job you take. If you become a computer programmer, you will earn more than if
you become a gas station attendant. This fact is not surprising, but it is not obvious
why it is true. No law requires that computer programmers be paid more than gas
station attendants. No ethical principle says that programmers are more deserving. What then determines which job will pay you the higher wage?
Your income, of course, is a small piece of a larger economic picture. In 1999
the total income of all U.S. residents was about $8 trillion. People earned this income in various ways. Workers earned about three-fourths of it in the form of
wages and fringe benefits. The rest went to landowners and to the owners of capital—the economy’s stock of equipment and structures—in the form of rent, profit,
and interest. What determines how much goes to workers? To landowners? To the
owners of capital? Why do some workers earn higher wages than others, some
397
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Learn why
equilibrium wages
equal the value of
the marginal
product of labor
Consider how the
other factors of
production—land
and capital—are
compensated
Examine how a
change in the
supply of one factor
alters the earnings
of all the factors
398
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
factors of production
the inputs used to produce goods and
services
landowners higher rental income than others, and some capital owners greater
profit than others? Why, in particular, do computer programmers earn more than
gas station attendants?
The answers to these questions, like most in economics, hinge on supply and
demand. The supply and demand for labor, land, and capital determine the prices
paid to workers, landowners, and capital owners. To understand why some people have higher incomes than others, therefore, we need to look more deeply at
the markets for the services they provide. That is our job in this and the next two
chapters.
This chapter provides the basic theory for the analysis of factor markets. As
you may recall from Chapter 2, the factors of production are the inputs used to
produce goods and services. Labor, land, and capital are the three most important
factors of production. When a computer firm produces a new software program, it
uses programmers’ time (labor), the physical space on which its offices sit (land),
and an office building and computer equipment (capital). Similarly, when a gas
station sells gas, it uses attendants’ time (labor), the physical space (land), and the
gas tanks and pumps (capital).
Although in many ways factor markets resemble the goods markets we have
analyzed in previous chapters, they are different in one important way: The demand for a factor of production is a derived demand. That is, a firm’s demand for a
factor of production is derived from its decision to supply a good in another market. The demand for computer programmers is inextricably tied to the supply of
computer software, and the demand for gas station attendants is inextricably tied
to the supply of gasoline.
In this chapter we analyze factor demand by considering how a competitive,
profit-maximizing firm decides how much of any factor to buy. We begin our
analysis by examining the demand for labor. Labor is the most important factor of
production, for workers receive most of the total income earned in the U.S. economy. Later in the chapter, we see that the lessons we learn about the labor market
apply directly to the markets for the other factors of production.
The basic theory of factor markets developed in this chapter takes a large step
toward explaining how the income of the U.S. economy is distributed among
workers, landowners, and owners of capital. Chapter 19 will build on this analysis
to examine in more detail why some workers earn more than others. Chapter 20
will examine how much inequality results from this process and then consider
what role the government should and does play in altering the distribution of
income.
THE DEMAND FOR LABOR
Labor markets, like other markets in the economy, are governed by the forces of
supply and demand. This is illustrated in Figure 18-1. In panel (a) the supply and
demand for apples determine the price of apples. In panel (b) the supply and demand for apple pickers determine the price, or wage, of apple pickers.
As we have already noted, labor markets are different from most other markets because labor demand is a derived demand. Most labor services, rather than
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CHAPTER 18
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
(a) The Market for Apples
(b) The Market for Apple Pickers
Price of
Apples
Wage of
Apple
Pickers
Supply
P
Supply
W
Demand
Demand
0
Q
Quantity of
Apples
0
T HE V ERSATILITY OF S UPPLY AND D EMAND . The basic tools of supply and demand
apply to goods and to labor services. Panel (a) shows how the supply and demand
for apples determine the price of apples. Panel (b) shows how the supply and demand for
apple pickers determine the wage of apple pickers.
being final goods ready to be enjoyed by consumers, are inputs into the production of other goods. To understand labor demand, we need to focus on the firms
that hire the labor and use it to produce goods for sale. By examining the link between the production of goods and the demand for labor, we gain insight into the
determination of equilibrium wages.
THE COMPETITIVE PROFIT-MAXIMIZING FIRM
Let’s look at how a typical firm, such as an apple producer, decides the quantity of
labor to demand. The firm owns an apple orchard and each week must decide
how many apple pickers to hire to harvest its crop. After the firm makes its hiring
decision, the workers pick as many apples as they can. The firm then sells the apples, pays the workers, and keeps what is left as profit.
We make two assumptions about our firm. First, we assume that our firm is
competitive both in the market for apples (where the firm is a seller) and in the
market for apple pickers (where the firm is a buyer). Recall from Chapter 14 that a
competitive firm is a price taker. Because there are many other firms selling apples
and hiring apple pickers, a single firm has little influence over the price it gets for
apples or the wage it pays apple pickers. The firm takes the price and the wage as
given by market conditions. It only has to decide how many workers to hire and
how many apples to sell.
Second, we assume that the firm is profit-maximizing. Thus, the firm does not
directly care about the number of workers it has or the number of apples it produces. It cares only about profit, which equals the total revenue from the sale of
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L
Quantity of
Apple Pickers
Figure 18-1
399
400
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
VALUE OF THE
MARGINAL PRODUCT
OF LABOR
WAGE
MARGINAL
PROFIT
LABOR
OUTPUT
MARGINAL PRODUCT
OF LABOR
L
(NUMBER OF WORKERS)
Q
(BUSHELS PER WEEK)
MPL ⴝ ∆Q/∆L
(BUSHELS PER WEEK)
VMPL ⴝ P ⴛ MPL
W
∆PROFIT ⴝ
VMPL ⴚ W
0
1
2
3
4
5
0
100
180
240
280
300
100
80
60
40
20
$1,000
800
600
400
200
$500
500
500
500
500
$500
300
100
⫺100
⫺300
Ta b l e 1 8 - 1
H OW
THE
C OMPETITIVE F IRM D ECIDES H OW M UCH L ABOR
TO
H IRE
apples minus the total cost of producing them. The firm’s supply of apples and its
demand for workers are derived from its primary goal of maximizing profit.
THE PRODUCTION FUNCTION AND THE
MARGINAL PRODUCT OF LABOR
production function
the relationship between the quantity
of inputs used to make a good and
the quantity of output of that good
marginal product
of labor
the increase in the amount of output
from an additional unit of labor
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To make its hiring decision, the firm must consider how the size of its workforce
affects the amount of output produced. In other words, it must consider how the
number of apple pickers affects the quantity of apples it can harvest and sell. Table 18-1 gives a numerical example. In the first column is the number of workers.
In the second column is the quantity of apples the workers harvest each week.
These two columns of numbers describe the firm’s ability to produce. As we
noted in Chapter 13, economists use the term production function to describe the
relationship between the quantity of the inputs used in production and the quantity of output from production. Here the “input” is the apple pickers and the “output” is the apples. The other inputs—the trees themselves, the land, the firm’s
trucks and tractors, and so on—are held fixed for now. This firm’s production
function shows that if the firm hires 1 worker, that worker will pick 100 bushels
of apples per week. If the firm hires 2 workers, the two workers together will pick
180 bushels per week, and so on.
Figure 18-2 graphs the data on labor and output presented in Table 18-1. The
number of workers is on the horizontal axis, and the amount of output is on the
vertical axis. This figure illustrates the production function.
One of the Ten Principles of Economics introduced in Chapter 1 is that rational
people think at the margin. This idea is the key to understanding how firms decide
what quantity of labor to hire. To take a step toward this decision, the third column
in Table 18-1 gives the marginal product of labor, the increase in the amount of
output from an additional unit of labor. When the firm increases the number of
workers from 1 to 2, for example, the amount of apples produced rises from 100 to
180 bushels. Therefore, the marginal product of the second worker is 80 bushels.
CHAPTER 18
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
401
Figure 18-2
Quantity
of Apples
Production
function
300
280
240
180
T HE P RODUCTION F UNCTION .
The production function is the
relationship between the inputs
into production (apple pickers)
and the output from production
(apples). As the quantity of the
input increases, the production
function gets flatter, reflecting the
property of diminishing marginal
product.
100
0
1
2
3
4
5
Quantity of
Apple Pickers
Notice that as the number of workers increases, the marginal product of labor
declines. As you may recall from Chapter 13, this property is called diminishing
marginal product. At first, when only a few workers are hired, they pick apples
from the best trees in the orchard. As the number of workers increases, additional
workers have to pick from the trees with fewer apples. Hence, as more and more
workers are hired, each additional worker contributes less to the production of
apples. For this reason, the production function in Figure 18-2 becomes flatter as
the number of workers rises.
diminishing marginal
product
the property whereby the marginal
product of an input declines as the
quantity of the input increases
T H E VA L U E O F T H E M A R G I N A L P R O D U C T
AND THE DEMAND FOR LABOR
Our profit-maximizing firm is concerned more with money than with apples. As a
result, when deciding how many workers to hire, the firm considers how much
profit each worker would bring in. Because profit is total revenue minus total cost,
the profit from an additional worker is the worker’s contribution to revenue minus
the worker’s wage.
To find the worker’s contribution to revenue, we must convert the marginal
product of labor (which is measured in bushels of apples) into the value of the marginal product (which is measured in dollars). We do this using the price of apples.
To continue our example, if a bushel of apples sells for $10 and if an additional
worker produces 80 bushels of apples, then the worker produces $800 of revenue.
The value of the marginal product of any input is the marginal product of
that input multiplied by the market price of the output. The fourth column in Table 18-1 shows the value of the marginal product of labor in our example, assuming the price of apples is $10 per bushel. Because the market price is constant for a
competitive firm, the value of the marginal product (like the marginal product itself) diminishes as the number of workers rises.
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value of the marginal
product
the marginal product of an input
times the price of the output
402
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
Figure 18-3
T HE VALUE OF THE M ARGINAL
P RODUCT OF L ABOR . This figure
shows how the value of the
marginal product (the marginal
product times the price of the
output) depends on the number
of workers. The curve slopes
downward because of
diminishing marginal product.
For a competitive, profitmaximizing firm, this value-ofmarginal-product curve is also
the firm’s labor demand curve.
Value
of the
Marginal
Product
Market
wage
Value of marginal product
(demand curve for labor)
0
Profit-maximizing quantity
Quantity of
Apple Pickers
Now consider how many workers the firm will hire. Suppose that the market
wage for apple pickers is $500 per week. In this case, the first worker that the firm
hires is profitable: The first worker yields $1,000 in revenue, or $500 in profit. Similarly, the second worker yields $800 in additional revenue, or $300 in profit. The
third worker produces $600 in additional revenue, or $100 in profit. After the third
worker, however, hiring workers is unprofitable. The fourth worker would yield
only $400 of additional revenue. Because the worker’s wage is $500, hiring the
fourth worker would mean a $100 reduction in profit. Thus, the firm hires only
three workers.
It is instructive to consider the firm’s decision graphically. Figure 18-3 graphs
the value of the marginal product. This curve slopes downward because the marginal product of labor diminishes as the number of workers rises. The figure also
includes a horizontal line at the market wage. To maximize profit, the firm hires
workers up to the point where these two curves cross. Below this level of employment, the value of the marginal product exceeds the wage, so hiring another
worker would increase profit. Above this level of employment, the value of the
marginal product is less than the wage, so the marginal worker is unprofitable.
Thus, a competitive, profit-maximizing firm hires workers up to the point where the value
of the marginal product of labor equals the wage.
Having explained the profit-maximizing hiring strategy for a competitive
firm, we can now offer a theory of labor demand. Recall that a firm’s labor demand
curve tells us the quantity of labor that a firm demands at any given wage. We
have just seen in Figure 18-3 that the firm makes that decision by choosing the
quantity of labor at which the value of the marginal product equals the wage. As a
result, the value-of-marginal-product curve is the labor demand curve for a competitive,
profit-maximizing firm.
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CHAPTER 18
FYI
Input Demand
and Output
Supply: Two
Sides of the
Same Coin
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
In Chapter 14 we saw how
a competitive, profit-maximizing
firm decides how much of its
output to sell: It chooses the
quantity of output at which the
price of the good equals the
marginal cost of production. We
have just seen how such a firm
decides how much labor to
hire: It chooses the quantity of
labor at which the wage equals
the value of the marginal product. Because the production
function links the quantity of inputs to the quantity of output,
you should not be surprised to learn that the firm’s decision
about input demand is closely linked to its decision about
output supply. In fact, these two decisions are two sides of
the same coin.
To see this relationship more fully, let’s consider how
the marginal product of labor (MPL) and marginal cost (MC)
are related. Suppose an additional worker costs $500 and
has a marginal product of 50 bushels of apples. In this
case, producing 50 more bushels costs $500; the marginal
cost of a bushel is $500/50, or $10. More generally, if W
is the wage, and an extra unit of labor produces MPL units
of output, then the marginal cost of a unit of output is
MC ⫽ W/MPL.
This analysis shows that diminishing marginal product
is closely related to increasing marginal cost. When our apple orchard grows crowded with workers, each additional
worker adds less to the production of apples (MPL falls).
Similarly, when the apple firm is producing a large quantity
of apples, the orchard is already crowded with workers, so it
is more costly to produce an additional bushel of apples
(MC rises).
Now consider our criterion for profit maximization. We
determined earlier that a profit-maximizing firm chooses the
quantity of labor so that the value of the marginal product
(P ⫻ MPL) equals the wage (W). We can write this mathematically as
P ⫻ MPL ⫽ W.
If we divide both sides of this equation by MPL, we obtain
P ⫽ W/MPL.
We just noted that W/MPL equals marginal cost MC. Therefore, we can substitute to obtain
P ⫽ MC.
This equation states that the price of the firm’s output is
equal to the marginal cost of producing a unit of output.
Thus, when a competitive firm hires labor up to the point at
which the value of the marginal product equals the wage, it
also produces up to the point at which the price equals marginal cost. Our analysis of labor demand in this chapter is
just another way of looking at the production decision we
first saw in Chapter 14.
W H AT C A U S E S T H E L A B O R D E M A N D C U R V E T O S H I F T ?
We now understand the labor demand curve: It is nothing more than a reflection
of the value of marginal product of labor. With this insight in mind, let’s consider
a few of the things that might cause the labor demand curve to shift.
T h e O u t p u t P r i c e The value of the marginal product is marginal product
times the price of the firm’s output. Thus, when the output price changes, the
value of the marginal product changes, and the labor demand curve shifts. An increase in the price of apples, for instance, raises the value of the marginal product
of each worker that picks apples and, therefore, increases labor demand from the
firms that supply apples. Conversely, a decrease in the price of apples reduces the
value of the marginal product and decreases labor demand.
Te c h n o l o g i c a l C h a n g e Between 1968 and 1998, the amount of output
a typical U.S. worker produced in an hour rose by 57 percent. Why? The most
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403
404
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
important reason is technological progress: Scientists and engineers are constantly
figuring out new and better ways of doing things. This has profound implications
for the labor market. Technological advance raises the marginal product of labor,
which in turn increases the demand for labor. Such technological advance explains
persistently rising employment in face of rising wages: Even though wages (adjusted for inflation) increased by 62 percent over these three decades, firms
nonetheless increased by 72 percent the number of workers they employed.
T h e S u p p l y o f O t h e r F a c t o r s The quantity available of one factor of
production can affect the marginal product of other factors. A fall in the supply of
ladders, for instance, will reduce the marginal product of apple pickers and thus
the demand for apple pickers. We consider this linkage among the factors of production more fully later in the chapter.
Q U I C K Q U I Z : Define marginal product of labor and value of the marginal
product of labor. ◆ Describe how a competitive, profit-maximizing firm
decides how many workers to hire.
T H E S U P P LY O F L A B O R
Having analyzed labor demand in detail, let’s turn to the other side of the market
and consider labor supply. A formal model of labor supply is included in Chapter
21, where we develop the theory of household decisionmaking. Here we discuss
briefly and informally the decisions that lie behind the labor supply curve.
THE TRADEOFF BETWEEN WORK AND LEISURE
One of the Ten Principles of Economics in Chapter 1 is that people face tradeoffs.
Probably no tradeoff is more obvious or more important in a person’s life than the
tradeoff between work and leisure. The more hours you spend working, the fewer
hours you have to watch TV, have dinner with friends, or pursue your favorite
hobby. The tradeoff between labor and leisure lies behind the labor supply curve.
Another one of the Ten Principles of Economics is that the cost of something is
what you give up to get it. What do you give up to get an hour of leisure? You give
up an hour of work, which in turn means an hour of wages. Thus, if your wage is
$15 per hour, the opportunity cost of an hour of leisure is $15. And when you get a
raise to $20 per hour, the opportunity cost of enjoying leisure goes up.
The labor supply curve reflects how workers’ decisions about the labor–leisure
tradeoff respond to a change in that opportunity cost. An upward-sloping labor
supply curve means that an increase in the wage induces workers to increase the
quantity of labor they supply. Because time is limited, more hours of work means
that workers are enjoying less leisure. That is, workers respond to the increase in
the opportunity cost of leisure by taking less of it.
It is worth noting that the labor supply curve need not be upward sloping.
Imagine you got that raise from $15 to $20 per hour. The opportunity cost of
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CHAPTER 18
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
leisure is now greater, but you are also richer than you were before. You might
decide that with your extra wealth you can now afford to enjoy more leisure;
in this case, your labor supply curve would slope backwards. In Chapter 21, we
discuss this possibility in terms of conflicting effects on your labor-supply decision (called income and substitution effects). For now, we ignore the possibility of
backward-sloping labor supply and assume that the labor supply curve is upward
sloping.
W H AT C A U S E S T H E L A B O R S U P P LY C U R V E T O S H I F T ?
The labor supply curve shifts whenever people change the amount they want to
work at a given wage. Let’s now consider some of the events that might cause such
a shift.
C h a n g e s i n Ta s t e s In 1950, 34 percent of women were employed at paid
jobs or looking for work. In 1998, the number had risen to 60 percent. There are, of
course, many explanations for this development, but one of them is changing
tastes, or attitudes toward work. A generation or two ago, it was the norm for
women to stay at home while raising children. Today, family sizes are smaller, and
more mothers choose to work. The result is an increase in the supply of labor.
Changes in Alternative Oppor tunities
The supply of labor in any
one labor market depends on the opportunities available in other labor markets. If
the wage earned by pear pickers suddenly rises, some apple pickers may choose to
switch occupations. The supply of labor in the market for apple pickers falls.
I m m i g r a t i o n Movements of workers from region to region, or country to
country, is an obvious and often important source of shifts in labor supply. When
immigrants come to the United States, for instance, the supply of labor in the
United States increases and the supply of labor in the immigrants’ home countries
contracts. In fact, much of the policy debate about immigration centers on its effect
on labor supply and, thereby, equilibrium in the labor market.
Q U I C K Q U I Z : Who has a greater opportunity cost of enjoying leisure—a
janitor or a brain surgeon? Explain. Can this help explain why doctors work
such long hours?
EQUILIBRIUM IN THE LABOR MARKET
So far we have established two facts about how wages are determined in competitive labor markets:
◆
◆
The wage adjusts to balance the supply and demand for labor.
The wage equals the value of the marginal product of labor.
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405
406
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
Figure 18-4
E QUILIBRIUM IN A L ABOR
M ARKET. Like all prices, the
price of labor (the wage) depends
on supply and demand. Because
the demand curve reflects the
value of the marginal product of
labor, in equilibrium workers
receive the value of their
marginal contribution to the
production of goods and services.
Wage
(price of
labor)
Supply
Equilibrium
wage, W
Demand
0
Equilibrium
employment, L
Quantity of
Labor
At first, it might seem surprising that the wage can do both these things at once. In
fact, there is no real puzzle here, but understanding why there is no puzzle is an
important step to understanding wage determination.
Figure 18-4 shows the labor market in equilibrium. The wage and the quantity
of labor have adjusted to balance supply and demand. When the market is in this
equilibrium, each firm has bought as much labor as it finds profitable at the equilibrium wage. That is, each firm has followed the rule for profit maximization: It
has hired workers until the value of the marginal product equals the wage. Hence,
the wage must equal the value of marginal product of labor once it has brought
supply and demand into equilibrium.
This brings us to an important lesson: Any event that changes the supply or demand for labor must change the equilibrium wage and the value of the marginal product by
the same amount, because these must always be equal. To see how this works, let’s consider some events that shift these curves.
S H I F T S I N L A B O R S U P P LY
Suppose that immigration increases the number of workers willing to pick apples.
As Figure 18-5 shows, the supply of labor shifts to the right from S1 to S2. At the
initial wage W1 , the quantity of labor supplied now exceeds the quantity demanded. This surplus of labor puts downward pressure on the wage of apple pickers, and the fall in the wage from W1 to W2 in turn makes it profitable for firms to
hire more workers. As the number of workers employed in each apple orchard
rises, the marginal product of a worker falls, and so does the value of the marginal
product. In the new equilibrium, both the wage and the value of the marginal
product of labor are lower than they were before the influx of new workers.
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CHAPTER 18
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
407
Figure 18-5
Wage
(price of
labor)
1. An increase in
labor supply . . .
Supply, S1
S2
W1
W2
2. . . . reduces
the wage . . .
Demand
0
L1
L2
Quantity of
Labor
3. . . . and raises employment.
An episode from Israel illustrates how a shift in labor supply can alter the
equilibrium in a labor market. During most of the 1980s, many thousands of Palestinians regularly commuted from their homes in the Israeli-occupied West Bank
and Gaza Strip to jobs in Israel, primarily in the construction and agriculture
industries. In 1988, however, political unrest in these occupied areas induced the
Israeli government to take steps that, as a by-product, reduced this supply of
workers. Curfews were imposed, work permits were checked more thoroughly,
and a ban on overnight stays of Palestinians in Israel was enforced more rigorously. The economic impact of these steps was exactly as theory predicts: The
number of Palestinians with jobs in Israel fell by half, while those who continued
to work in Israel enjoyed wage increases of about 50 percent. With a reduced number of Palestinian workers in Israel, the value of the marginal product of the remaining workers was much higher.
SHIFTS IN LABOR DEMAND
Now suppose that an increase in the popularity of apples causes their price to rise.
This price increase does not change the marginal product of labor for any given
number of workers, but it does raise the value of the marginal product. With a
higher price of apples, hiring more apple pickers is now profitable. As Figure 18-6
shows, when the demand for labor shifts to the right from D1 to D2 , the equilibrium wage rises from W1 to W2 , and equilibrium employment rises from L1 to L2.
Once again, the wage and the value of the marginal product of labor move
together.
This analysis shows that prosperity for firms in an industry is often linked
to prosperity for workers in that industry. When the price of apples rises, apple
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A S HIFT IN L ABOR S UPPLY.
When labor supply increases
from S1 to S2 , perhaps because of
an immigration of new workers,
the equilibrium wage falls from
W1 to W2 . At this lower wage,
firms hire more labor, so
employment rises from L1 to L2.
The change in the wage reflects a
change in the value of the
marginal product of labor: With
more workers, the added output
from an extra worker is smaller.
408
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
Figure 18-6
A S HIFT IN L ABOR D EMAND .
When labor demand increases
from D1 to D2 , perhaps because of
an increase in the price of the
firms’ output, the equilibrium
wage rises from W1 to W2 , and
employment rises from L1 to L2.
Again, the change in the wage
reflects a change in the value of
the marginal product of labor:
With a higher output price, the
added output from an extra
worker is more valuable.
Wage
(price of
labor)
Supply
W2
1. An increase in
labor demand . . .
W1
2. . . . increases
the wage . . .
D2
Demand, D1
0
L1
L2
Quantity of
Labor
3. . . . and increases employment.
producers make greater profit, and apple pickers earn higher wages. When the
price of apples falls, apple producers earn smaller profit, and apple pickers earn
lower wages. This lesson is well known to workers in industries with highly
volatile prices. Workers in oil fields, for instance, know from experience that their
earnings are closely linked to the world price of crude oil.
From these examples, you should now have a good understanding of how
wages are set in competitive labor markets. Labor supply and labor demand together determine the equilibrium wage, and shifts in the supply or demand curve
for labor cause the equilibrium wage to change. At the same time, profit maximization by the firms that demand labor ensures that the equilibrium wage always
equals the value of the marginal product of labor.
CASE STUDY
PRODUCTIVITY AND WAGES
One of the Ten Principles of Economics in Chapter 1 is that our standard of living
depends on our ability to produce goods and services. We can now see how this
principle works in the market for labor. In particular, our analysis of labor demand shows that wages equal productivity as measured by the value of the
marginal product of labor. Put simply, highly productive workers are highly
paid, and less productive workers are less highly paid.
This lesson is key to understanding why workers today are better off than
workers in previous generations. Table 18-2 presents some data on growth in
productivity and growth in wages (adjusted for inflation). From 1959 to 1997,
productivity as measured by output per hour of work grew about 1.8 percent
per year; at this rate, productivity doubles about every 40 years. Over this period, wages grew at a similar rate of 1.7 percent per year.
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CHAPTER 18
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
409
Ta b l e 1 8 - 2
TIME PERIOD
GROWTH RATE
PRODUCTIVITY
OF
GROWTH RATE
REAL WAGES
OF
1959–1997
1.8
1.7
1959–1973
1973–1997
2.9
1.1
2.9
1.0
SOURCE: Economic Report of the President 1999, table B-49, p. 384. Growth in productivity is measured here
as the annualized rate of change in output per hour in the nonfarm business sector. Growth in real
wages is measured as the annualized change in compensation per hour in the nonfarm business sector
divided by the implicit price deflator for that sector. These productivity data measure average
productivity—the quantity of output divided by the quantity of labor—rather than marginal
productivity, but average and marginal productivity are thought to move closely together.
Table 18-2 also shows that, beginning around 1973, growth in productivity
slowed from 2.9 to 1.1 percent per year. This 1.8 percentage-point slowdown in
productivity coincided with a slowdown in wage growth of 1.9 percentage
points. Because of this productivity slowdown, workers in the 1980s and 1990s
did not experience the same rapid growth in living standards that their parents
enjoyed. A slowdown of 1.8 percentage points might not seem large, but accumulated over many years, even a small change in a growth rate is significant. If
productivity and wages had grown at the same rate since 1973 as they did previously, workers’ earnings would now be about 50 percent higher than they are.
The link between productivity and wages also sheds light on international
experience. Table 18-3 presents some data on productivity growth and wage
growth for a representative group of countries, ranked in order of their productivity growth. Although these international data are far from precise, a close link
between the two variables is apparent. In South Korea, Hong Kong, and Singapore, productivity has grown rapidly, and so have wages. In Mexico, Argentina,
and Iran, productivity has fallen, and so have wages. The United States falls
about in the middle of the distribution: By international standards, U.S. productivity growth and wage growth have been neither exceptionally bad nor exceptionally good.
What causes productivity and wages to vary so much over time and across
countries? A complete answer to this question requires an analysis of long-run
economic growth, a topic beyond the scope of this chapter. We can, however,
briefly note three key determinants of productivity:
◆
◆
◆
Physical capital: When workers work with a larger quantity of equipment
and structures, they produce more.
Human capital: When workers are more educated, they produce more.
Technological knowledge: When workers have access to more sophisticated
technologies, they produce more.
Physical capital, human capital, and technological knowledge are the ultimate sources of most of the differences in productivity, wages, and standards of
living.
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P RODUCTIVITY AND WAGE
G ROWTH IN THE U NITED S TATES
410
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
Ta b l e 1 8 - 3
P RODUCTIVITY AND WAGE
G ROWTH AROUND THE W ORLD
COUNTRY
South Korea
Hong Kong
Singapore
Indonesia
Japan
India
United Kingdom
United States
Brazil
Mexico
Argentina
Iran
GROWTH RATE
PRODUCTIVITY
OF
GROWTH RATE
REAL WAGES
OF
8.5
5.5
5.3
4.0
3.6
3.1
2.4
1.7
0.4
⫺0.2
⫺0.9
⫺1.4
7.9
4.9
5.0
4.4
2.0
3.4
2.4
0.5
⫺2.4
⫺3.0
⫺1.3
⫺7.9
SOURCE: World Development Report 1994, table 1, pp. 162–163, and table 7, pp. 174–175. Growth in
productivity is measured here as the annualized rate of change in gross national product per person
from 1980 to 1992. Growth in wages is measured as the annualized change in earnings per employee in
manufacturing from 1980 to 1991.
Q U I C K Q U I Z : How does an immigration of workers affect labor supply,
labor demand, the marginal product of labor, and the equilibrium wage?
T H E O T H E R FA C T O R S O F P R O D U C T I O N :
L A N D A N D C A P I TA L
capital
the equipment and structures used to
produce goods and services
We have seen how firms decide how much labor to hire and how these decisions
determine workers’ wages. At the same time that firms are hiring workers, they
are also deciding about other inputs to production. For example, our appleproducing firm might have to choose the size of its apple orchard and the number
of ladders to make available to its apple pickers. We can think of the firm’s factors
of production as falling into three categories: labor, land, and capital.
The meaning of the terms labor and land is clear, but the definition of capital is
somewhat tricky. Economists use the term capital to refer to the stock of equipment and structures used for production. That is, the economy’s capital represents
the accumulation of goods produced in the past that are being used in the present
to produce new goods and services. For our apple firm, the capital stock includes
the ladders used to climb the trees, the trucks used to transport the apples, the
buildings used to store the apples, and even the trees themselves.
E Q U I L I B R I U M I N T H E M A R K E T S F O R L A N D A N D C A P I TA L
What determines how much the owners of land and capital earn for their contribution to the production process? Before answering this question, we need to
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CHAPTER 18
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
(a) The Market for Land
Rental
Price of
Land
(b) The Market for Capital
Rental
Price of
Capital
Supply
P
Supply
P
Demand
Demand
0
Q
Quantity of
Land
0
T HE M ARKETS FOR L AND AND C APITAL . Supply and demand determine the
compensation paid to the owners of land, as shown in panel (a), and the compensation
paid to the owners of capital, as shown in panel (b). The demand for each factor, in turn,
depends on the value of the marginal product of that factor.
distinguish between two prices: the purchase price and the rental price. The purchase price of land or capital is the price a person pays to own that factor of production indefinitely. The rental price is the price a person pays to use that factor for
a limited period of time. It is important to keep this distinction in mind because, as
we will see, these prices are determined by somewhat different economic forces.
Having defined these terms, we can now apply the theory of factor demand
we developed for the labor market to the markets for land and capital. The wage
is, after all, simply the rental price of labor. Therefore, much of what we have
learned about wage determination applies also to the rental prices of land and capital. As Figure 18-7 illustrates, the rental price of land, shown in panel (a), and the
rental price of capital, shown in panel (b), are determined by supply and demand.
Moreover, the demand for land and capital is determined just like the demand for
labor. That is, when our apple-producing firm is deciding how much land and
how many ladders to rent, it follows the same logic as when deciding how many
workers to hire. For both land and capital, the firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price. Thus, the demand curve for each factor reflects the marginal productivity of that factor.
We can now explain how much income goes to labor, how much goes to
landowners, and how much goes to the owners of capital. As long as the firms
using the factors of production are competitive and profit-maximizing, each factor’s rental price must equal the value of the marginal product for that factor.
Labor, land, and capital each earn the value of their marginal contribution to the production process.
Now consider the purchase price of land and capital. The rental price and the
purchase price are obviously related: Buyers are willing to pay more to buy a piece
of land or capital if it produces a valuable stream of rental income. And, as we
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Q
Quantity of
Capital
Figure 18-7
411
412
PA R T S I X
FYI
THE ECONOMICS OF LABOR MARKETS
Labor income is an easy concept to understand: It is the
What Is
paycheck that workers get from
Capital Income?
their employers. The income
earned by capital, however, is
less obvious.
In our analysis, we have
been implicitly assuming that
households own the economy’s
stock of capital—ladders, drill
presses, warehouses, etc.—
and rent it to the firms that use
it. Capital income, in this case,
is the rent that households receive for the use of their capital. This assumption simplified our analysis of how capital
owners are compensated, but it is not entirely realistic. In
fact, firms usually own the capital they use and, therefore,
they receive the earnings from this capital.
These earnings from capital, however, eventually get
paid to households. Some of the earnings are paid in the
form of interest to those households who have lent money
to firms. Bondholders and bank depositors are two examples of recipients of interest. Thus, when you receive inter-
est on your bank account, that income is part of the economy’s capital income.
In addition, some of the earnings from capital are paid
to households in the form of dividends. Dividends are payments by a firm to the firm’s stockholders. A stockholder is
a person who has bought a share in the ownership of the
firm and, therefore, is entitled to share in the firm’s profits.
A firm does not have to pay out all of its earnings to
households in the form of interest and dividends. Instead, it
can retain some earnings within the firm and use these
earnings to buy additional capital. Although these retained
earnings do not get paid to the firm’s stockholders, the
stockholders benefit from them nonetheless. Because retained earnings increase the amount of capital the firm
owns, they tend to increase future earnings and, thereby,
the value of the firm’s stock.
These institutional details are interesting and important, but they do not alter our conclusion about the income
earned by the owners of capital. Capital is paid according to
the value of its marginal product, regardless of whether this
income gets transmitted to households in the form of interest or dividends or whether it is kept within firms as retained earnings.
have just seen, the equilibrium rental income at any point in time equals the value
of that factor’s marginal product. Therefore, the equilibrium purchase price of a
piece of land or capital depends on both the current value of the marginal product
and the value of the marginal product expected to prevail in the future.
L I N K A G E S A M O N G T H E FA C T O R S O F P R O D U C T I O N
We have seen that the price paid to any factor of production—labor, land, or capital—equals the value of the marginal product of that factor. The marginal product
of any factor, in turn, depends on the quantity of that factor that is available. Because of diminishing returns, a factor in abundant supply has a low marginal
product and thus a low price, and a factor in scarce supply has a high marginal
product and a high price. As a result, when the supply of a factor falls, its equilibrium factor price rises.
When the supply of any factor changes, however, the effects are not limited to
the market for that factor. In most situations, factors of production are used together in a way that makes the productivity of each factor dependent on the quantities of the other factors available to be used in the production process. As a result,
a change in the supply of any one factor alters the earnings of all the factors.
For example, suppose that a hurricane destroys many of the ladders that
workers use to pick apples from the orchards. What happens to the earnings of the
various factors of production? Most obviously, the supply of ladders falls and,
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CHAPTER 18
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
413
therefore, the equilibrium rental price of ladders rises. Those owners who were
lucky enough to avoid damage to their ladders now earn a higher return when
they rent out their ladders to the firms that produce apples.
Yet the effects of this event do not stop at the ladder market. Because there are
fewer ladders with which to work, the workers who pick apples have a smaller
marginal product. Thus, the reduction in the supply of ladders reduces the demand for the labor of apple pickers, and this causes the equilibrium wage to fall.
This story shows a general lesson: An event that changes the supply of any
factor of production can alter the earnings of all the factors. The change in earnings
of any factor can be found by analyzing the impact of the event on the value of the
marginal product of that factor.
CASE STUDY
THE ECONOMICS OF THE BLACK DEATH
In fourteenth-century Europe, the bubonic plague wiped out about one-third of
the population within a few years. This event, called the Black Death, provides a
grisly natural experiment to test the theory of factor markets that we have just
developed. Consider the effects of the Black Death on those who were lucky
enough to survive. What do you think happened to the wages earned by workers and the rents earned by landowners?
To answer this question, let’s examine the effects of a reduced population
on the marginal product of labor and the marginal product of land. With a
smaller supply of workers, the marginal product of labor rises. (This is simply
diminishing marginal product working in reverse.) Thus, we would expect the
Black Death to raise wages.
Because land and labor are used together in production, a smaller supply of
workers also affects the market for land, the other major factor of production in
medieval Europe. With fewer workers available to farm the land, an additional
unit of land produced less additional output. In other words, the marginal
product of land fell. Thus, we would expect the Black Death to lower rents.
In fact, both predictions are consistent with the historical evidence. Wages
approximately doubled during this period, and rents declined 50 percent or
more. The Black Death led to economic prosperity for the peasant classes and
reduced incomes for the landed classes.
Q U I C K Q U I Z : What determines the income of the owners of land and
capital? ◆ How would an increase in the quantity of capital affect the
incomes of those who already own capital? How would it affect the incomes
of workers?
CONCLUSION
This chapter explained how labor, land, and capital are compensated for the roles
they play in the production process. The theory developed here is called the neoclassical theory of distribution. According to the neoclassical theory, the amount paid
to each factor of production depends on the supply and demand for that factor.
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WORKERS WHO SURVIVED THE PLAGUE
WERE LUCKY IN MORE WAYS THAN ONE.
414
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
The demand, in turn, depends on that particular factor’s marginal productivity. In
equilibrium, each factor of production earns the value of its marginal contribution
to the production of goods and services.
The neoclassical theory of distribution is widely accepted. Most economists
begin with the neoclassical theory when trying to explain how the U.S. economy’s
$8 trillion of income is distributed among the economy’s various members. In the
following two chapters, we consider the distribution of income in more detail. As
you will see, the neoclassical theory provides the framework for this discussion.
Even at this point you can use the theory to answer the question that began
this chapter: Why are computer programmers paid more than gas station attendants? It is because programmers can produce a good of greater market value than
can a gas station attendant. People are willing to pay dearly for a good computer
game, but they are willing to pay little to have their gas pumped and their windshield washed. The wages of these workers reflect the market prices of the goods
they produce. If people suddenly got tired of using computers and decided to
spend more time driving, the prices of these goods would change, and so would
the equilibrium wages of these two groups of workers.
Summary
◆
The economy’s income is distributed in the markets for
the factors of production. The three most important
factors of production are labor, land, and capital.
◆
The demand for factors, such as labor, is a derived
demand that comes from firms that use the factors to
produce goods and services. Competitive, profitmaximizing firms hire each factor up to the point at
which the value of the marginal product of the factor
equals its price.
◆
The supply of labor arises from individuals’ tradeoff
between work and leisure. An upward-sloping labor
supply curve means that people respond to an increase
in the wage by enjoying less leisure and working more
hours.
◆
The price paid to each factor adjusts to balance the
supply and demand for that factor. Because factor
demand reflects the value of the marginal product of
that factor, in equilibrium each factor is compensated
according to its marginal contribution to the production
of goods and services.
◆
Because factors of production are used together, the
marginal product of any one factor depends on the
quantities of all factors that are available. As a result, a
change in the supply of one factor alters the equilibrium
earnings of all the factors.
Key Concepts
factors of production, p. 398
production function, p. 400
marginal product of labor, p. 400
diminishing marginal product, p. 401
value of the marginal product, p. 401
capital, p. 410
Questions for Review
1.
Explain how a firm’s production function is related
to its marginal product of labor, how a firm’s
marginal product of labor is related to the value
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of its marginal product, and how a firm’s value
of marginal product is related to its demand for
labor.
CHAPTER 18
2.
Give two examples of events that could shift the
demand for labor.
3.
Give two examples of events that could shift the supply
of labor.
4.
Explain how the wage can adjust to balance the supply
and demand for labor while simultaneously equaling
the value of the marginal product of labor.
T H E M A R K E T S F O R T H E FA C T O R S O F P R O D U C T I O N
5.
415
If the population of the United States suddenly grew
because of a large immigration, what would happen to
wages? What would happen to the rents earned by the
owners of land and capital?
Problems and Applications
1. Suppose that the president proposes a new law aimed at
reducing heath care costs: All Americans are to be
required to eat one apple daily.
a. How would this apple-a-day law affect the demand
and equilibrium price of apples?
b. How would the law affect the marginal product
and the value of the marginal product of apple
pickers?
c. How would the law affect the demand and
equilibrium wage for apple pickers?
2. Henry Ford once said: “It is not the employer who pays
wages—he only handles the money. It is the product
that pays wages.” Explain.
3. Show the effect of each of the following events on the
market for labor in the computer manufacturing
industry.
a. Congress buys personal computers for all American
college students.
b. More college students major in engineering and
computer science.
c. Computer firms build new manufacturing plants.
4. Your enterprising uncle opens a sandwich shop that
employs 7 people. The employees are paid $6 per hour,
and a sandwich sells for $3. If your uncle is maximizing
his profit, what is the value of the marginal product of
the last worker he hired? What is that worker’s
marginal product?
5. Imagine a firm that hires two types of workers—some
with computer skills and some without. If technology
advances, so that computers become more useful to the
firm, what happens to the marginal product of the two
types? What happens to equilibrium wages? Explain,
using appropriate diagrams.
6. Suppose a freeze in Florida destroys part of the Florida
orange crop.
a. Explain what happens to the price of oranges and
the marginal product of orange pickers as a result
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b.
c.
of the freeze. Can you say what happens to the
demand for orange pickers? Why or why not?
Suppose the price of oranges doubles and the
marginal product falls by 30 percent. What happens
to the equilibrium wage of orange pickers?
Suppose the price of oranges rises by 30 percent
and the marginal product falls by 50 percent.
What happens to the equilibrium wage of orange
pickers?
7. During the 1980s and 1990s the United States
experienced a significant inflow of capital from other
countries. For example, Toyota, BMW, and other
foreign car companies built auto plants in the United
States.
a. Using a diagram of the U.S. capital market, show
the effect of this inflow on the rental price of capital
in the United States and on the quantity of capital
in use.
b. Using a diagram of the U.S. labor market, show the
effect of the capital inflow on the average wage
paid to U.S. workers.
8. Suppose that labor is the only input used by a perfectly
competitive firm that can hire workers for $50 per day.
The firm’s production function is as follows:
DAYS OF LABOR
UNITS OF OUTPUT
0
1
2
3
4
5
6
0
7
13
19
25
28
29
Each unit of output sells for $10. Plot the firm’s demand
for labor. How many days of labor should the firm hire?
Show this point on your graph.
416
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
9. (This question is challenging.) In recent years some
policymakers have proposed requiring firms to give
workers certain fringe benefits. For example, in 1993
President Clinton proposed requiring firms to provide
health insurance to their workers. Let’s consider the
effects of such a policy on the labor market.
a. Suppose that a law required firms to give each
worker $3 of fringe benefits for every hour that the
worker is employed by the firm. How does this law
affect the marginal profit that a firm earns from
each worker? How does the law affect the demand
curve for labor? Draw your answer on a graph with
the cash wage on the vertical axis.
b. If there is no change in labor supply, how would
this law affect employment and wages?
c. Why might the labor supply curve shift in response
to this law? Would this shift in labor supply raise or
lower the impact of the law on wages and
employment?
d. As Chapter 6 discussed, the wages of some
workers, particularly the unskilled and
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inexperienced, are kept above the equilibrium level
by minimum-wage laws. What effect would a
fringe-benefit mandate have for these workers?
10. (This question is challenging.) This chapter has assumed
that labor is supplied by individual workers acting
competitively. In some markets, however, the supply of
labor is determined by a union of workers.
a. Explain why the situation faced by a labor union
may resemble the situation faced by a monopoly
firm.
b. The goal of a monopoly firm is to maximize profits.
Is there an analogous goal for labor unions?
c. Now extend the analogy between monopoly firms
and unions. How do you suppose that the wage set
by a union compares to the wage in a competitive
market? How do you suppose employment differs
in the two cases?
d. What other goals might unions have that make
unions different from monopoly firms?
IN THIS CHAPTER
YOU WILL . . .
Examine how wages
compensate for
dif ferences in job
characteristics
Learn and compare
the human-capital
and signaling
theories of
education
Examine why in
some occupations a
few superstars earn
tremendous
incomes
Learn why wages
rise above the level
that balances
supply and demand
EARNINGS
AND
D I S C R I M I N AT I O N
In the United States today, the typical physician earns about $200,000 a year, the
typical police officer about $50,000, and the typical farmworker about $20,000.
These examples illustrate the large differences in earnings that are so common in
our economy. These differences explain why some people live in mansions, ride in
limousines, and vacation on the French Riviera, while other people live in small
apartments, ride the bus, and vacation in their own back yards.
Why do earnings vary so much from person to person? Chapter 18, which developed the basic neoclassical theory of the labor market, offers an answer to this
question. There we saw that wages are governed by labor supply and labor demand. Labor demand, in turn, reflects the marginal productivity of labor. In equilibrium, each worker is paid the value of his or her marginal contribution to the
economy’s production of goods and services.
417
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Consider why it is
dif ficult to measure
the impact of
discrimination on
wages
See when market
forces can and
cannot provide a
natural remedy for
discrimination
Consider the debate
over comparable
wor th as a system
for setting wages
418
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
This theory of the labor market, though widely accepted by economists, is
only the beginning of the story. To understand the wide variation in earnings that
we observe, we must go beyond this general framework and examine more precisely what determines the supply and demand for different types of labor. That is
our goal in this chapter.
S O M E D E T E R M I N A N T S O F E Q U I L I B R I U M WA G E S
Workers differ from one another in many ways. Jobs also have differing characteristics—both in terms of the wage they pay and in terms of their nonmonetary attributes. In this section we consider how the characteristics of workers and jobs
affect labor supply, labor demand, and equilibrium wages.
C O M P E N S AT I N G D I F F E R E N T I A L S
When a worker is deciding whether to take a job, the wage is only one of many job
attributes that the worker takes into account. Some jobs are easy, fun, and safe; others are hard, dull, and dangerous. The better the job as gauged by these nonmonetary characteristics, the more people there are who are willing to do the job at any
“On the one hand, I know I could make more money if I
left public service for the private sector, but, on the other
hand, I couldn’t chop off heads.”
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CHAPTER 19
E A R N I N G S A N D D I S C R I M I N AT I O N
given wage. In other words, the supply of labor for easy, fun, and safe jobs is
greater than the supply of labor for hard, dull, and dangerous jobs. As a result,
“good” jobs will tend to have lower equilibrium wages than “bad” jobs.
For example, imagine you are looking for a summer job in the local beach
community. Two kinds of jobs are available. You can take a job as a beach-badge
checker, or you can take a job as a garbage collector. The beach-badge checkers
take leisurely strolls along the beach during the day and check to make sure the
tourists have bought the required beach permits. The garbage collectors wake up
before dawn to drive dirty, noisy trucks around town to pick up garbage. Which
job would you want? Most people would prefer the beach job if the wages were
the same. To induce people to become garbage collectors, the town has to offer
higher wages to garbage collectors than to beach-badge checkers.
Economists use the term compensating differential to refer to a difference in
wages that arises from nonmonetary characteristics of different jobs. Compensating differentials are prevalent in the economy. Here are some examples:
◆
◆
◆
419
compensating dif ferential
a difference in wages that arises
to offset the nonmonetary
characteristics of different jobs
Coal miners are paid more than other workers with similar levels of
education. Their higher wage compensates them for the dirty and dangerous
nature of coal mining, as well as the long-term health problems that coal
miners experience.
Workers who work the night shift at factories are paid more than similar
workers who work the day shift. The higher wage compensates them for
having to work at night and sleep during the day, a lifestyle that most people
find undesirable.
Professors are paid less than lawyers and doctors, who have similar amounts
of education. Professors’ lower wages compensate them for the great
intellectual and personal satisfaction that their jobs offer. (Indeed, teaching
economics is so much fun that it is surprising that economics professors get
paid anything at all!)
H U M A N C A P I TA L
As we discussed in the previous chapter, the word capital usually refers to the economy’s stock of equipment and structures. The capital stock includes the farmer’s
tractor, the manufacturer’s factory, and the teacher’s blackboard. The essence of capital is that it is a factor of production that itself has been produced.
There is another type of capital that, while less tangible than physical capital,
is just as important to the economy’s production. Human capital is the accumulation of investments in people. The most important type of human capital is education. Like all forms of capital, education represents an expenditure of resources at
one point in time to raise productivity in the future. But, unlike an investment in
other forms of capital, an investment in education is tied to a specific person, and
this linkage is what makes it human capital.
Not surprisingly, workers with more human capital on average earn more
than those with less human capital. College graduates in the United States, for example, earn about twice as much as those workers who end their education with a
high school diploma. This large difference has been documented in many countries around the world. It tends to be even larger in less developed countries,
where educated workers are in scarce supply.
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human capital
the accumulation of investments in
people, such as education and on-thejob training
420
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
It is easy to see why education raises wages from the perspective of supply
and demand. Firms—the demanders of labor—are willing to pay more for the
highly educated because highly educated workers have higher marginal products.
Workers—the suppliers of labor—are willing to pay the cost of becoming educated
only if there is a reward for doing so. In essence, the difference in wages between
highly educated workers and less educated workers may be considered a compensating differential for the cost of becoming educated.
CASE STUDY
THE INCREASING VALUE OF SKILLS
“The rich get richer, and the poor get poorer.” Like many adages, this one is not
always true, but recently it has been. Many studies have documented that the
earnings gap between workers with high skills and workers with low skills has
increased over the past two decades.
Table 19-1 presents data on the average earnings of college graduates and of
high school graduates without any additional education. These data show the
increase in the financial reward from education. In 1978, a man on average
earned 66 percent more with a college degree than without one; by 1998, this
figure had risen to 118 percent. For woman, the reward for attending college
rose from a 55 percent increase in earnings to a 98 percent increase. The incentive to stay in school is as great today as it has ever been.
Why has the gap in earnings between skilled and unskilled workers risen in
recent years? No one knows for sure, but economists have proposed two hypotheses to explain this trend. Both hypotheses suggest that the demand for
skilled labor has risen over time relative to the demand for unskilled labor. The
shift in demand has led to a corresponding change in wages, which in turn has
led to greater inequality.
The first hypothesis is that international trade has altered the relative demand for skilled and unskilled labor. In recent years, the amount of trade with
other countries has increased substantially. Imports into the United States have
risen from 5 percent of total U.S. production in 1970 to 13 percent in 1998. Exports from the United States have risen from 6 percent in 1970 to 11 percent in
1998. Because unskilled labor is plentiful and cheap in many foreign countries,
Ta b l e 1 9 - 1
AVERAGE A NNUAL E ARNINGS BY
E DUCATIONAL ATTAINMENT.
College graduates have always
earned more than workers
without the benefit of college, but
the salary gap grew even larger
during the 1980s and 1990s.
1978
1998
MEN
High school, no college
College graduates
Percent extra for college grads
$31,847
$52,761
⫹66%
$28,742
$62,588
⫹118%
WOMEN
High school, no college
College graduates
Percent extra for college grads
$14,953
$23,170
⫹55%
$17,898
$35,431
⫹98%
NOTE: Earnings data are adjusted for inflation and are expressed in 1998 dollars. Data apply to workers
age 18 and over.
SOURCE: U.S. Census Bureau.
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the United States tends to import goods produced with unskilled labor and export goods produced with skilled labor. Thus, when international trade expands, the domestic demand for skilled labor rises, and the domestic demand
for unskilled labor falls.
The second hypothesis is that changes in technology have altered the relative demand for skilled and unskilled labor. Consider, for instance, the introduction of computers. Computers raise the demand for skilled workers who
can use the new machines and reduce the demand for the unskilled workers
whose jobs are replaced by the computers. For example, many companies now
rely more on computer databases, and less on filing cabinets, to keep business
records. This change raises the demand for computer programmers and reduces
the demand for filing clerks. Thus, as more firms begin to use computers, the
demand for skilled labor rises, and the demand for unskilled labor falls.
Economists have found it difficult to gauge the validity of these two hypotheses. It is possible, of course, that both are true: Increasing international
trade and technological change may share responsibility for the increasing inequality we have observed in recent decades.
A B I L I T Y, E F F O R T, A N D C H A N C E
Why do major league baseball players get paid more than minor league players?
Certainly, the higher wage is not a compensating differential. Playing in the major
leagues is not a less pleasant task than playing in the minor leagues; in fact, the opposite is true. The major leagues do not require more years of schooling or more
experience. To a large extent, players in the major leagues earn more just because
they have greater natural ability.
Natural ability is important for workers in all occupations. Because of heredity and upbringing, people differ in their physical and mental attributes. Some
people are strong, others weak. Some people are smart, others less so. Some people are outgoing, others awkward in social situations. These and many other personal characteristics determine how productive workers are and, therefore, play a
role in determining the wages they earn.
Closely related to ability is effort. Some people work hard; others are lazy. We
should not be surprised to find that those who work hard are more productive and
earn higher wages. To some extent, firms reward workers directly by paying people on the basis of what they produce. Salespeople, for instance, are often paid as
a percentage of the sales they make. At other times, hard work is rewarded less directly in the form of a higher annual salary or a bonus.
Chance also plays a role in determining wages. If a person attended a trade
school to learn how to repair televisions with vacuum tubes and then found this
skill made obsolete by the invention of solid-state electronics, he or she would end
up earning a low wage compared to others with similar years of training. The low
wage of this worker is due to chance—a phenomenon that economists recognize
but do not shed much light on.
How important are ability, effort, and chance in determining wages? It is hard
to say, because ability, effort, and chance are hard to measure. But indirect evidence suggests that they are very important. When labor economists study wages,
they relate a worker’s wage to those variables that can be measured—years of
schooling, years of experience, age, and job characteristics. Although all of these
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measured variables affect a worker’s wage as theory predicts, they account for less
than half of the variation in wages in our economy. Because so much of the variation in wages is left unexplained, omitted variables, including ability, effort, and
chance, must play an important role.
CASE STUDY
GOOD LOOKS PAY.
THE BENEFITS OF BEAUTY
People differ in many ways. One difference is in how attractive they are. The actor Mel Gibson, for instance, is a handsome man. In part for this reason, his
movies attract large audiences. Not surprisingly, the large audiences mean a
large income for Mr. Gibson.
How prevalent are the economic benefits of beauty? Labor economists Daniel
Hamermesh and Jeff Biddle tried to answer this question in a study published in
the December 1994 issue of the American Economic Review. Hamermesh and Biddle examined data from surveys of individuals in the United States and Canada.
The interviewers who conducted the survey were asked to rate each respondent’s
physical appearance. Hamermesh and Biddle then examined how much the
wages of the respondents depended on the standard determinants—education,
experience, and so on—and how much they depended on physical appearance.
Hamermesh and Biddle found that beauty pays. People who are deemed to
be more attractive than average earn 5 percent more than people of average
looks. People of average looks earn 5 to 10 percent more than people considered
less attractive than average. Similar results were found for men and women.
What explains these differences in wages? There are several ways to interpret the “beauty premium.”
One interpretation is that good looks are themselves a type of innate ability
determining productivity and wages. Some people are born with the attributes
of a movie star; other people are not. Good looks are useful in any job in which
workers present themselves to the public—such as acting, sales, and waiting on
tables. In this case, an attractive worker is more valuable to the firm than an unattractive worker. The firm’s willingness to pay more to attractive workers reflects its customers’ preferences.
A second interpretation is that reported beauty is an indirect measure of
other types of ability. How attractive a person appears depends on more than
just heredity. It also depends on dress, hairstyle, personal demeanor, and other
attributes that a person can control. Perhaps a person who successfully projects
an attractive image in a survey interview is more likely to be an intelligent person who succeeds at other tasks as well.
A third interpretation is that the beauty premium is a type of discrimination, a topic to which we return later.
A N A LT E R N AT I V E V I E W O F E D U C AT I O N : S I G N A L I N G
Earlier we discussed the human-capital view of education, according to which
schooling raises workers’ wages because it makes them more productive. Although this view is widely accepted, some economists have proposed an alternative theory, which emphasizes that firms use educational attainment as a way of
sorting between high-ability and low-ability workers. According to this alternative
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view, when people earn a college degree, for instance, they do not become more
productive, but they do signal their high ability to prospective employers. Because
it is easier for high-ability people to earn a college degree than it is for low-ability
people, more high-ability people get college degrees. As a result, it is rational for
firms to interpret a college degree as a signal of ability.
The signaling theory of education is similar to the signaling theory of advertising discussed in Chapter 17. In the signaling theory of advertising, the advertisement itself contains no real information, but the firm signals the quality of its
product to consumers by its willingness to spend money on advertising. In the
signaling theory of education, schooling has no real productivity benefit, but the
worker signals his innate productivity to employers by his willingness to spend
years at school. In both cases, an action is being taken not for its intrinsic benefit
but because the willingness to take that action conveys private information to
someone observing it.
Thus, we now have two views of education: the human-capital theory and the
signaling theory. Both views can explain why more educated workers tend to earn
more than less educated workers. According to the human-capital view, education
makes workers more productive; according to the signaling view, education is correlated with natural ability. But the two views have radically different predictions
for the effects of policies that aim to increase educational attainment. According to
the human-capital view, increasing educational levels for all workers would raise
all workers’ productivity and thereby their wages. According to the signaling
view, education does not enhance productivity, so raising all workers’ educational
levels would not affect wages.
Most likely, truth lies somewhere between these two extremes. The benefits to
education are probably a combination of the productivity-enhancing effects of human capital and the productivity-revealing effects of signaling. The open question
is the relative size of these two effects.
CASE STUDY
HUMAN CAPITAL, NATURAL ABILITY, AND
COMPULSORY SCHOOL ATTENDANCE
Does attending school increase wages because it increases productivity, or does
it only appear to increase productivity because high-ability people are more
likely to stay in school? This question is important both for judging the various
theories of education and for evaluating alternative education policies.
If economists could conduct controlled experiments like laboratory scientists, it would be easy to answer this question. We could choose some experimental subjects from the school-age population and then randomly divide them
into various groups. For each group we could require a different amount of
school attendance. By comparing the difference in the educational attainment
and the difference in subsequent wages of the various groups, we could see
whether education does in fact increase productivity. Because the groups would
be chosen randomly, we could be sure that the difference in wages was not attributable to a difference in natural ability.
Although conducting such an experiment might seem difficult, the laws of
the United States inadvertently provide a natural experiment that is quite similar. All students in the United States are required by law to attend school, but
the laws vary from state to state. Some states allow students to drop out at age
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16, while others require attendance until age 17 or 18. Moreover, the laws have
changed over time. Between 1970 and 1980, for instance, Wyoming reduced the
school-attendance age from 17 to 16, while Washington raised it from 16 to 18.
This variation across states and over time provides data with which to study the
effects of compulsory school attendance.
Even within a state, school-attendance laws have different effects on different people. Students start attending school at different ages, depending on the
month of the year in which they were born. Yet all students can drop out as
soon as they reach the minimum legal age; they are not required to finish out
the school year. As a result, those who start school at a relatively young age are
required to spend more time in school than those who start school at a relatively
old age. This variation across students within a state also provides a way to
study the effects of compulsory attendance.
In an article published in the November 1991 issue of the Quarterly Journal of
Economics, labor economists Joshua Angrist and Alan Krueger used this natural
experiment to study the relationship between schooling and wages. Because the
duration of each student’s compulsory schooling depends on his or her state of
residence and month of birth, and not on natural ability, it was possible to isolate
the productivity-enhancing effect of education from the ability-signaling effect.
According to Angrist and Krueger’s research, those students who were required
to finish more school did earn significantly higher subsequent wages than those
with lower requirements. This finding indicates that education does raise a
worker’s productivity, as the human-capital theory suggests.
Although establishing the benefits of compulsory schooling is useful, it does
not by itself tell us whether these laws are desirable. That policy judgment requires a more complete analysis of the costs and benefits. At the very least, we
would need to compare the benefits of schooling to the opportunity cost—the
wages that the student could have earned by dropping out. In addition, requiring a student to stay in school may have external effects on others in society. On
the one hand, compulsory school attendance may reduce crime rates, for young
dropouts are at high risk of engaging in criminal activity. On the other hand, students who stay in school only because they are required to do so may interfere
with the learning of other students who are more committed to their educations.
T H E S U P E R S TA R P H E N O M E N O N
Although most actors earn very little and often have to take jobs as waiters to
support themselves, actor Robin Williams earned $23 million in 1997. Similarly,
although most people who play football do it for free as a hobby, Brett Favre earned
$6.75 million as a pro quarterback. Robin Williams and Brett Favre are superstars in
their fields, and their great public appeal is reflected in astronomical incomes.
Why do Robin Williams and Brett Favre earn so much? It is not surprising that
there are differences in incomes within occupations. Good carpenters earn more
than mediocre carpenters, and good plumbers earn more than mediocre plumbers.
People vary in ability and effort, and these differences lead to differences in income. Yet the best carpenters and plumbers do not earn the many millions that are
common among the best actors and athletes. What explains the difference?
To understand the tremendous incomes of Robin Williams and Brett Favre, we
must examine the special features of the markets in which they sell their services.
Superstars arise in markets that have two characteristics:
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◆
◆
E A R N I N G S A N D D I S C R I M I N AT I O N
425
Every customer in the market wants to enjoy the good supplied by the best
producer.
The good is produced with a technology that makes it possible for the best
producer to supply every customer at low cost.
If Robin Williams is the funniest actor around, then everyone will want to see his
next movie; seeing twice as many movies by an actor half as funny is not a good
substitute. Moreover, it is possible for everyone to enjoy the comedy of Robin
Williams. Because it is easy to make multiple copies of a film, Robin Williams can
provide his service to millions of people simultaneously. Similarly, because football games are broadcast on television, millions of fans can enjoy the extraordinary
athletic skills of Brett Favre.
We can now see why there are no superstar carpenters and plumbers. Other
things equal, everyone prefers to employ the best carpenter, but a carpenter, unlike
a movie actor, can provide his services to only a limited number of customers. Although the best carpenter will be able to command a somewhat higher wage than
the average carpenter, the average carpenter will still be able to earn a good living.
A B O V E - E Q U I L I B R I U M WA G E S :
M I N I M U M - WA G E L AW S , U N I O N S , A N D E F F I C I E N C Y WA G E S
Most analyses of wage differences among workers are based on the equilibrium
model of the labor market—that is, wages are assumed to adjust to balance labor
supply and labor demand. But this assumption does not always apply. For some
workers, wages are set above the level that brings supply and demand into equilibrium. Let’s consider three reasons why this might be so.
One reason for above-equilibrium wages is minimum-wage laws, as we first
saw in Chapter 6. Most workers in the economy are not affected by these laws because their equilibrium wages are well above the legal minimum. But for some
workers, especially the least skilled and experienced, minimum-wage laws raise
wages above the level they would earn in an unregulated labor market.
A second reason that wages might rise above their equilibrium level is the
market power of labor unions. A union is a worker association that bargains with
employers over wages and working conditions. Unions often raise wages above
the level that would prevail without a union, perhaps because they can threaten to
withhold labor from the firm by calling a strike. Studies suggest that union workers earn about 10 to 20 percent more than similar nonunion workers.
A third reason for above-equilibrium wages is suggested by the theory of efficiency wages. This theory holds that a firm can find it profitable to pay high wages
because doing so increases the productivity of its workers. In particular, high
wages may reduce worker turnover, increase worker effort, and raise the quality
of workers who apply for jobs at the firm. If this theory is correct, then some firms
may choose to pay their workers more than they would normally earn.
Above-equilibrium wages, whether caused by minimum-wage laws, unions,
or efficiency wages, have similar effects on the labor market. In particular, pushing
a wage above the equilibrium level raises the quantity of labor supplied and reduces the quantity of labor demanded. The result is a surplus of labor, or unemployment. The study of unemployment and the public policies aimed to deal with
it is usually considered a topic within macroeconomics, so it goes beyond the
scope of this chapter. But it would be a mistake to ignore these issues completely
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union
a worker association that bargains
with employers over wages and
working conditions
strike
the organized withdrawal of labor
from a firm by a union
ef ficiency wages
above-equilibrium wages paid by
firms in order to increase worker
productivity
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PA R T S I X
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when analyzing earnings. Although most wage differences can be understood
while maintaining the assumption of equilibrium in the labor market, aboveequilibrium wages play a role in some cases.
Q U I C K Q U I Z : Define compensating differential and give an example.
◆ Give two reasons why more educated workers earn more than less
educated workers.
T H E E C O N O M I C S O F D I S C R I M I N AT I O N
discrimination
the offering of different opportunities
to similar individuals who differ only
by race, ethnic group, sex, age, or
other personal characteristics
Another source of differences in wages is discrimination. Discrimination occurs
when the marketplace offers different opportunities to similar individuals who
differ only by race, ethnic group, sex, age, or other personal characteristics. Discrimination reflects some people’s prejudice against certain groups in society. Although discrimination is an emotionally charged topic that often generates heated
debate, economists try to study the topic objectively in order to separate myth
from reality.
M E A S U R I N G L A B O R - M A R K E T D I S C R I M I N AT I O N
How much does discrimination in labor markets affect the earnings of different
groups of workers? This question is important, but answering it is not easy.
It might seem natural to gauge the amount of discrimination in labor markets
by looking at the average wages of different groups. For instance, in recent years
the wage of the average black worker in the United States has been about 20 percent less than the wage of the average white worker. The wage of the average female worker has been about 30 percent less than the wage of the average male
worker. These wage differentials are sometimes presented in political debate as evidence that many employers discriminate against blacks and women.
Yet there is an obvious problem with this approach. Even in a labor market free
of discrimination, different people have different wages. People differ in the
amount of human capital they have and in the kinds of work they are able and willing to do. The wage differences we observe in the economy are, to a large extent, attributable to the determinants of equilibrium wages we discussed in the preceding
section. Simply observing differences in wages among broad groups—whites and
blacks, men and women—says little about the prevalence of discrimination.
Consider, for example, the role of human capital. About 80 percent of white
male workers have a high school diploma, and 25 percent have a college degree.
By contrast, only 67 percent of black male workers have a high school diploma,
and only 12 percent have a college degree. Thus, at least some of the difference between the wages of whites and the wages of blacks can be traced to differences in
educational attainment. Similarly, among white workers, 25 percent of men have a
college degree, whereas only 19 percent of women have a college degree, indicating that some of the difference between the wages of men and women is attributable to educational attainment.
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In fact, human capital is probably even more important in explaining wage
differentials than the foregoing numbers suggest. For many years, public schools
in predominantly black areas have been of lower quality—as measured by expenditure, class size, and so on—than public schools in predominantly white areas.
Similarly, for many years, schools directed girls away from science and math
courses, even though these subjects may have had greater value in the marketplace than some of the alternatives. If we could measure the quality as well as the
quantity of education, the differences in human capital among these groups would
seem even larger.
Human capital acquired in the form of job experience can also help explain
wage differences. In particular, women tend to have less job experience on average
than men. One reason is that female labor-force participation has increased over the
past several decades. Because of this historic change, the average female worker today is younger than the average male worker. In addition, women are more likely
to interrupt their careers to raise children. For both reasons, the experience of the
average female worker is less than the experience of the average male worker.
Yet another source of wage differences is compensating differentials. Some analysts have suggested that women take more pleasant jobs on average than men
and that this fact explains some of the earnings differential between men and
women. For example, women are more likely to be secretaries, and men are more
likely to be truck drivers. The relative wages of secretaries and truck drivers depend in part on the working conditions of each job. Because these nonmonetary aspects are hard to measure, it is difficult to gauge the practical importance of
compensating differentials in explaining the wage differences that we observe.
In the end, the study of wage differences among groups does not establish any
clear conclusion about the prevalence of discrimination in U.S. labor markets.
Most economists believe that some of the observed wage differentials are attributable to discrimination, but there is no consensus about how much. The only conclusion about which economists are in consensus is a negative one: Because the
differences in average wages among groups in part reflect differences in human capital and
job characteristics, they do not by themselves say anything about how much discrimination
there is in the labor market.
Of course, differences in human capital among groups of workers may themselves reflect discrimination. The inferior schools historically available to black
students, for instance, may be traced to prejudice on the part of city councils and
school boards. But this kind of discrimination occurs long before the worker enters
the labor market. In this case, the disease is political, even if the symptom is
economic.
D I S C R I M I N AT I O N B Y E M P L O Y E R S
Let’s now turn from measurement to the economic forces that lie behind discrimination in labor markets. If one group in society receives a lower wage than another
group, even after controlling for human capital and job characteristics, who is to
blame for this differential?
The answer is not obvious. It might seem natural to blame employers for discriminatory wage differences. After all, employers make the hiring decisions that determine labor demand and wages. If some groups of workers earn lower wages than
they should, then it seems that employers are responsible. Yet many economists are
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skeptical of this easy answer. They believe that competitive, market economies provide a natural antidote to employer discrimination. That antidote is called the profit
motive.
Imagine an economy in which workers are differentiated by their hair color.
Blondes and brunettes have the same skills, experience, and work ethic. Yet, because of discrimination, employers prefer not to hire workers with blonde hair.
Thus, the demand for blondes is lower than it otherwise would be. As a result,
blondes earn a lower wage than brunettes.
How long can this wage differential persist? In this economy, there is an easy
way for a firm to beat out its competitors: It can hire blonde workers. By hiring
blondes, a firm pays lower wages and thus has lower costs than firms that hire
brunettes. Over time, more and more “blonde” firms enter the market to take advantage of this cost advantage. The existing “brunette” firms have higher costs
and, therefore, begin to lose money when faced with the new competitors. These
losses induce the brunette firms to go out of business. Eventually, the entry of
blonde firms and the exit of brunette firms cause the demand for blonde workers
to rise and the demand for brunette workers to fall. This process continues until
the wage differential disappears.
Put simply, business owners who care only about making money are at an advantage when competing against those who also care about discriminating. As a
result, firms that do not discriminate tend to replace those that do. In this way,
competitive markets have a natural remedy for employer discrimination.
CASE STUDY
SEGREGATED STREETCARS AND
THE PROFIT MOTIVE
In the early twentieth century, streetcars in many southern cities were segregated by race. White passengers sat in the front of the streetcars, and black passengers sat in the back. What do you suppose caused and maintained this
discriminatory practice? And how was this practice viewed by the firms that
ran the streetcars?
In a 1986 article in the Journal of Economic History, economic historian Jennifer Roback looked at these questions. Roback found that the segregation of
races on streetcars was the result of laws that required such segregation. Before
these laws were passed, racial discrimination in seating was rare. It was far
more common to segregate smokers and nonsmokers.
Moreover, the firms that ran the streetcars often opposed the laws requiring
racial segregation. Providing separate seating for different races raised the
firms’ costs and reduced their profit. One railroad company manager complained to the city council that, under the segregation laws, “the company has
to haul around a good deal of empty space.”
Here is how Roback describes the situation in one southern city:
The railroad company did not initiate the segregation policy and was not at
all eager to abide by it. State legislation, public agitation, and a threat to
arrest the president of the railroad were all required to induce them to
separate the races on their cars. . . . There is no indication that the
management was motivated by belief in civil rights or racial equality. The
evidence indicates their primary motives were economic; separation was
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costly. . . . Officials of the company may or may not have disliked blacks,
but they were not willing to forgo the profits necessary to indulge such
prejudice.
The story of southern streetcars illustrates a general lesson: Business owners are
usually more interested in making profit than in discriminating against a particular group. When firms engage in discriminatory practices, the ultimate
source of the discrimination often lies not with the firms themselves but elsewhere. In this particular case, the streetcar companies segregated whites and
blacks because discriminatory laws, which the companies opposed, required
them to do so.
D I S C R I M I N AT I O N B Y C U S T O M E R S A N D G O V E R N M E N T S
Although the profit motive is a strong force acting to eliminate discriminatory
wage differentials, there are limits to its corrective abilities. Here we consider two
of the most important limits: customer preferences and government policies.
To see how customer preferences for discrimination can affect wages, consider
again our imaginary economy with blondes and brunettes. Suppose that restaurant owners discriminate against blondes when hiring waiters. As a result, blonde
waiters earn lower wages than brunette waiters. In this case, a restaurant could
open up with blonde waiters and charge lower prices. If customers only cared
about the quality and price of their meals, the discriminatory firms would be driven out of business, and the wage differential would disappear.
On the other hand, it is possible that customers prefer being served by brunette
waiters. If this preference for discrimination is strong, the entry of blonde restaurants need not succeed in eliminating the wage differential between brunettes and
blondes. That is, if customers have discriminatory preferences, a competitive market is consistent with a discriminatory wage differential. An economy with such
discrimination would contain two types of restaurants. Blonde restaurants hire
blondes, have lower costs, and charge lower prices. Brunette restaurants hire
brunettes, have higher costs, and charge higher prices. Customers who did not care
about the hair color of their waiters would be attracted to the lower prices at the
blonde restaurants. Bigoted customers would go to the brunette restaurants. They
would pay for their discriminatory preference in the form of higher prices.
Another way for discrimination to persist in competitive markets is for the
government to mandate discriminatory practices. If, for instance, the government
passed a law stating that blondes could wash dishes in restaurants but could not
work as waiters, then a wage differential could persist in a competitive market.
The example of segregated streetcars in the foregoing case study is one example of
government-mandated discrimination. More recently, before South Africa abandoned its system of apartheid, blacks were prohibited from working in some jobs.
Discriminatory governments pass such laws to suppress the normal equalizing
force of free and competitive markets.
To sum up: Competitive markets contain a natural remedy for employer discrimination. The entry of firms that care only about profit tends to eliminate discriminatory wage
differentials. These wage differentials persist in competitive markets only when customers
are willing to pay to maintain the discriminatory practice or when the government mandates it.
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IN THE NEWS
Men, Women, and Wages
WHY DOES THE AVERAGE FEMALE WORKER
earn less than the average male
worker? In the following article, economist June O’Neill offers some answers
to this question.
The Shrinking Pay Gap
BY JUNE ELLENOFF O’NEILL
“Fifty-nine cents,” the popular button
said, a symbol of the stubborn fact that
throughout the post–World War II period,
women’s wages hovered at around 60
percent of men’s, despite an increasing
proportion of women working outside
the home. This gender gap did not decline through the 1960s and the 1970s
despite the rise of the feminist movement, equal pay and employment legislation, and affirmative action.
But starting in the Reagan years, the
gender gap in wages began to decline
dramatically. By some measures the ratio
of women’s earnings to men’s rose to
nearly 80 percent; and even this number,
I believe, overstates the gender gap between men and women with similar skills
and training. Why did this dramatic narrowing in relative wages happen?
The answer has less to do with politics or protests than with the realities of
the labor market. Although basic skills
are acquired in school, it is in the labor
market where specialized skills are developed that bring higher wages. During
the three decades following World War II
women entered the labor market in
record numbers. But many of the new
entrants had been out of the labor force
for considerable periods of time, raising
their children. These women diluted the
skill level of the rapidly expanding group
of employed women. This was the main
reason why the gender gap in pay did
not narrow during the postwar years.
CASE STUDY
Today’s working women, particularly
those younger than forty, are much more
nearly equal to men in work experience
than were their mothers. Through delayed
marriage, low fertility, and an increasing
tendency for mothers of young children to
work, women have acquired many more
years of continuous work experience than
was true in the past. (Close to 60 percent
of married women with children under age
six are now in the labor force; in 1960, the
proportion was only 19 percent.)
And the work experience gained by
these younger women is likely to have an
even greater impact on their future earnings because their work experience has
been more correctly anticipated. Many investment choices affecting careers are
made at younger ages: years of schooling, subjects in school, other professional
training. In the past, women were much
less likely than men to invest in lengthy
training because they assumed they
would not be working enough years to
justify it.
In fact, the National Longitudinal
Surveys found that even in the late
1960s less than 30 percent of young
DISCRIMINATION IN SPORTS
As we have seen, measuring discrimination is often difficult. To determine
whether one group of workers is discriminated against, a researcher must correct for differences in the productivity between that group and other workers in
the economy. Yet, in most firms, it is difficult to measure a particular worker’s
contribution to the production of goods and services.
One type of firm in which such corrections are easier is the sports team. Professional teams have many objective measures of productivity. In baseball, for
instance, we can measure a player’s batting average, the frequency of home
runs, the number of stolen bases, and so on.
Studies of sports teams suggest that racial discrimination is, in fact, common
and that much of the blame lies with customers. One study, published in the Journal of Labor Economics in 1988, examined the salaries of basketball players. It found
that black players earned 20 percent less than white players of comparable ability.
The study also found that attendance at basketball games was larger for teams
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CHAPTER 19
women anticipated that they would be
working at age thirty-five, yet when this
group actually reached thirty-five, more
than 70 percent of them were in the labor
force. Their underestimation of future
work activity surely influenced their early
career preparations (or lack thereof).
More recent survey data show a dramatic change in expectations. The vast
majority of young women now report an
intention to work at age thirty-five.
Those changing work expectations
are reflected in rising female enrollments
in higher education. In 1960, women received 35 percent of all bachelor’s degrees in the U.S.; by the 1980s, they
received somewhat more than half of
them. In 1968, women received 8 percent of the medical degrees, 3 percent
of the MBAs, and 4 percent of the law
degrees granted that year. In 1986, they
received 31 percent of the medical degrees and MBAs and 39 percent of the
law degrees. This recent trend in schooling is likely to reinforce the rise in work
experience and contribute to continuing
increases in the relative earnings of
women workers. . . .
E A R N I N G S A N D D I S C R I M I N AT I O N
Despite the advances of the past
decade, women still earn less than men.
The hourly earnings of women were 74
percent of the earnings of men in 1992
when ages twenty-five to sixty-four are
considered, up from 62 percent in 1979.
At ages twenty-five to thirty-four, where
women’s skills have increased the most,
the ratio is 87 percent.
Economist Barbara Bergmann and
others attribute the pay gap to “widespread, severe, ongoing discrimination by
employers and fellow workers.” But discrimination cannot be directly measured.
Instead, researchers estimate the extent
to which differences in productivity appear to explain the gap and then attribute
the rest to discrimination. Such a conclusion is premature, however, when productivity differences are not accurately
measured, which is usually the case.
For example, data are seldom available on lifetime patterns of work experience, and even less material is available
on factors bearing on work expectations
and the intensity and nature of work investments. As these are still the key
sources of skill differences between men
with a greater proportion of white players. One interpretation of these facts is that
customer discrimination makes black players less profitable than white players
for team owners. In the presence of such customer discrimination, a discriminatory wage gap can persist, even if team owners care only about profit.
A similar situation once existed for baseball players. A study using data
from the late 1960s showed that black players earned less than comparable
white players. Moreover, fewer fans attended games pitched by blacks than
games pitched by whites, even though black pitchers had better records than
white pitchers. Studies of more recent salaries in baseball, however, have found
no evidence of discriminatory wage differentials.
Another study, published in the Quarterly Journal of Economics in 1990, examined the market prices of old baseball cards. This study found similar evidence of discrimination. The cards of black hitters sold for 10 percent less than
the cards of comparable white hitters. The cards of black pitchers sold for 13
percent less than the cards of comparable white pitchers. These results suggest
customer discrimination among baseball fans.
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431
and women, there is considerable room
for interpretation and disagreement.
When earnings comparisons are restricted to men and women more similar
in their experience and life situations, the
measured earnings differentials are typically quite small. For example, among
people twenty-seven to thirty-three who
have never had a child, the earnings of
women in the National Longitudinal Survey of Youth are close to 98 percent of
men’s. . . .
It is true that women and men still do
not have the same earnings. But I believe
that the differential is largely due to continuing gender differences in the priority
placed on market work vs. family responsibilities. Until family roles are more equal,
women are not likely to have the same
pattern of market work and earnings as
men. Technology has reduced the burden
of housework, but child care remains a
responsibility that is harder to shift to the
market.
SOURCE: The Wall Street Journal, October 7, 1994,
p. A10.
432
PA R T S I X
THE ECONOMICS OF LABOR MARKETS
T H E D E B AT E O V E R C O M PA R A B L E W O R T H
comparable wor th
a doctrine according to which jobs
deemed comparable should be paid
the same wage
Should engineers get paid more than librarians? This question is at the heart of the
debate over comparable worth, a doctrine whereby jobs deemed comparable should
be paid the same wage.
Advocates of comparable worth point out that traditionally male occupations
have higher wages than traditionally female occupations. They believe that these occupational differences are discriminatory against women. Even if women were paid
the same as men for the same type of work, the gender gap in wages would persist
until comparable occupations were paid similar wages. Comparable-worth advocates want jobs rated according to a set of impartial criteria—education, experience,
responsibility, working conditions, and so on. Under this system, comparably rated
jobs would pay the same wage. A librarian with a master’s degree, ten years of experience, and a 40-hour workweek, for instance, would be paid the same as an engineer with a master’s degree, ten years of experience, and a 40-hour workweek.
Most economists are critical of comparable-worth proposals. They argue that
a competitive market is the best mechanism for setting wages. It would be nearly
impossible, they claim, to measure all of the factors that are relevant for determining the right wage for any job. Moreover, the fact that traditionally female occupations pay less than traditionally male occupations is not by itself evidence of
discrimination. Women have in the past spent more time than men raising children. Women are, therefore, more likely to choose occupations that offer flexible
hours and other working conditions compatible with child-rearing. To some extent, the gender gap in wages is a compensating differential.
Economists also point out that comparable-worth proposals would have an
important unintended side effect. Comparable-worth advocates want the wages in
traditionally female occupations to be raised by legal decree. Such a policy would
have many of the effects of a minimum wage, which we first discussed in Chapter
6. In particular, when the wage is forced to rise above the equilibrium level, the
quantity of labor supplied to these occupations would rise, and the quantity demanded would fall. The result would be higher unemployment in traditionally female occupations. In this way, a comparable-worth law could adversely affect
some members of groups that the policy is aimed at helping.
Q U I C K Q U I Z : Why is it hard to establish whether a group of workers is
being discriminated against? ◆ Explain how profit-maximizing firms tend to
eliminate discriminatory wage differentials. ◆ How might a discriminatory
wage differential persist?
CONCLUSION
In competitive markets, workers earn a wage equal to the value of their marginal
contribution to the production of goods and services. There are, however, many
things that affect the value of the marginal product. Firms pay more for workers
who are more talented, more diligent, more experienced, and more educated because these workers are more productive. Firms pay less to those workers against
whom customers discriminate because these workers contribute less to revenue.
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