Download THE LABOR MARKET

INTRODUCTION

This chapter covers why there are differences in
wages:



How do people decide how much time to spend
working?
What determines the wage rate an employer is
willing to pay?
Why are some workers paid so much and others so
little?
THE LABOR MARKET
Chapter 15
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LABOR SUPPLY

INCOME VS. LEISURE
The labor supply is the willingness and ability
to work specific amounts of time at alternative
wage rates in a given time period, ceteris
paribus.
The opportunity cost of working is the amount of
leisure time that must be given up in the process.
 Higher wage rates are needed to compensate for
the increasing opportunity cost of labor.
 The marginal utility of income may decline as
you earn more.

3

THE SUPPLY OF LABOR
The upward slope of an individual’s labor-supply
curve is a reflection of two phenomena:
G
G
The increasing opportunity cost of labor as
leisure time declines.
The decreasing marginal utility of income as a
person works more hours.
Wage Rate (dollars per hour)
INCOME VS. LEISURE
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Labor supply
w1
A
People supply more
Labor when wages rise
0
5
B
w2
q1
q2
Quantity of Labor (hours per week)
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A BACKWARD BEND?
A BACKWARD BEND?
The force that drives people up the labor-supply
curve is the marginal utility of income.
 Higher wages represent more goods and services
and thus induce people to substitute labor for
leisure.
 Substitution Effect of Wages – An increased
wage rate encourages people to work more hours
(to substitute leisure for labor).


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A worker might also respond to higher wage
rates by working less, not more.
This negative labor-supply response to
increased wage rates is referred to as the
income effect of a wage increase.
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A BACKWARD BEND?
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THE BACKWARD-BENDING SUPPLY CURVE
Income Effect of Wages – An increased wage
rate allows a person to reduce hours worked
without losing income.
 If income effects outweigh substitution effects, an
individual will supply less labor at higher wages.
Wage Rate (dollars per hour)

Income effects
dominate
Substitution
effects
dominate
0
Quantity of Labor Supplied (hours per week)
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MARKET SUPPLY

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MARKET SUPPLY
The market supply of labor is the total
quantity of labor that workers are willing and
able to supply at alternative wage rates in a
given time period, ceteris paribus.

The labor supply curve shifts when the
determinates of labor supply change:
G
G
G
G
G
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Tastes – for leisure, income, and work.
Income and wealth.
Expectations – for income or consumption.
Prices of consumer goods.
Taxes.
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SHIFTS IN MARKET SUPPLY

ELASTICITY OF LABOR SUPPLY
Over time, the labor supply curve has shifted
leftward:



We use the concept of elasticity to measure the
movements along the labor-supply curve
resulting from wage rate changes.
 The elasticity of labor supply is the percentage
change in the quantity of labor supplied divided
by the percentage change in wage rate.

A rise in living standards.
Income transfer programs that provide economic
security when not working.
Increased diversity and attractiveness of leisure
activities.

13
LABOR DEMAND
A workers responsiveness to wage changes is
often constrained by institutional constraints
such as specified work hours such as 8 – 5 shifts.
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DERIVED DEMAND
Regardless of how many people are willing to
work, it is up to employers to decide the demand
for labor.
 The demand for labor is the quantity of labor
employers are willing and able to hire at
alternative wage rates in a given time period,
ceteris paribus.
The quantity of resources purchased by a
business depends on the firm’s expected sales
and output.
 It is a derived demand.


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DERIVED DEMAND
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THE LABOR-DEMAND CURVE
Derived demand is the demand for labor and
other factors of production resulting from
(depending on) the demand for final goods and
services produced by these factors.
 The principle of derived demand suggests that
one way to increase someone’s wages is to
increase the demand for the goods he or she
produces.
The number of workers hired is not completely
dependent upon the demand for the product.
 The quantity of labor demanded also depends on
its price (the wage rate).


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THE DEMAND FOR LABOR
MARGINAL PHYSICAL PRODUCT
The shape and location of the demand curve for
labor determines how much labor is demanded
and the wage rate that is paid.
 Marginal physical product (MPP) is the
change in total output associated with one
additional unit of input.
Wage Rate (dollars per hour)

Demand for labor
More workers are
sought at lower wages
A
W1
B
W2
0
L1
L2
Quantity of Labor (hours per month)
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MARGINAL REVENUE PRODUCT

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MARGINAL REVENUE PRODUCT
The dollar value of a worker’s contribution to
output is called marginal revenue product (MRP).
Marginal revenue product sets an upper limit to
the wage rate an employer will pay.
 Marginal revenue product (MRP) - the change
in total revenue associated with one additional
unit of input.

MRP = MPP X p
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THE LAW OF DIMINISHING RETURNS

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THE LAW OF DIMINISHING RETURNS
The marginal physical product of labor
eventually declines as the quantity of labor
employed increases.
According to the law of diminishing returns,
the marginal physical product of a variable factor
declines as more of it is employed with a given
quantity of other (fixed) inputs.
 As marginal physical product diminishes, so does
marginal revenue product as MRP=MPP x p.

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Output of Strawberries
(boxes per hour)
THE LAW OF DIMINISHING RETURNS
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20
18
16
14
12
10
8
6
4
2
0
–2
–4
G
F
E
DIMINISHING MRP
H
D
I
Total output
C
B
b
A
c
d
e
f
Marginal output
(per picker)
0
1
2
g
h
3
4
5
6
7
8
Number of Pickers (per hour)
i
9
10
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THE HIRING DECISION
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MRP = FIRM’S LABOR DEMAND
revenue product determines how
much labor will be hired.
 A firm that is a perfect competitor in the
labor market can hire all the labor it
wants at the prevailing market wage.
An employer will continue to hire people until
the MRP has declined to the level of the
market wage rate.
 Each (identical) worker is worth no more than
the marginal revenue product of the last
worker hired, and all workers are paid the
same wage rate.
MARGINAL REVENUE PRODUCT
(per hour)
 Marginal

$11
10
9
8
7
6
5
4
3
2
1
A
MRP
C
Wage rate
D
0
1
2
3
4
5
6
7
8
9
QUANTITY OF LABOR (workers per hour)
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CHANGES IN WAGE RATES
B
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INCENTIVES TO HIRE
There is a tradeoff between wages and the
number of workers hired.
 If the wage rates go up, fewer workers will be
hired.

Wage Rate (dollars per hour)
$12
10
8
B
Lower wages spur
more hires
MRP = demand
G
6
Initial wage rate
C
4
D
2
0
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A
1
New wage rate
2
3
4
5
6
7
8
9
Quantity of Labor Demanded (pickers per hour)
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CHANGES IN PRODUCTIVITY
INCENTIVES TO HIRE
To get higher wages without sacrificing jobs,
productivity (MRP) must increase.
 Increased productivity implies that workers can
get higher wages without sacrificing jobs or more
employment without lowering wages.

Wage Rate (dollars per hour)
$12
D2
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CHANGES IN PRICE
Higher productivity spurs
more hires
New demand curve
8
F
6
E
4
Initial wage rate
C
2
0
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D1
Initial demand curve
1
2
3
4
5
6
7
8
9
Quantity of Labor Demanded (pickers per hour)
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MARKET EQUILIBRIUM
An increase in product price will also increase
MRP and thus demand for labor.
 Price changes depend on changes in the market
supply and demand for the product being sold.


The market demand for labor depends on:



The number of employers.
The marginal revenue product of labor in each firm
and industry.
The market supply of labor depends on:
G
G
The number of workers.
Each worker’s willingness to work at
alternative wage rates.
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EQUILIBRIUM WAGE
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EQUILIBRIUM WAGE
The intersection of the market supply and
demand establishes the equilibrium wage.
 The equilibrium wage is the wage at which the
quantity of labor supplied in a given time period
equals the quantity of labor demanded.
 Competitive employers act like price takers with
respect to wages as well as prices.

Wage Rate (dollars per hour)
The labor market
A competitive firm
Market
supply
we
Labor supply
confronting firm
we
Market
demand
MRP of
firm's labor
q0
35
Quantity of Labor
(workers per time period)
Quantity of Labor
(workers per time period)
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MINIMUM WAGES

MINIMUM WAGES
A government-imposed minimum wage (wage
floor):



The size of the job loss caused by a higher
minimum wage depends on labor-market
conditions.
 When the minimum wage is below the
equilibrium wage, an increase in the minimum
may have little or no adverse employment effects.
 The further the minimum wage rises above the
market’s equilibrium wage, the greater the job
loss.

Reduces the quantity of labor demanded.
Increases the quantity of labor supplied.
Creates a market surplus.
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MINIMUM WAGE EFFECTS
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CHOOSING AMONG INPUTS
Employers can use more machinery in place of
labor.
 To determine whether to hire a worker or use a
machine, a firm compares the ratio of the
marginal physical products to their cost.
 This ratio expresses the cost efficiency of an
input.
Wage Rate (dollars per hour)

Labor demand
Labor supply
Market surplus
wm
we
Minimum wage
E
Workers who keep
jobs at higher wage
Equilibrium wage rate
Job
losers
0
New entrants who
can't find jobs
qd
qe
qs
Quantity of Labor (hours per year)
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COST EFFICIENCY


ALTERNATIVE PRODUCTION PROCESSES
Cost efficiency is the amount of output
associated with an additional dollar spent on
input – the MPP of a product divided by its price
(cost).
The most cost-efficient factor is the one that
produces the most output per dollar.
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
Typically a producer does not choose between
individual inputs but rather between alternative
production processes.

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Production process - A specific combination of
resources used to produce a good or service.
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ALTERNATIVE PRODUCTION PROCESSES
THE EFFICIENCY DECISION

The producer seeks to use the combination of
resources that produces a given rate of output for
the least cost.

Efficiency decision - The choice of a production
process for any given rate of output.
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CAPPING CEO PAY
Critics of CEO pay believe that CEO paychecks
are out of line with realities of supply and
demand.
 They want corporations to revise the process used
for setting CEO pay levels.
 One of the difficulties in determining the
appropriate level of CEO pay is the elusiveness of
marginal revenue product.

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UNMEASURED MRP

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UNMEASURED MRP
It is easy to measure the MRP of a strawberry
picker, but a corporate CEO’s contributions are
less well-defined.

I
I
Congress confronts the same problem in
setting the president’s pay.
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The wage of the president and other public
officials is set by their opportunity wage.
The opportunity wage is the highest wage
an individual would earn in his or her best
alternative job.
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UNMEASURED MRP
UNMEASURED MRP
Opportunity wages help explain CEO pay but
don’t fully justify such high pay levels.
 Critics of CEO pay conclude that the process of
setting CEO pay levels should be changed.
 If markets work efficiently, such government
intervention should not be necessary.
Corporations that pay their CEOs excessively
will end up with smaller profits than companies
who pay market-based wages.
 Over time, “lean” companies will be more
competitive than “fat” companies, and excessive
pay scales will be eliminated.


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THE LABOR MARKET
End of Chapter 15
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