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Chapter 8
The Labor Market
Labor Supply
• The willingness and ability to work specific
amounts of time at alternative wage rates in
a given time period, ceteris paribus.
Labor Supply
Income vs. Leisure
• The opportunity cost of working is the
amount of leisure time that must be given
up in the process:
– Opportunity cost is the most desired goods or
services that are forgone in order to obtain
something else.
Income vs. Leisure
• As the opportunity cost of work increases,
we require higher rates of pay.
• The marginal utility of income declines as
more is earned.
Income vs. Leisure
• The upward slope of an individual labor
supply curve reflects two things:
– Increasing opportunity cost of labor.
– Decreasing marginal utility of income.
Market Supply
• Market supply of labor – the total quantity
of labor that workers are willing and able to
supply at alternative wage rates in a given
time period, ceteris paribus.
• As labor-market entrants increase, the
quantity of labor supplied goes up.
Labor Demand
• Demand for labor – the quantities of labor
employers are willing and able to hire at
alternative wage rates in a given time
period, ceteris paribus.
The Demand for Labor
Derived Demand
• The quantity of resources purchased by a
business depends on the firm’s expected
sales and output.
• The demand for labor depends on the
demand for the product that the labor is
producing.
Derived Demand
• Derived Demand:
– The demand for labor and other factors of
production results (is derived) from the
demand for the final goods and services
produced by these factors.
The Wage Rate
• The quantity of labor demanded depends
on its price - the wage rate.
Marginal Physical Product (MPP)
• We measure a worker’s value to the firm by
his or her marginal physical product (MPP).
Marginal Physical Product (MPP)
• Marginal physical product – the change
in total output associated with one
additional unit of input:
Marginal physical product =
change in total output
change in quantity of labor
Marginal Physical Product (MPP)
• In most situations, the marginal physical
product declines as more workers are
hired.
Marginal Physical Product (MPP)
Marginal Physical Product (MPP)
Marginal Revenue Product (MRP)
• Marginal revenue product – the change in
total revenue associated with one
additional unit of input:
Marginal revenue product =
change in total revenue
change in quantity of labor
Marginal Revenue Product (MRP)
• Marginal revenue product sets an upper
limit to the wage rate an employer will pay.
Marginal Revenue Product (MRP)
The Law of Diminishing Returns
• The marginal physical product of labor
eventually declines (or diminishes) as the
quantity of labor employed increases.
• Marginal physical product declines as more
people must share limited facilities.
The Law of Diminishing Returns
• 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.
The Law of Diminishing Returns
Diminishing Marginal Revenue Product
(MRP)
• As MPP diminishes so does MRP.
MRP = MPP x p
• If p is assumed to be constant, then MRP
diminishes along with MPP.
Diminishing Marginal Revenue Product
(MRP)
The Hiring Decision
• How many workers that will be hired is
determined by the demand for and supply
of labor.
The Firm’s Demand for Labor
• A firm will continue to hire until the MRP
has declined to the level of the market
wage rate.
• The Marginal Revenue Product curve is the
labor-demand curve.
The Firm’s Demand for Labor
• Each (identical) worker is worth no more
than the MRP of the last worker hired, and
all workers are paid the same wage rate.
The Labor-Demand Curve
Market Equilibrium
• The market demand for labor depends on:
– The number of employers.
– The Marginal Revenue Product of labor in
each firm and the industry.
Market Equilibrium
• The market supply of labor depends on:
– The number of workers.
– Each workers’ willingness to work at alternative
wage rates.
Equilibrium Wage
• The intersection of the market supply and
demand curves establishes the equilibrium
wage.
• It is the only wage where the quantity of
labor supplied equals the quantity of labor
demanded.
Equilibrium Wage
Equilibrium Employment
• The only sustainable level of employment
in a market given the prevailing supply and
demand conditions.
Changing Market Outcomes
• Changing market conditions alter wages
and employment levels:
– Changes in labor productivity
– Changes in the price of the good produced by
labor
– Legal minimum wages
– Labor unions
Changes in Productivity
• If labor productivity (MPP) rises, wages can
increase without sacrificing jobs.
• Increased productivity implies that workers
can get higher wages without sacrificing
jobs or more employment without lowering
wages.
Changes in Price
• Marginal revenue product reflects the
interaction of productivity and product
prices.
• MRP depends on the market price of the
product being produced.
• MRP shifts to the right if the market price of
a product increases.
Shifts in Labor-Demand
Legal Minimum Wages
• Minimum wages are mandated by
Congress.
• Effects of a minimum wage:
– Reduces the quantity of labor demanded.
– Increases the quantity of labor supplied.
– Creates a market surplus.
– Some workers end up better off while others
end up worse off (a tradeoff).
Minimum-Wage Effects
Labor Unions
• Workers may take collective action to get
higher wages.
• They form a labor union and bargain
collectively with employers.
• A union must exclude some workers from
the market to get and maintain an aboveequilibrium wage.
Labor Unions
• Unions decrease wages in non-union
industries.
• Excluded workers increase non-union labor
supply.
The Effect of Unions on Relative
Wages
Capping CEO Pay
• Critics of CEO (Chief Executive Officer)
pay levels want to reduce their pay and
revise the process used to set their pay
levels.
Unmeasured MRP
• Measuring the MRP of a CEO is difficult
because a CEO’s contributions are not
easy to quantify.
• CEO salaries are higher because they
reflect their opportunity wage:
– Opportunity wage is the highest wage an
individual would earn in his or her best
alternative job.
The Labor
Market
End of Chapter 8