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CHAPTER
18
The Labor Market
1
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
The Labor Market


The model of supply and demand can be
used to study the determination of wages
and employment in the labor market.
Topics in this chapter include:



The determination of wages in a perfectly
competitive market
An explanation of why wages differ from one
occupation to another
The effects of labor market imperfections
2
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Firm Buys Inputs in a Perfectly
Competitive Market

A perfectly competitive firm:



Takes the prices of its inputs as given
(price taker in the input market)
Hires only a tiny fraction of the
workers in the labor market
Can hire as many workers as it wants
as long as it pays the market wage
rate
3
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Diminishing Returns and the Optimal
Quantity of Labor

The firm uses the marginal principle to decide how
many workers to hire.
Marginal PRINCIPLE
Increase the level of an activity if its marginal benefit
exceeds its marginal cost, but reduce the level if the
marginal cost exceeds the marginal benefit. If
possible, pick the level at which the marginal benefit
equals the marginal cost.

The firm will pick the quantity of labor at which the
marginal benefit of labor equals the marginal cost of
labor.
4
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Marginal Cost of Labor

The marginal cost of
labor is simply the
hourly wage in the
market, or the extra
cost associated with
one more hour of
labor.

The marginal cost
curve is also the
labor-supply curve
faced by the firm.

When the wage is $8 an
hour, the firm can hire 3, 5 or
any number of workers at
that wage.
5
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Marginal Benefit of Labor


The marginal benefit of labor equals the
monetary value of the output produced with an
additional hour of labor.
The marginal benefit of labor is called marginal
revenue product (MRP), or the extra revenue
generated by one additional worker.
MRP = price of output x marginal product
6
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Firm Faces Diminishing Returns in
the Short Run

In the short run, the firm is subject to
diminishing marginal returns from labor. The
change in output from one additional worker
decreases as the number of workers increases.
PRINCIPLE of Diminishing Returns
Suppose that output is produced with two or more
inputs and that we increase one input while holding
the other inputs fixed. Beyond some point—called
the point of diminishing returns—output will increase
at a decreasing rate.
7
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Marginal Benefit and Diminishing
Returns

Because the firm faces
diminishing returns in
the short run, the
marginal product of
labor decreases with
additional workers
hired.

In other words, there is
a negative relationship
between the number of
workers hired and
marginal revenue
product.

The MRP curve (or marginal
benefit) is also the firm’s
short-run demand curve
for labor.
8
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Number
of
Balls per
Workers
Hour
Marginal
Product
Price per
ball
Marginal
Benefit =
Marginal
Rev enue
Product
Marginal
Cost =
Wage =
$8
L
Q
MP
P
MRP
MC
(given)
(given)
Q
L
(given)
(P x MP)
(given)
1
2
3
4
5
6
7
8
26
50
72
92
108
120
128
130
26
24
22
20
16
12
8
2
$0.50
0.50
0.50
0.50
0.50
0.50
0.50
0.50
$13
12
11
10
8
6
4
1
$8
8
8
8
8
8
8
8

M a rg in a l re v e n u e o r m a rg in a l c o s t
The Marginal Benefit (Demand) and the
Marginal Cost (Supply) of Labor
14
12
10
8
6
4
2
0
0
1
2
3
4
5
6
7
Number of workers
Marginal Revenue Product
Marginal Cost
At an hourly wage of $8, marginal revenue
product equals marginal cost when the firm hires
five workers.
9
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
8
How Many Workers Will the Firm Hire?

At $8 an hour, the
firm hires 5
workers. If the
wage goes up to
$11 an hour, the
firm hires 3
workers.

© 2001 Prentice Hall Business Publishing
If you pick a wage, the
MRP curve tells you
exactly how much labor
the firm will demand.10
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Shifts in the Demand for Labor Curve


To draw the labor
demand curve, we
hold fixed the
price of the output
and the
productivity of
workers.
An increase in the
price of the output
or in productivity
will shift the labor
demand curve to
the right.
© 2001 Prentice Hall Business Publishing

At each wage, the firm
will hire more workers.
Economics: Principles and Tools, 2/e
11
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The Short-run Market Demand for
Labor

The short-run market demand curve for
labor is the sum of the labor demands of all the
firms that use a particular type of labor.
12
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Labor Demand in the Long Run

The long-run labor demand
curve shows the relationship
between the wage and the
quantity of labor demanded
over the long run, when the
number of firms and the size
of their production facilities can
change.
13
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Labor Demand in the Long Run

Although there are no diminishing returns in the
long run, the long-run labor demand curve is still
negatively sloped for two reasons:
 The output effect: higher wages mean higher
production costs, higher prices, lower quantity
demanded, lower output sold; therefore, less
need for inputs
 The input-substitution effect: higher wages
will cause the firm to substitute other inputs
for labor; the firm will use more machinery and
fewer workers
14
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Short-run Versus Long-run Labor
Demand

The demand for labor is less elastic (steeper) in the
short-run than in the long run (flatter), because in the
short run the firm has less flexibility to substitute other
inputs for labor or modify its production facilities.
 A decrease in
wages, for example,
results in a larger
number of workers
hired in the long run,
after firms have a
chance to make
their facilities more
labor-intensive. 15
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Supply of Labor

The labor supply curve
shows the amount of labor
hours that will be supplied
at each wage, for a
specific occupation, in a
specific geographical
area.
16
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Individual Decision: How Many
Hours?

The decision to work is based on the principle
of opportunity cost.
PRINCIPLE of Opportunity Cost
The opportunity cost of something is what you
sacrifice to get it.

The decision to work is a decision to sacrifice
leisure, and vice versa. In other words, the
opportunity cost of leisure is the income
sacrificed for each hour of leisure, or the
hourly wage.
17
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Demand for Leisure

An increase in the wage—the price of
labor—has the following effects on the
demand for leisure:


Substitution effect: as the wage increases,
a worker will substitute income for leisure
time
Income effect: an increase in the wage
increases the worker’s real income and the
demand for leisure time
18
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Demand for Leisure

The substitution and income effects of a higher
wage move in opposite directions:



The substitution effect increases the desired
leisure time
The income effect decreases the desired
leisure time
Therefore, we can’t predict if a higher wage will
increase or decrease the preference for leisure,
and consequently the supply of labor.
19
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Demand for Leisure


There are three possible responses to a higher
wage:
 A decrease in hours worked while income
remains the same
 No change in hours worked, while income
increases and leisure remains the same
 An increase in hours worked, while income
increases and leisure decreases
Studies show that in most labor markets,
increases in hours worked nearly offset
decreases.
20
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Market Supply Curve

The market supply
curve for labor
shows the
relationship
between the wage
and the quantity of
labor supplied.

The positive slope of the labor supply curve is
consistent with the law of supply. The higher the
wage, the larger the quantity of labor supplied.
21
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Reasons for the Positive Slope of the
Labor Supply Curve

An increase in the wage affects the quantity of
labor supplied in three ways:
1. An increase in hours worked per worker
2. Occupational choice: a higher wage will attract
workers to that occupation
3. Migration: people will move to the city where
wages in a given occupation are higher

The first effect is uncertain, but the second and
third effects carry sufficient weight to make the
supply curve positively sloped.
22
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Market Equilibrium

Equilibrium in the labor market exists when
there is no pressure for the wage to change.
Changes in demand and supply will affect
market equilibrium.
 In this example,
an increase in
demand
increases the
wage and the
quantity of
nursing services.
23
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Explaining Differences in Wage and
Income

When the supply of workers is small relative to the
demand for those workers, the wage will be high.

© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
Supply could be small for
four reasons:
• Few people have the
required skills
• There are high training
costs involved
• Undesirable job features
• Artificial barriers to
entry
24
O’Sullivan & Sheffrin
Gender Discrimination

Studies about the gender gap have found
that:


Women in many occupations have less
education, less work experience, thus are
less productive and are paid less.
Access denied to many occupations has
caused women to flood certain other
occupations. To close the gender gap,
women would have to change occupations.
25
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Race Discrimination

Studies about the gender gap have found that:




In 1993, black males earned 73% as much as their
white counterparts.
Hispanic males earned 62% as much as white males.
Hispanic females eared 73% as much as white females.
Discrimination decreases the wages of black men by
about 13%.
Part of the earnings gap is due to productivity
differences and part is due to racial discrimination, but
in the 1990s, most disparities were due to differences in
skills, not discrimination.
26
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Why Do College Graduates Earn
Higher Wages?

In 1997, the typical graduate earned 78% more
than the typical high-school graduate. Here are
two reasons why:


The learning effect: college students learn the
skills required for certain occupations for which
there is a smaller supply of workers
The signaling effect: a person who completes a
college degree sends a signal to the employers that
some of the skills required to complete a degree are
the same skills required at work (time management,
ability to learn, etc.)
27
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Public Policy and Labor Markets:
Effects of the Minimum Wage

The minimum wage decreases the quantity of labor
employed and yields good news and bad news for workers
and employers:
 Good news: some
workers keep their jobs
and earn a higher
wage.

Bad news: some
workers lose their jobs,
and production costs
rise, increasing the price
of goods and services.
28
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Public Policy and Labor Markets:
Occupational Licensing

Government-sanctioned licensing boards
require a person to:

Complete an educational program.

Pass an examination.

Have a certain amount of work experience.
29
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Public Policy and Labor Markets:
Occupational Licensing

Occupational licensing has been criticized on
three grounds:
1. Weak link between
performance and
licensing requirements
2. Alternative means of
protection from
incompetent workers
3. Restrictions that
increase the cost of entry
result in a decrease in the
supply of workers, and an
increase the wages paid
© 2001 Prentice Hall Business Publishing
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Labor Unions


A labor union is an organized group of workers
who generally pursue the following objectives:

To increase job security

To improve working conditions

To increase wages and fringe benefits
There are two types of labor unions:

Craft unions

Industrial unions
31
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Unionization Rates in the United States
Percent of workers that are union members
Unionization Rates in the United States, 1997
37.2
40
35
30
25
20
14.1
15
9.7
10
5
0
All wage & salary
workers
Public sector workers
Private sector workers
Statistical Abstract of the United States, 1998
32
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Important Pieces of Labor Legislation
1935
The Wagner Act guaranteed workers the right to join unions
and required each firm to bargain with a union formed by a
majority of its workers. The National Labor Relations Act was
established to enforce the provisions of the Wagner Act.
1947
The Taft-Harley Act gave government the power to stop
strikes that “imperiled the national health or safety” and gave
the states the right to pass “right-to-work” laws. Right-to-work
laws outlaw union membership as a precondition of
employment.
1959
The Landrum-Griffin Act was a response to allegations of
corruption and misconduct by union officials. This act
guaranteed union members the right to fair elections, made it
easier to monitor union finances, and made the theft of union
funds a federal offense.
33
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Labor Unions and Wages

Three approaches to increase the wages
of union workers:
1. Organize workers and negotiate a higher
wage—restricting membership
2. Promote the products produced by union
workers; labor demand is derived demand
3. Increase the amount of labor required to
produce a given quantity of output—a
practice known as “featherbedding” 34
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Imperfect Information in the Labor
Market

There is asymmetric information in the labor
market because employers cannot distinguish
between skillful and unskillful workers, or
between hard workers and lazy workers.

If the employer cannot distinguish between
different types of workers, it will pay a single
wage, realizing that it will probably hire workers
of each type.
35
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Efficiency Wages

To attract some high-skill workers, the employer
must pay a wage that exceeds the opportunity
cost of high-skill workers.

As the firm attracts more skilled workers, the
average productivity of the workforce rises.

It follows that by paying efficiency wages to
increase the average productivity of its
workforce, a firm could increase its profit.
36
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Monopsony Power

A monopsony is a single buyer of a
particular input.

A monopsonist
faces the entire
labor supply of an
input—a positively
sloped curve.

In order to attract more workers, it must pay a
higher wage.
37
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Marginal Labor Cost for the
Monopsonist


The marginal labor cost is the increase in
total cost from hiring one more worker.
The marginal cost of labor exceeds the hourly
wage because in order to hire an additional
worker, the firm must pay a higher wage to all
workers.
Marginal
Wage paid
labor
= to new
+
cost
worker
(Change in wage x
quantity of original
workers)
38
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Labor Supply and Marginal Labor Cost
for the Monopsonist
Wage
Workers
Hired
$10
7
$70
$12
8
$96
Marginal
labor
cost
$26

Total Marginal
Labor Labor
Cost Cost
Wage
= paid to
new
worker
=
$12
$26
(Change in
+ wage x quantity
of original
workers)
+
($2 x 7)
When the firm faces an upward-sloping labor supply curve,
the marginal labor cost curve rises above the labor supply
curve.
39
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Monopsony Versus Perfectly
Competitive Firm


Both types of firms use
the marginal principle
to determine how many
workers to hire.
Since the marginal
labor cost exceeds the
wage for the
monopsonist, but not
for the competitive
firms, the monopsonist
hires fewer workers at
a lower wage.
© 2001 Prentice Hall Business Publishing


The competitive firms hire
52 workers at $13 an hour.
The monopsonist hires 36
workers at $10 an hour. 40
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin