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 In this chapter, we learn:
 how a basic supply-and-demand model helps us understand the labor
market.
 how labor market distortions like taxes and firing costs affect
employment in the long run.
 how to compute present discounted values, and how to value your
human capital.
 the return to a college education has risen enormously over the last
half-century.
 the wages of a person starting to work this year and continuing to
work for the next 45 years are worth approximately $1 million in
today’s dollars.
 Wages account for two-thirds of per capita GDP…and have for a long time
 Average wages adjusted for the cost of living have grown 2 percent per
year for the last century, reflecting increases in productivity.
 Since 1990, however, average hourly earnings adjusted for inflation have
grown only 0.61% and average weekly earnings have grown only 0.43%
Labor Market Facts: Employment – to – Population Ratio
2010
Composition of the Laborforce: 2005 and January 2010
2005
Jan 2010
237 million
153
138
14.8
84
 The unemployment rate is the fraction of the labor force that is
unemployed
 A person is unemployed if she does not have a job that pays a wage or
salary, she actively looked for a job during the four weeks before
measuring the unemployment rate, and she is available to work.
 The unemployment rate in 2005 was 7.6/149 = 5.1%
 The unemployment rate in 2010 was 14.8/153 = 9.7%
Labor Market Facts: The Unemployment Rate
2010
Dynamics of the Labor Market
 Job creation and job destruction are the gross flows of jobs that are being created and
destroyed every month as part of normal changes in the U.S. economy.
 Most spells of unemployment were relatively short.
 People who are unemployed for long periods account for most of the total weeks
of lost work.
 Hysteresis: long-term unemployed become unemployable and stay unemployed
 The duration of unemployment has increased sharply in the current Great
Recession.
Labor Market Monthly Flows, 1996 – 2003
Labor Force Data, 1994 – 1999
(monthly
Separation
rate =flows)
(2.8+1.8+2.8)/122 = 6%
per month
Employment
127 million
Unemployed finding
work
= 1.4/6.2 = 23% /mo.
Job Change
3.5 million
1.1
Unemployment
7.0 million
Population leaving labor
force/month
= (2.8 + 1.4)/(122 +59.3) = 2.3 %
Out of labor
force
66.7 million
Unemployed leaving unemployment each1.3month = (1.4+1.4)/6.2 = 45%
Avg duraation of unemployment = 1/.45 = 2.2 months
7
Labor Supply and Demand
 The labor demand curve is derived from the firm’s profit maximization
problem.
 Firms hire workers until the marginal value product of labor (MPL)
equals the wage rate.
 If MPL > Wage, firms wants to hire additional workers
 If MPL < Wage, firms wants to hire fewer workers
 The demand curve for slopes downward because of the diminishing
marginal product of labor.
 As we add more workers and hold all else equal, each additional
worker produces less.
 The labor supply curve slopes upward because the price of leisure is higher
when wages are higher.
 It takes a higher wage to get workers to give up more and more “leisure”
 The intersection of labor supply and demand determines the level of
employment and the wage rate.
Reflects
diminishing
marginal
product of
labor.
Change in Labor Supply: An income tax or payroll tax
 A Wedge Between What Firm Pays and Worker Gets
 If the government collects a tax on a worker’s wage, labor supply shifts
left.
 For any given wage, a worker receives less money and supplies less labor.
 In order to be in equilibrium, firms must raise wages.

As firms raise wages, they
will need to fire some
workers and the
unemployment rate will
rise.

However, over time,
workers will become
discouraged and may drop
out of the labor force.

If all laid-off workers
become discouraged, the
unemployment rate is
unchanged in the long run.
A Change in Labor Demand:
Regulations making it harder to
fire workers.

Firms will demand fewer workers because they
will not be able to fire them later.

Labor demand shifts left causing wages and
employment fall.

The unemployment rate rises initially and
recovers as discouraged workers drop out of the
labor force.
Rigid (“sticky”) wages:
•If wages are sticky, the failure of wages to fall to clear
the labor market will result in a larger fall in
employment.
Efficiency Wages: Keep wages high!
 Paying a wage greater than the wage needed to retain a worker may
actually increase a firm’s profits.
 Paying higher wages allows workers to eat healthier and become more
productive.
 Paying higher wages ensures a higher level of effort and less shirking.
 Higher wages will attract more able workers to a firm.
 Reduced hiring costs
 Higher wages will reduce turnover
 Reduced training costs
Supply and Demand Shocks in the U.S. Labor Market
 Increases in the employment-population ratio are due in large part to
increases in the number of women working.
 Supply shocks include changes in social norms and changes in
technology for managing fertility.
 Demand shocks include reduced discrimination against women.
 Rising unemployment in the 1960s and 1970s and the subsequent
decline in the 1980s is possibly explained by the baby boom.
 Young people have higher unemployment rates traditionally – and
the baby boom increased the proportion of young people in those
decades.
Flavors of Unemployment
 The “natural rate” of unemployment is the rate that would prevail if the economy
were in neither a boom nor a bust.
 The natural rate of unemployment includes two components:
 Frictional unemployment is due to workers being between jobs in the
dynamic economy
Search unemployment
Wait unemployment
 Structural unemployment results from the labor market failing to match up
workers and firms in the market.
– In a healthy, dynamic economy, some industries are growing while
others are declining
 Cyclical unemployment is the difference between the actual rate and the natural rate
and is associated with short-run fluctuations in output.
Labor Markets around the World
 Unemployment in Europe had been substantially above America’s rate
since 1980, while Japan’s rate was historically below the United States.
Euro-sclerosis???:
 European unemployment has increased
dramatically because of:
 Adverse shocks (productivity showdown
and high oil prices) hit Europe and other
countries.
 Inefficient labor market institutions exist in
Europe, as unemployment and welfare
benefits are substantially higher.
 Many programs are designed such that there
is a high implicit tax rate for returning to
work.
 GDP per capita is lower in Europe
because workers work less hours.
 If the choice is voluntary, then
Europeans enjoy leisure more and
welfare is likely improved.
 If the decrease in hours worked is a
result of distortions in the labor market,
it is likely not welfare enhancing.
How Much is Your Human Capital Worth?
 The present discounted value of your lifetime income is likely greater than
1 million dollars.
 The premium to having a college degree relative to a high school degree
has been rising rapidly over the last forty years.
 The wage premium of a college degree over a person’s years worked far
outweighs the forgone wages and tuition costs of going to college.
 Explanations for a large shift in demand for highly educated workers include:
 Skill-biased technical change is the idea that new technologies are more effective at
improving productivity of college-educated workers than of high school educated workers.
 Globalization is the increased opening of trade. Because highly educated workers are a
scarce resource in the world as a whole, trade will raise wages of college-educated workers.
 As wages have grown, so has the supply of
college graduates – such a supply shock implies
wages should decline.
 Because the supply of works has increased, it must
also be the case that the demand for collegeeducated workers has increased by an amount
large enough to offset supply.
 Furthermore, the demand shift for collegeeducated workers must be large enough to also
counteract any shifts occurring in the market for
high school graduates.