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Chapter
Thirteen
Labor Markets
The Labor Market
• The labor market, just like the goods market, can
be represented using a labor supply and labor
demand curve. One big difference between the
labor market and the goods market however, is
households are sellers in the labor market, while
firms are buyers.
• Figure 13.1 illustrates a typical labor supply and
labor demand curve.
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The Labor Market (cont’d)
Figure 13.1
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Measuring Worker’s Pay
• Fringe benefits – Compensation that a
worker receives excluding direct money
payments for time worked; includes
insurance, retirement benefits, vacation
time, and sick leave.
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Adjusting for Inflation
• Wage – The price of labor defined over
period of time; expressed as currency per
unit of labor worked.
• Real wage – The wage or price of labor
adjusted for inflation; in contrast, nominal
wage has not been adjusted for inflation.
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Adjusting for Inflation (cont’d)
• The real wage is computed by dividing the
nominal wage by an index of prices. The
most commonly used index for prices is
the CPI.
Real wage = nominal wage
CPI
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Wage Trends
• Figure 13.2 shows the trend for the
average real hourly wage in the United
States from 1991 – 2004.
• The average wage in the US in 2004
(expressed in 1999 dollars) was about
$22.23 per hour, which includes about
$6.48 in fringe benefits.
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Wage Trends (cont’d)
Figure 13.2
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Wage Trends (cont’d)
• From Figure 13.2, we can see that the US
average hourly real wage fell between
1993-1994, but has risen dramatically
between 1996-2002.
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Wage Trends (cont’d)
Other US labor market trends:
1) Workers with higher skills are paid more than
unskilled workers and the gap is increasing.
2) College graduates earn more than high school
graduates and the gap has been increasing.
3) Women are paid lower than men, although the
gap has become more narrow over the years.
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Labor Demand
• Labor Market – The market in which
individuals supply their labor time to firms
in exchange for salaries and wages.
• Labor Supply – The relationship between
the quantity of labor supplied by
individuals and the wage.
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Labor Demand (cont’d)
• Labor Demand – The relationship between
the quantity of labor demanded by firms
and the wage. Labor demand is a derived
demand.
• Derived Demand – The demand for an
input derived from the demand for the
product produced with that input.
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A Firm’s Employment Decisions
Simple rule to follow when hiring a worker:
• If employing another worker increases the
firm’s profits, then the firm will employ that
worker.
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A Firm’s Employment Decisions (cont’d)
• Marginal product of labor – The change in
production due to a one-unit increase in the
labor input.
• Marginal revenue product of labor = the change
in total revenue due to a one-unit increase in
the labor input.
• Table 13.1 illustrates an example showing how
the marginal product and the marginal revenue
product of labor is calculated.
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A Firm’s Employment Decisions (cont’d)
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A Firm’s Employment Decisions (cont’d)
• From Table 13.1, we can see that the
marginal product of labor and the marginal
revenue product of labor is calculated as:
MP =
Change in Q
Change in L
MRP =
Change in TR
Change in L
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A Firm’s Employment Decisions (cont’d)
From Table 13.1, we observe that
1) The marginal product of labor is declining.
This is because the firm is producing in the
short run, and has a fixed capital input.
2) The marginal revenue product of labor is
declining. Because the MRP = P X MP, then a
decline in marginal product will result in a
declining marginal revenue product as well.
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MRP = Wage
• If a firm is profit maximizing, it will hire the
largest number of workers for which the
MRP is greater than the wage. If the firm
can hire fractional units of labor, then the
firm will continue to hire until the MRP =
Wage.
• Note: At the point where the MRP equals the wage, the
MRP must be downward sloping.
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MRP = Wage (cont’d)
Intuition
• If MRP of the next worker is greater than
the wage, hiring the next worker will bring
more revenues than costs, so profits will
increase.
• If MRP of the next worker is less than the
wage, hiring the next worker will bring less
revenues than costs, so profits will
decrease.
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The Firm’s Demand for Labor
• Because the firm will hire workers using
the rule MRP = Wage, then the demand
curve for labor is determined completely
by the marginal revenue product of labor.
• Figure 13.3 illustrates how the labor
demand curve is determined.
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The Firm’s Demand for Labor (cont’d)
Figure 13.3
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What if the Firm has Market Power?
• The derivation of the demand for labor using the
marginal revenue product of labor (MRP) holds
only when the firm has no market power. If a
firm has market power, then the price of the
good is no longer constant, and the rule of MRP
= wage no longer applies.
• To best understand this point, we look at a
sample firm with market power in Table 13.2.
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What if the Firm has Market Power?
(cont’d)
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What if the Firm has Market Power?
(cont’d)
• In Table 13.2, the firm has market power,
as illustrated by the inverse relationship
between the price of the good and the
quantity.
• Note: In the calculation for marginal
product, marginal revenue is the same for
a competitive firm as it is for a firm with
market power.
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What if the Firm has Market Power?
(cont’d)
• The marginal revenue product of labor is still the
change in the total revenue resulting from the hiring
of one more unit of labor.
MRP =
Change in TR
Change in L
• The marginal revenue product of labor is no
longer calculated as MRP = P X MP, because
the price is not constant.
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What if the Firm has Market Power?
(cont’d)
Instead, the MRP is calculated as follows:
MRP =
=
the marginal revenue times the
marginal product of labor
MR X MP.
• Because the MR drops faster than the price,
then the marginal revenue product of labor will
fall faster in a firm with market power than in a
competitive firm.
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The Market Demand for Labor
• The market demand for labor is derived by
the horizontal summation of the individual
demand curves of the labor market.
• Figure 13.4 illustrates an example where
the market demand for labor is derived
from two firms. Note that the market
demand curve is flatter than either of the
individual demand curves.
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The Market Demand for Labor (cont’d)
Figure 13.4
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Labor Supply
• In economics, the decision to supply labor
is analyzed as a decision between working
and the other activities that can be done
instead of working.
• Leisure – Generic term used by
economists for non-work activities.
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Labor Supply (cont’d)
Recall
• Labor Supply – The relationship between
the quantity of labor supplied by
individuals and the wage.
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Labor Supply (cont’d)
• Like the decision to consume a
commodity, the decision to work more or
less given a wage change can be
analyzed with the concepts of the income
effect and the substitution effect.
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The Substitution Effect
of a Wage Change
• The substitution effect states that the
higher the hourly wage, the more attractive
work will seem relative to the other
activities. As a result, the quantity of work
supplied will increase when the wage
increases.
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The Income Effect of a Wage Change
• The income effect reflects the effect of a wage
change (remember, wage is the price of labor)
on your real income.
• The income effect can either induce you to work
more (if you consider leisure an inferior good) or
to work less (if you consider leisure a normal
good). Our discussion revolves only in leisure
as normal goods, so an increase in income will
make you work less.
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The Income and Substitution Effect of a
Wage Change
• An individual’s reaction to a change in the
wage rate depends on the direction of the
income effect, and the relative sizes of the
income and substitution effect. Again, we
assume that the income effect is negative,
i.e., higher wages make you want to work
less.
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The Shape of the Supply Curve
•
•
•
The supply curve will be upward sloping if the
income effect is smaller than the substitution
effect.
The supply curve will be downward sloping if
the income effect is greater than the
substitution effect (this is also known as the
backward-bending labor supply curve).
The supply curve will be vertical if the income
effect equals the substitution effect.
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The Shape of the Supply Curve (cont’d)
• Figure 13.5 illustrates the three possible
shapes of the labor supply curve. Figure
13.6 summarizes the relative sizes of the
income and substitution effects associated
with the differing slopes of the labor supply
curve.
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The Shape of the Supply Curve (cont’d)
Figure 13.5
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The Shape of the Supply Curve (cont’d)
Figure 13.6
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Work vs. Getting Human Capital
• Another alternative for working is getting
more education and training in order to
increase skills or human capital.
• Human capital – A person’s accumulated
knowledge and skills.
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Work vs. Getting Human Capital (cont’d)
• The decision to either work or “invest” on
human capital is analyzed just like any
other economic choice. To make the
correct choice, we need to compare the
benefits of investing in human capital with
the benefits of not investing in human
capital.
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Work vs. Getting Human Capital (cont’d)
Analyzing the Decision of Going to College
• Benefits: College will improve skills and
increase the probability of landing a higher
paying job (higher pay).
• Costs: Forego earning income, pay tuition.
– You decide to go to college if you perceive the
benefits are greater than the cost.
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Work vs. Getting Human Capital (cont’d)
• On-the-job training is another way to increase
worker’s productivity. Training can either be firm
specific (learning a software that only your
company uses) or general purpose (acquiring
skills transferable to other jobs).
• On-the-job training – The building of skills of a
firm’s employees while they work for the firm.
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Higher Education and Success
• Figure 13.7 shows the mean earnings of
workers classified based on gender, race
and educational attainment. Based on the
figure, we can conclude that higher
educational attainment may increase
average earning potential of workers.
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Higher Education and Success (cont’d)
Figure 13.7
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Labor Market Equilibrium
• Labor market equilibrium – The situation in
which the quantity of labor supplied equals
the quantity of labor demanded; the point
of intersection of the labor supply and the
labor demand curve.
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Labor Productivity
Labor productivity – Output per hour of work.
• Figure 13.8 illustrates the growth rate (in
percent) of labor productivity (the bar
graph) and the growth rate of real wages
(the line graph) between 1990 – 2004.
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Labor Productivity (cont’d)
Figure 13.8
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Labor Productivity (cont’d)
• Figure 13.8 shows a strong correlation between
labor productivity and the real wage. When the
growth rate of labor productivity is low, the real
wages drop or rise slowly. When the growth rate
of labor productivity is high, the real wages rise
faster.
• This observation suggests that the growth rate of
labor productivity is a major explanation for
wage changes over time.
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Compensating Wage Differentials
• Compensating Wage Differential – A
difference in wage for people with similar
skills based on some characteristics of the
job, such as riskiness, discomfort, or
convenience of time schedule.
Compensating wage differentials are not
based on the marginal product.
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Discrimination
• Discrimination – Not hiring workers even though
their marginal product is as high or exceeds
other workers; may also be defined as paying a
lower wage to a worker when the marginal
product of labor of the worker is equal to or
greater than that of other workers.
• Discrimination may be based on race, gender, or
other observable differences in workers.
• The effects of discrimination on a firm is best
illustrated in Figure 13.9.
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Discrimination (cont’d)
Figure 13.9
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Discrimination (cont’d)
• From Figure 13.9, discrimination can be
illustrated as an incorrect perception of a
lower marginal revenue product for the
discriminated worker. The lower perceived
marginal revenue product will cause the
firm to hire fewer of these discriminated
workers and to hire them at a lower wage.
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Discrimination (cont’d)
• From Figure 13.9, discrimination will lead
to sub-optimal profits made by the firm. If
the firm hired more of the workers it
discriminated against, its profits would
rise.
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Minimum Wage Laws
• Minimum wage laws – A government
legislation that requires that firms pay a
worker a wage no lower than the legislated
minimum. The minimum wage is
effectively a price floor, where paying a
wage lower than the floor is not legal.
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Minimum Wage Laws (cont’d)
Minimum Wages of Some States (as of Jan. 2006):
Alaska - $7.15
Alabama – no minimum wage law
Arizona – no minimum wage law
California - $6.75 per hour
Colorado - $5.15 per hour
Connecticut - $7.40 per hour
Florida - $6.40 per hour
Hawaii - $6.75 per hour
(Source: Department of Labor, Wage and Hour Division)
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Minimum Wage Laws (cont’d)
Minimum Wages of Some States (as of Jan. 2006):
Kentucky - $5.15
Louisiana – no minimum wage law
Massachusetts - $6.75 per hour.
Michigan - $5.15
Ohio - $4.25 ($3.35 if firm annual sales $150,000-500,000, $2.80 if firm
sales less than $150,000)
Texas - $5.15
Washington - $7.35
District of Columbia - $7.00
(Source: Department of Labor, Wage and Hour Division)
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Minimum Wage Laws (cont’d)
• Figure 13.10 illustrates the impact of a
minimum wage law.
• Unemployment will arise if the minimum
wage rate is higher than the market
equilibrium. A minimum wage law will
have no effect (market will be in
equilibrium) if the minimum wage is set
below market equilibrium.
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Minimum Wage Laws (cont’d)
Figure 13.10
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Wage Payments and Incentives
•
Piece - rate system – A system in which
workers are paid a specific amount per
unit of output that they produce.
Examples
1) Lettuce growers pay harvesters and
packers per box of lettuce that they pack.
2) Cotton pickers are paid per 100 pounds
of cotton that they pick.
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Wage Payments and Incentives (cont’d)
•
Deferred wage contract – An agreement
between a worker and an employer where the
worker is paid less than the marginal revenue
product when young, and subsequently paid
more than marginal revenue product when old.
•
Example: Lawyers and Accountants get paid a
lot more once they become partners.
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Labor Unions
• Labor Union – A coalition of workers organized
to improve wages and working conditions of
members.
• Industrial union – A union organized within an
industry. Whose members come from a variety
of occupations.
• Craft union – A union organized to represent a
single occupation, whose members come from a
variety of industries.
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Labor Unions (cont’d)
• National Labor Relations Act (1935) – A
law that gives workers the right to organize
into unions and bargain with employers.
• National Labor Relations Board – The
government agency that has been set up
to make sure that firms do not illegally
prevent workers from organizing and to
monitor union election of officials.
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Labor Unions (cont’d)
• One observation of industries with labor unions
is that wages of union workers are higher than
non-union workers.
• According to one theory, unions can raise wages
by restricting labor supply. By restricting the
supply of workers in the union, the supply of
non-union workers increases and the equilibrium
wages drop for non-union workers. This is
illustrated in Figure 13.11.
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Labor Unions (cont’d)
Figure 13.11
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Labor Unions (cont’d)
• Another explanation why union wages are
higher, is that unions can increase worker
marginal productivity. Their argument goes like
this:
• Consider a worker who identifies an opportunity
to increase wages (say by providing better tools)
and goes to management. Management might
not choose to hear the worker if he is alone.
However, the voice may be heard and
implemented if a collection of workers go to
management instead.
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Monopsony and Bilateral Monopoly
• Monopsony – A situation in which there is
a single buyer of a particular good or
service in a given market.
• Bilateral monopoly – The situation in which
there is one buyer and one seller in a
market.
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Key Terms
•
•
•
•
•
•
•
•
Fringe benefits
Wage and real wage
Labor market
Labor demand and labor supply
Derived demand
Marginal revenue product of labor
Backward bending labor supply curve
Human capital
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Key Terms (cont’d)
•
•
•
•
•
•
•
•
•
On-the-job training
Labor market equilibrium
Labor productivity
Compensating wage differential
Piece-rate system
Deferred payment contract
Labor union
Craft union and industrial union
Monopsony and bilateral monopoly.
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