Download Contemporary Labor Economics

Chapter 6
Wage Determination and the
Allocation of Labor
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
1. Theory of a Perfectly
Competitive Labor
Market
6-2
Perfectly Competitive Labor
Market
o Perfectly competitive labor markets have
the following characteristics:
• Large number of firms trying to hire an
identical type of labor
• Numerous qualified people independently
offering their services
• Neither firms nor workers have control over
the market wage
• Perfect, costless information and labor
mobility
6-3
• Though individuals have
backward-bending labor supply
curves, market supply curves
are usually positively sloped
over normal wage ranges.
Wage rate
Market Labor Supply
S
• High relative wages attract
workers away from household
production, leisure, or their
previous jobs.
• The height of the market
supply curve measures the
opportunity cost of using the
marginal labor hour in this
employment.
• The shorter the time period,
the less elastic is the labor
supply curve.
Quantity of
Labor Hours
6-4
Wage and Employment
Determination
Wage rate
S
• The equilibrium wage rate W0
and level of employment Q0
occur at the intersection of labor Wes
supply and demand.
W0
• An excess demand of Q2- Q1
Wed
would occur at a wage rate of
Wed.
D
• An excess supply of Q2- Q1
would occur at a wage rate of
Wes.
Q1 Q0
Q2
Quantity of
Labor
Hours
6-5
Labor Supply Determinants
Labor Supply will change if there are
changes in the following factors:
o Other wage rates
o Nonwage income
o Preferences for work versus leisure
o Nonwage aspects of job
o Number of qualified suppliers
6-6
Labor Supply Determinants
o Other wage rates
• If wages in other occupations rise (fall), then
labor supply will fall (rise).
o Nonwage income
• If nonwage income rises (falls), then labor
supply will fall (rise).
o Preferences for work versus leisure
• If preferences for work increase (decrease),
then labor supply will increase (decrease).
6-7
Labor Supply Determinants
o Nonwage aspects of job
• If the nonwage aspects of a job improve
(worsen), then labor supply will increase
(decrease).
o Number of qualified suppliers
• An increase (decrease) in the number of
qualified workers will increase (decrease)
labor supply.
6-8
Labor Demand Determinants
Labor Demand will change if there are
changes in:
o Product demand
o Productivity
o Prices of other resources
• Gross substitutes
• Gross complements
o Number of employers
6-9
Labor Demand Determinants
o Product demand
• Changes in product demand that
increase (decrease) the product price, will
increase (decrease) labor demand.
o Productivity
• An increase (decrease) in productivity will
increase (decrease) labor demand,
assuming that it does not cause an offset
in the product price.
6-10
Labor Demand Determinants
o Prices of other resources
• For gross substitutes, an increase
(decrease) in the price of a substitute
input will increase (decrease) labor
demand.
• For gross complements, an increase
(decrease) in the price of a complement
input will decrease (increase) labor
demand.
6-11
Labor Demand Determinants
o Prices of other resources
• For pure complements, an increase
(decrease) in the price of a complement
input will decrease (increase) labor
demand.
o Number of employers
• An increase (decrease) in the number of
employers will increase (decrease) labor
demand.
6-12
Changes in Labor Demand
• Assume that the productivity
of workers rises due to
computer innovations.
• This will raise the marginal
product and thus shift the
labor demand curve to the
right (D0 to D1).
Wage rate
S
W1
W0
D1
D0
• The equilibrium wage rate
will rise to W1 and equilibrium
quantity will rise to Q1.
Q0 Q1
Quantity of
Labor Hours
6-13
Changes in Labor Supply
Wage rate
S0
• Assume that the number of
working-age immigrants
increases substantially.
• This will shift the labor
supply curve to the right (S0 to
S1).
S1
W0
W1
• The equilibrium wage rate
will fall to W1 and equilibrium
quantity will rise to Q1.
D0
Q0 Q1
Quantity of
Labor Hours
6-14
Labor Market Demand & Supply
Elasticities
o Wage Elasticity of Labor Demand
• Inelastic: very little change in the number of jobs
if wages change
• Elastic: a large change in the number of jobs if
wages change
o Wage Elasticity of Labor Supply
• Inelastic: very little change in the number of job
seekers if wages change
• Elastic: a large change in the number of job
seekers if wages change
6-15
Digression: Labor Supply
Elasticity Determinants
Key:
• Are individuals willing & able to enter and exit
an occupation if wages either increase or
decrease?
• Elastic Supply: workers are willing & able to
enter if wages increase and leave if wages
decrease
• Inelastic Supply: workers are unwilling &
unable to enter if wages increase and leave if
wages decrease
6-16
Digression: Labor Supply
Elasticity Determinants
o Labor Supply will be more/less elastic if:
• Relative wages are low/high
• Relative training/skills are low/high
• Training/skills can/can’t be transferred from
other occupations
• Nonwage benefits of the job aren’t/are
important
• Typical jobs require relatively few/many hours
per week (Income vs. Substitution Effect)
6-17
Digression: Labor Demand Elasticity
Determinants
Key:
• Are employers willing & able to increase or
decrease the number of persons hired in an
occupation if wages either decrease or
increase?
• Elastic Demand: firms are willing & able to
decrease employment if wages increase and
increase employment if wages decrease
• Inelastic Demand: firms are willing & able to
decrease employment if wages increase and
increase employment if wages decrease
6-18
Digression: Labor Demand
Elasticity Determinants
o Labor demand will be more/less elastic if
• Customers do/don’t care about product price
• Labor costs are a large/small part of total
costs
• Substitutes for labor do/don’t exist
• Supplies of labor substitutes are ample/scarce
6-19
Equilibrium Changes and the Labor
Demand Elasticity
o If labor supply increases and labor
demand is inelastic
• Wages will decrease a lot
• Employment will increase a little
• Total wages to workers will decrease
o If labor supply increases and labor
demand is elastic
• Wages will decrease a little
• Employment will increase a lot
• Total wages to workers will increase
6-20
Equilibrium Changes and the Labor
Demand Elasticity
6-21
Equilibrium Changes and the Labor
Demand Elasticity
o If labor demand increases and labor
supply is inelastic
• Wages will increase a lot
• Employment will increase a little
o If labor demand increases and labor
supply is elastic
• Wages will increase a little
• Employment will increase a lot
o Rising labor demand increases total wages and
falling labor demand decreases total wages
6-22
Equilibrium Changes and the Labor
Supply Elasticity
6-23
Wage and Employment for Firms with
Competitive Product & Labor Markets
• Assume wages are the only
cost
• a firm hiring in a perfectly
competitive labor market is a
“wage taker.” Its labor supply
curve, SL=MLC=PL, is perfectly
elastic at W0.
Wage rate
SL=MLC=PL
W0
• A firm will hire another
worker if the additional
revenue the worker generates,
marginal revenue product
(MRP), is greater than the cost
of hiring an additional worker,
marginal labor cost (MLC).
• The firm maximizes its profits
by hiring Q0 units of labor
(MRP=MLC).
DL=MRP=VMP
Q0
Quantity of
Labor Hours
6-24
Allocative Efficiency
o An efficient allocation of labor is
obtained when society gets the largest
possible amount of output from a given
amount of labor.
o Efficient allocation requires the VMP of
labor for each product be equal to the
price of labor.
o Perfect competition in the product and
labor markets creates allocative
efficiency.
6-25
Questions for Thought
1. What effect will each of the following have on
the market demand for a specific type of labor:
(a) An increase in product demand that increases the
product price.
(b) A decline in the productivity of this type of labor.
(c) An increase in the price of a gross substitute of labor.
(d) An increase in the price of a gross complement of
labor.
(e) The demise of several firms that hire this type of
labor.
(f) A decline in the market wage for this type of labor.
6-26
2. Wage and
Employment
Determination: Market
Power in the Product
Market
6-27
Wage and Employment for Firms with NonCompetitive Product Markets
• Assume wages are the only
cost
•Because a monopolist faces a
downward sloping demand
curve, increased hiring of labor
and the resulting larger output
force the firm to lower its price.
• Because it must lower its
price on all units, its marginal
revenue (MR) is less than the
price.
• The firm’s MRP curve (MP *
MR) lies below the VMP curve
(MP * P), and thus firm hires QM
rather than QC.
• An efficiency loss of abc
results.
Wage rate
b
W0
c
a
SL=MLC=PL
DC=VMP (MP*P)
DM=MRP (MP*MR)
QM
QC
Quantity of
Labor Hours
6-28
Questions for Thought
1. Complete the following table for a firm operating
in labor market A and product market AA.
Labor
Wage
1
TLC
MLC
MRP
VMP
$10
$16
$16
2
$10
$14
$15
3
$10
$12
$14
4
$10
$10
$12
5
$10
$8
$10
6
$10
$6
$8
(a) What can we conclude about the degree of
competition in the labor market and product market?
(b) What is the profit maximizing level of employment?
6-29
3. Market Power in the
Labor Market: the Case
of Monopsony
6-30
Monopsony
o A monopsony is a labor
market where a single firm is
the sole hirer of a particular
type of labor.
• A monopsonist has control over
the wage rate workers are paid
by hiring more or less labor.
6-31
Monopsony
• A monopsonist faces an upward sloping labor curve. It has to pay a
higher wage to get more workers.
• The total labor cost (TLC) to the firm is calculated as the number of units
of labor times the wage rate (assuming no other costs when hiring).
• The firm maximizes profits by hiring MRP = MLC at 3 units.
• The marginal labor cost (MLC) is the additional cost of hiring the last
worker.
Units of
Labor (L)
(1)
0
1
2
3
4
5
6
7
Wage
TLC
MLC
(2)
(3)
(4)
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00
----$2
$6
$12
$20
$30
$42
$56
--$ 2
$ 4
$ 6
$ 8
$10
$12
$14
(VMP)
MRP
(5)
$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$4
$3
6-32
Wage and Employment
for a Monopsonist
• The firm’s MLC lies above
the SL.
• The monopsonist equates its
MRP with its MLC at point a
and hires QM units of labor.
• To attract these workers, it
need only pay WM.
• The firm thus pays a lower
wage (WM rather than WC) and
hires fewer units of labor (QM
instead of QC) than firms in a
competitive labor market.
• An efficiency loss of abc
results.
MLC
Wage rate
SL=PL
a
WC
WM
c
b
DL=MRP=VMP
QM QC
Quantity of
Labor Hours
6-33
Baseball Free Agency
o Before 1976, baseball players were bound
to single teams = monopsony power. In
1976, players could become “free agents”
after 6 years
o Theory says that pre 1976 players should
have been paid far less than MRP
• Studies confirm, with star pitchers only
receiving 21% of their MRPs, bad pitchers
receiving 54% and bad hitters receiving 37%.
6-34
• After free-agency, market competition
reduced monopsony power
• Wages soared to more closely match MRP
6-35
4. Wage Determination:
Delayed Supply
Responses
6-36
Cobweb Model
• The market for highly trained
professionals such as nurses
has delayed supply responses
to changes in demand and
wage rates.
• Because the quantity of labor
supplied is temporarily fixed at
Q0, the wage rate rises to W1
when demand changes from D0
to D1.
• At wage rate W1, Q1 nurses
are attracted to the profession.
• With supply fixed at Q1, the
wage rate falls to W2.
• With this wage rate, the
quantity of nurses falls over
time to Q2.
• The cycle repeats until
equilibrium is achieved at the
intersection of S and D.
S
Wage rate
W1
W2
W0
D1
D0
Q0 Q2
Q1 Quantity of
Labor Hours
6-37
Evidence
o Some evidence exists for cobweb
adjustments in markets such as
lawyers and engineers.
o Critics argue that:
• Students make choices on the basis of the
lifetime earnings stream rather than
starting salaries.
• Students make a forecast of the long-run
outcome of a change in demand or supply
and make the right choice.
6-38