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Labor Market Equilibrium (Week 6) 1 Textbook reading • Borjas, Chapters 4 and 5. • Ehrenberg & Smith, Chapter 8. • Cahuc & Zylberberg, Chapter 5. 2 Additional readings • A. Roy, “Some Thoughts on the Distribution of Earnings.” Oxford Economic Papers (1951). • J. Heckman and B. Honore, “The Empirical Content of the Roy Model.” Econometrica (1990). • G. Borjas, “Self-Selection and the Earnings of Immigrants.” American Economic Review (1987). • J. Roback, “Wages, Rent and the Quality of Life”. Journal of Political Economy (1982). 3 Why study labor market equilibrium? • Main questions: – Why do wages differ? • Across workers, jobs, industries, regions… – Why do wages and employment go up and down? • Basic (competitive) model: LD=LS – Equilibrium level of employment and wages. • We will start from there, derive its implications, then extend it to more realistic settings. 4 Competitive labor markets • Main assumptions: – Transparency (perfect information). – Free entry (no market power). • LD=LS – Equilibrium level of employment and wage. – Given the demand for the final good, the prices of other factors, technology, public programs, etc. 5 • “A competitive economy where a homogeneous group of workers and firms can enter and exit the market has a single equilibrium wage across all labor markets” 6 In equilibrium, • No pressure for wages to go up or down. • No unemployment. • Efficiency: – Output is maximized. • In a given labor market, wages are the same for all workers and jobs, even though: – Workers may differ in their “taste for work” and their non-labor income. – Firms can differ in their production function. 7 All jobs are the same • In the basic model, all jobs are the same: – They all pay the same wage. – Workers are indifferent between different firms. – Implicit assumption: non-wage characteristics of jobs are the same across firms. 8 What are wages a function of? • Characteristics of workers and jobs. • LS: demography, distribution of non-labor income, public programs, etc. • LD: demand for the final good, capital markets, regulations, etc. 9 Implications • Even the basic, competitive model generates interesting implications. • Allowing us to think about the effects of a number of policies. – – – – – Minimum wages Payroll taxes International trade Migration etc. 10 Extensions • In practice, there are additional reasons why different workers get paid different wages: – Workers’ have different skills: formal education, experience, innate ability, … – Jobs vary in how demanding they are (how hard or unpleasant): non-wage characteristics. • We can incorporate these dimensions of heterogeneity in the competitive model. 11 Heterogeneity in workers’ skills • The Roy model focuses on heterogeneity of skills or talents across workers. – Self-selection. • The human capital model stresses that workers can choose to invest in increasing their productivity. 12 Non-wage characteristics of the job • The compensating differentials model focuses on the “difficulty” of a job. – “Hedonic theory of wages”. 13 What if the LM is not competitive? • Social norms • Imperfect information • Market power – Monopsony – Monopoly 14