Download Market 1 - McGraw Hill Higher Education

Chapter 12: Labor Markets,
Poverty, and Income
Distribution
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1
Learning Objectives
1. Understand the relationship between wages and
the marginal productivity of workers
2. Analyze how wages and employment are
determined in competitive labor markets
3. Compare and contrast the various hypotheses
economists have proposed to explain earnings
differences
4. Discuss recent trends in income inequality and
philosophical justifications for income
redistribution
5. Describe and analyze some of the methods used to
reduce poverty
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2
Story
Winning a gold medal at the Olympics can
bring fame and fortune to many athletes
 Nawal
Al Moutawakil, a Moroccan gold
medalist in the 400-meter hurdles at the Los
Angeles Summer Olympic Games in 1984

Since her 1984 win, she gained her fortune from:
Product endorsements / TV appearances / Earning
several international awards / Serving as a member
of the International Olympic Committee / Her
appointment as the Minister of Youth and Sports in
Morocco
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Story
 However, a silver or bronze medalist, despite
potentially being within a hairbreadth to
winning can drop completely from view
 The
silver medalist from 1984 has dropped
completely from view
 Judi Brown, an American athlete, and although
potentially just as talented as Al Moutawakil,
wealth and international recognition were not to
be hers
 Individual income vary widely
 Comparable
skills seem to earn different incomes
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Story
 Many physicians in Arab countries such as
Egypt are likewise every bit as talented and
hardworking as physicians in the West
 However,
American physicians earn an average
annual income of almost $200,000
 Egyptian physicians earn as little as $63 a month
that most of them (about 89%) supplement their
incomes by holding multiple jobs
 Why do some people earn so much more
than others?
 No
other single question in economics has
stimulated nearly as much interest and discussion
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5
The Economic Value of Work
 In some respects, the sale of human labor is
profoundly different from the sale of other
goods and services
 For example, although someone may legally
relinquish all future rights to the use of her
television set by selling it, the law does not
permit people to sell themselves into slavery
 The law does, however, permit employers to
“rent” our services
 In many ways the rental market for labor
services functions much like the market for
most other goods and services
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The Market for Labor
Economics analysis applies to labor markets

Equilibrium wage and quantity are determined
by supply of and demand for a each category of
labor

Labor categories include unskilled, skilled, managers,
and so on

Changes in supply and demand will change the
equilibrium wage and quantity
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7
Khazaf Works
Pottery uses free clay and labor
 Selling


price is $1.10 per piece
Handling costs are $0.10 per piece
Net price is $1.00 per piece
Rafiq and Lina each work full time at potting
 Rafiq
120
delivers 100 pots per week and Lina delivers
• If the labor market for potters is perfectly competitive, how
much will each be paid?
- Assume that the values of the pots that Rafiq and Lina
deliver are $100 and $120 respectively
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Khazaf Pottery Works
Rafiq earns $100 and Lina
earns $120 per week
One reason for
different earnings is
differences in
output per person
 If Khazaf paid Rafiq only $90 per week, the company would
then enjoy an economic profit of $10 per week as a result of
hiring him
 Seeing this cash on the table, a rival firm could then offer
Rafiq $91, thus earning an additional economic profit of $9
per week by bidding him away from Khazaf
 Khazaf will have difficulty keeping Rafiq if it pays him less than
$100 per week
 That will be his competitive equilibrium wage
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9
The Labor Market
Marginal product of labor (MP)
 The
additional output a firm gets by employing
one additional unit of labor


100 pots for Rafiq
120 pots for Lina
Value of marginal product of labor (VMP)
MP * (Net P) = VMP
 The
dollar value of the additional output a firm
gets by employing one additional unit of labor
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The Labor Market
 General rule in a competitive labor market is:
A
worker’s pay in long-run equilibrium will be equal to
his or her VMP—the net contribution he or she makes
to the employer’s revenue
wage = VMP
 Employers would be delighted to pay workers
less than their respective VMPs
 But
if labor markets are truly competitive, they
cannot get away with doing so for long
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Potters' Production
 To summarize:
 Value

of Marginal Product
Marginal product of labor multiplied times the net price
of each unit sold ($1)
• Rafiq’s VMP is $100 and Lina’s VMP is $120

In a competitive market each worker is paid the value of
his marginal product
 Each worker’s VMP is independent of the
number of other workers employed by the firm
 In
such cases, we cannot predict how many
workers a firm will hire
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12
Ouzai Woodworking Company
Makes cutting boards from free scrap wood
 Price
of a cutting board is $20
Going wage is $350 per week
# of Workers
Output
0
0
1
30
2
55
3
76
4
94
5
108
MP
VMP
30
$600
25
500
21
420
18
360
14
280
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Ouzai Woodworking Company
The company will hire workers until the value
of the marginal product of the last worker is
equal to the wage
 Cost-Benefit
Principle
 Workers earn $350 per
week
# of Workers
VMP
1
$600
2
500
3
420
4
360
5
280
Hire four workers
 The
fifth worker costs
more ($350) than the
benefits he delivers ($280)
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14
Firm’s Decision to Hire
 Note the similarity between the perfectly competitive
firm’s decision about how many workers to hire and
the perfectly competitive firm’s output decision

When labor is the only variable factor of production, the
two decisions are essentially the same
 There are three important factors:



The number of boards cut
The price of cutting boards
The wage rate


An increase in product price will lead employers to hire more
workers
Employers also will increase hiring when the wage rate falls
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The Equilibrium Wage and Employment Levels
The equilibrium price and quantity in any
competitive market occur at the
intersection of the relevant supply and
demand curves
The same is true in competitive markets
for labor
 Demand
curve for labor  employer
 Supply curve for labor  employee
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Demand for Labor  employer
An employer’s reservation price for a
worker is the most the employer could pay
without suffering a decline in profit
 The
reservation price for the employer in a
perfectly competitive labor market is simply
the value of the worker’s marginal product
(VMP)
 Because of the law of diminishing returns, the
VMP declines in the short run as the quantity
of labor rises  DL = VMP
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Firm 1
12
D1 = VMP1
12
D = VMP1 +
VMP2
6
100 150
Wage ($/hour)
Market
12
Firm 2
Wage ($/hour)
Wage ($/hour)
Demand for Labor
6
D2 = VMP2
6
150
250
Total Employment
50 100
Work hours/day
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Supply for Labor  employee
 Individuals trade-off income and leisure
 More
work hours means more income AND less
leisure
 Suppose the wage increases
 Substitution


effect: work more
Leisure is more expensive
 Income
Income Effect
effect: work less
Substitution
Effect
Purchasing power increases for a given work schedule
A
higher wage may increase or decrease the
quantity of labor supplied by the individual
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Labor Supply of Programmers

Higher wages attract
workers from other
careers
 An increase in wages
from W1 to W2 increases
quantity of labor supplied
from L1 to L2

S
Wage ($/hour)
 Labor supply for a single
profession has a positive
slope
W2
W1
L1 L2
Employment of programmers
(work-hours/year)
Movement along the
labor supply curve
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Market Shift: Increase in the Demand for
Programmers
W3
S
Wage ($/hour)
 Demand for programmers
increases from D1 to D2
 Initial impact is a shortage of
programmers at W1
 In the short-run, wages are bid
up to W3
 In the long run
 Movement up the supply curve
and down the demand curve
 Quantity of labor supplied
increases from L1 to L2
 Wages settle at W2
W2
W1
D2
D1
L1
L2
Employment of programmers
(work-hours/year)
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Market Shift: Increase in the Demand for
Programmers
 Labor markets are often relatively slow to
adjust
 When the demand for workers in a given
profession increases, shortages may remain
for months or even years
 It
all depends on how long it takes people to
acquire the skills and training needed to enter
the profession (or to change profession to the
one in demand)
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Explaining Differences in Earnings
 When labor markets are competitive,
differences in wages are determined by
differences in VMP
 Lina
earned 20% more than Rafiq because she
made 20% more pots each week than he did
 This difference in productivity may have resulted
from an underlying difference in talent or training,
or perhaps Lina simply worked harder than Rafiq
 Yet often we see large salary differences even
among people who appear equally talented and
hardworking
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Explaining Differences in Earnings
 Why, for instance, do lawyers earn so much more
than those plumbers who are just as smart as they
are and work just as hard? And why do surgeons earn
so much more than general practitioners?
 No-Cash-on-the-Table Principle says that only
differences in talent, luck, or hard work can account
for long-run differences in earnings

If plumbers could earn more by becoming lawyers, why
don’t they just switch occupations?

Answer to that is Human Capital Theory
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Human Capital and Differences in Earnings
 Human capital theory holds that an
individual’s VMP (or wage) is proportional to
his or her stock of human capital
 Human
capital stock is a mixture of factors such as
Factors Affecting Differences in Earnings
Education
Experience
Training
Intelligence
Energy
Work Habits
Trustworthiness
 Individuals
capital
Initiative
Political Skills
make decisions about acquiring human
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Human Capital and Differences in Earnings
Some jobs require more human capital


For example, a general practitioner could become a
surgeon, but only by extending her formal
education by several more years
An even larger investment in additional education is
required for a plumber to become a lawyer
 These
jobs usually pay more
 Demand for specific kinds of human capital also
cause earnings differences
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Labor Unions and Differences in Earnings
 In general, two workers with the same amount of
human capital may earn different wages if one of them
belongs to a labor union and the other does not
 A labor union is a group of workers who bargain
collectively with employers for better wages and
working conditions  entry to the union is restricted
 Unions restrict the supply of labor and raise wages
Similar to a cartel
 Unions increase the supply of labor to the non-union
companies


Wages in non-union companies go down
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Market 1
D1 = VMP1
S0
D = VMP1
+ VMP2
9
125
Wage ($/hour)
Total Market
Market 2
D2 = VMP2
Wage ($/hour)
Wage ($/hour)
Market Equilibrium Without Unions
9
9
75
Employment
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200
Total employment
(workers/day)
28
Market 1
D1 = VMP1
12
9
100
Wage ($/hour)
 Workers in market 1
unionize
 Negotiate a wage of $12
 25 workers out of work
 In market 2, labor increases
by 25 workers from market 1
 Wage decreases to $6
 Employment increases to 100
 Net welfare loss to society
 Move workers from low VMP
to high VMP will increase total
surplus
Wage ($/hour)
Market 1 Is Unionized
125
Market 2
D2 = VMP2
9
6
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75 100
Employment
29
Size of the Union Wage Advantage
 Our analysis of two markets resulted in union
workers earning twice the non-union wage
 Suggest
unionized firms have a cost disadvantage
 Unionized firms remain competitive
 Unions


Union workers are more skilled and experienced
Wage gap is ±10% for comparable human capital
 Unions


attract most productive workers
increase productivity
Improved communications and motivation
Lower labor turnover means lower costs
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Compensating Wage Differentials
 If people are paid the value of what they produce,
why do chefs earn more than lifeguards?

Preparing food is important, to be sure, but is it more
valuable than saving the life of a drowning child?
 Similarly, why plumbers may get paid more than
teachers?

Is replacing faucet washers really more valuable than
educating children?
 The wage for a particular job depends not only on
the value of what workers produce, but also on
how attractive they find its working conditions
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Compensating Wage Differentials
Compensating wage differentials
describe the difference in wage rates from
differences in working conditions
 Wages
depend on VMP and also on working
conditions
 Workers have preferences about their work
schedule, environment and other conditions

Working in less desirable conditions increases wage
Safety and work schedule are conditions that
matter to workers
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Discrimination in the Labor Market
Wage differentials not based on differences
in VMP leave cash on the table
 On
average, women and minorities receive
lower wages than white males

Pattern holds even if we compare people with
similar human capital levels
One way to explain differential is that some
human capital differences are not measured
Another view attributes the differential to
discrimination
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Employer Discrimination
Employer discrimination is an arbitrary
preference by an employer for one group
of workers over another
Assumptions
 Productivity
is distributed the same for men
and women

Average productivity is the same
 One
employer prefers to hire male employees
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Employer Discrimination
Discriminating firm has higher costs than
non-discriminator
 Discriminating
employers earn lower profits
Non-discriminator has higher profits
 Expands

business
Eventually supply of women is exhausted
 Bid
up female wages
No Cash on the Table Principle results in
equal wages between discriminator and
non-discriminator
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Discrimination by Others
 If employer discrimination is not the primary
explanation of the wage gap, what is?
 Customer discrimination causes buyers to pay
more for goods produced by favored group for the
same product

Attorneys: Some groups more credible with juries and
clients than others

Reduces incentives for non-favored groups to enter the
profession
 Socialization within the family can affect individual's
career choices and therefore the supply of labor

Traditional female roles: nurses, teachers, secretaries
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Other Sources of the Wage Gap
Basis for compensating wage differentials
 Willingness

Coal mining, entrepreneurs, construction, farming
 Quality

to accept risk
versus quantity of education
Difficult to measure
 Courses
taken and degrees (humanities versus
sciences) pursued by sex and race


Wage gaps remain across industries and
occupations
If one group disproportionately pursues higher-paid
occupations, wage gap will persist
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Winner-Take-All Markets
 Winner-take-all markets are ones in which
small differences in human capital translate
into large differences in pay
 Technology
plays a role
 Some participants earn high salaries

Many more do not
 Examples
Entertainment
Law
Consulting
Medicine
Investment Banking
CEOs
Publishing
Design, Fashion
Academia
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38
Trends in Inequality
 An attractive feature of the free-market
system is that it rewards initiative, effort, and
risk taking
 The
harder, longer, and more effectively a person
works, the more he or she will be paid
 Yet relying on the marketplace to distribute
income also entails an important drawback:
 Those
who do well often end up with vastly more
money than they can spend
 Those who fail often cannot afford even basic
goods and services.
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Trends in Inequality
 Market outcomes produce disparities in
income
Median Income by Quintile for US
(2005 dollars)
Quintile
Bottom 20%
Second 20%
1980
$14,386
31,316
1990
$14,241
33,217
2000
$16,008
36,602
Middle 20%
Fourth 20%
Top 20%
47,308
65,634
110,507
51,157
73,569
136,725
57,525
84,781
177,879
Top 5%
157,094
214,527
315,205
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US Median Income by Quintile
$350,000
$300,000
Growing inequality
$200,000
$100,000
Bottom
20%
Second
20%
1980
Middle
20%
1990
Fourth
20%
Top 20%
Top 5%
2000
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41
Recent Trends in Inequality
 From WWII to the 1970s income
growth was ± 3% per year for all
groups
 Between 1980 and 2000, growth rates
increase from bottom quintile to top
 Does not show mobility between groups
 Median income is not a measure of
individual welfare
 In 1980, CEOs earned 42 times salary of
average worker
 By 2000, this multiple increased to
more than 500 times
Median Income Growth
1980 - 2000
Bottom 20%
11%
Second 20%
17%
Middle 20%
22%
Fourth 20%
29%
Top 20%
61%
Top 5%
101%
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42
Is Income Inequality a Moral Problem?
The "right" income distribution is a
normative matter
Rawls proposed a "fair" income distribution
is one that people would accept before they
know their position in the distribution
 Equality
of distribution is favored by the
strongly risk averse

Since an unequal income distribution would involve
not only a chance of doing well but a chance of
doing poorly, most people would prefer to
eliminate the risk by choosing an equal distribution
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43
Acceptable Income Distributions
 If income is distributed equally, total output is
smaller than in a country with earnings
incentives
 Rawls argued that inequality would be
acceptable if it increases total output by
"enough"
 Rawls also argued that the market system
produces more inequality than acceptable
 Fear
of being disadvantaged beats hope of being
rich
 Fairness requires some attempt to reduce income
inequality produced by the market
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44
The Challenge of Income Redistribution
Raising incomes of the needy reduce
incentives to work
 Difficulty
distinguishing between needy and
others



Risk takers may appear "needy"
People who prefer not to work are ineligible
Hurricane victims
No perfect solution
 Choose
among imperfect alternatives
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Welfare Payments and In-kind Transfers
In-kind transfers are direct transfers of
goods or services
 Food
subsidies, subsidized public housing,
subsidized school meals, free education, and
health care
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Welfare Programs in Egypt
 One of the most important welfare programs in Egypt
comes in the form of food subsidies, which cover sugar,
cooking oil, tea, and rice
The green card targets low-income households and provides a
higher rate of subsidy
 The red card targets higher-income households and provides a
lower rate of subsidy

 Critics of this program charge that ambiguous selection
criterion and weak monitoring have rendered the subsidies
ineffective
 Green cards: held by 61 percent of households in the three
richest quintiles, which receive 62 percent of total benefits.
 Red cards: held by 10 percent of households in the poorest
two quintiles (in lieu of green cards).
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Means-Tested Benefit Programs
 A means-tested program means that the more
income a family has, the smaller are the
benefits it receives under these programs
 Intends
to avoid paying benefits to those who can
support themselves
 Administrative structure discourages work
 If
benefits are reduced by $1 for each $2 earned,
participants in multiple programs may lose more
benefits than the income they earn
 Administrative costs are high
 Simplify
the program and distribute the cost
savings to the needy
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The Negative Income Tax (NIT)
No
Taxes
After-Tax Income
($000s)
 Negative income tax is a tax
credit for each person financed
by tax on earned income
 With no taxes, pre-tax income
equals after-tax income
 With NIT, low income families
receive a cash transfer while high
income families pay tax
 Family with no income would
receive the federal poverty
threshold
20
tax
16
15
14
NIT
10
transfer
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10 15
20
Pre-Tax Income
($000s)
49
Negative Income Tax
Advantages
 Incentive
to work is greater than with welfare
 Lower administrative cost
Disadvantages
 Creates
and incentive not to work
 The political cost is high

NIT guarantees income to all who do not work
 Would
need to be at least as large as the
government’s official poverty threshold, if
sole means of insulating people against poverty
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50
Negative Income Tax and Poverty
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51
Negative Income Tax and Poverty
 According to the World Bank, the poverty
threshold is $1.25 per day, which represents about
$450 per year.
 In the U.S. it is $21,756 for a family of four.
 Couldn’t eight families in the U.S. live nicely with
$144,000 per year (from pooling their negative tax
payments) after moving to a home in the
mountains?
 Two practical difficulties:


More people living at the government’s expense would
make the program prohibitively costly
The program is likely to be quickly abandoned by
political supporters
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52
Minimum Wage Legislation
 Loss
Wmin
Wage ($/hour)
 Minimum wage above
equilibrium creates
unemployment
Unemployment
S
W
in total surplus
 L1 workers earn more
L1 L0
 (L0 – L1) are unemployed
Employment
 Change in total earning
depends on the elasticity of demand for labor
D
 Studies show little effect of minimum wage on
employment
 Loss
in total surplus may be small
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53
Minimum Wages and Total Surplus
No Minimum Wage
Minimum Wage ($7)
10
S
5
Worker
surplus
$12.5K
0
10
W ($/hour)
W ($/hour)
Employer
surplus
$12.5K
5,000
Employer
surplus
($4.5K)
S
7
Total surplus
lost ($4K)
5
3
Worker
D
surplus
($16.5K)
D
0
L (work-hours/day)
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3,000 5,000
L (work-hours/day)
54
Public Employment for the Poor
 Government could employ the poor
 If
wages are the same as the private sector, some
workers will prefer government jobs

Increases the cost of the program
 Make-work
programs are not productive
 Increases size of government
 Acting alone, government-sponsored jobs for
the poor or the negative income tax cannot
solve the income-transfer problem
 But
a combination of these programs might do so
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55
A Combination of Methods
 Use
a NIT with payment set below the poverty
threshold
 Set the public service wage below the minimum
wage
 Privatize the management of the public service
employment program
Public
Job
Poverty
threshold
NIT +
Public Job
NIT +
Private Job
NIT
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56