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The Labor Market
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Product Markets
• Markets in which firms sell
goods and services to
households or other firms
• Products made from the
economy’s resources
2
Factor Markets
• Markets in which resources are
sold to firms
–Resources include
• Capital, land, labor, and natural
resources
• Resources are sometimes
called factors of production
3
Figure 1: Product and Factor
Markets
4
Labor Markets in Particular
• Determining a worker’s wage rate
– Groups of economic decision makers come
together in markets in order to trade
– Each decision maker tries to maximize
something and faces constraints
– Observe equilibrium price determined in those
markets
– Explore how various changes affect that
equilibrium price
5
Special Meaning
• The special meaning of the price in the
labor market—the wage rate
– Income people earn over their lifetime will
determine how they will be able to provide for
themselves and their families
– Adds a special moral dimension to events in
labor markets
6
Defining a Labor Market
• How broadly or narrowly we define a
market depends on the specific questions
we wish to answer
– Broadly defined markets may look at markets
that draw on labor from all over the world
– Narrowly defined markets may look at markets
that draw on labor on a very localized level
7
Competitive Labor Markets
• Market with many indistinguishable sellers
of labor and many buyers
– Involves no barriers to entry or exit
– Perfectly competitive labor markets must
satisfy three conditions
• Great many buyers (firms) and sellers (households)
of labor in market
• All workers in market appear the same to firms
• No barriers to entering or leaving labor market
8
Firms in Labor Markets
• Sometimes firms that compete in the same product
market also compete in the same labor markets, but
– Some firms that compete in the same product market operate in
different labor markets
– Some firms that operate in different product markets compete in
the same labor market
• The demand side of a labor market includes all firms hiring
labor in that labor market
– These firms may (but not necessarily) compete in the same
product market
9
Derived Demand
• The demand for labor is a derived
demand―it arises from, and will vary
with—the demand for the firm’s output
– The phrase “will vary with” is important
• The demand for labor by a firm will change
whenever demand for the firm’s product
changes
10
Resource Demand: A General
Rule
• Marginal approach to profit
– Firm should take any action that adds more to its revenue than it adds to
its cost
• When we view firm as a buyer in a resource or factor market, we use
same principle of marginal decision making
– This time action under consideration is “increase employment of the
resource by another unit”
– Rule becomes
• Increase employment of any resource whenever doing so adds more to
revenue than it adds to cost
– To avoid confusion between decisions about resources and decisions
about output, we don’t use terms “marginal revenue” and “marginal cost”
when discussing factor markets
• To track changes on the revenue side, use term “marginal revenue product”
11
Marginal Revenue Product (MRP)
• The change in firm’s total revenue divided
by change in its employment of a resource
Marginal Revenue Product (MRP) 
change in total revenue ( TR )
change in quantity of resource ( L)
When firm thinks about changing resource by one unit at a time
MRP is the change in the firm’s revenue when it employs one more unit of the
resource
12
Marginal Factor Cost (MFC)
• To track changes on the cost side, we use the term
marginal factor cost
Marginal Factor Cost (MFC) 
change in total cost ( TC )
change in quantity of resource ( L)
The MFC tells us the rise in cost per unit increase in the resource
When Δ Quantity of Resource = 1 MFC is increase in cost from employing one more
unit of resource
13
Marginal Approach to Profit
• To maximize profit firm should increase its employment of any
resource whenever MRP > MFC
– But not when MRP < MFC
• Profit-maximizing quantity of any resource is quantity at which MRP =
MFC
• If MRP > MFC, employing more of resource increases revenue more
than cost
– Profit will rise
• When MRP < MFC, using more of resource adds more to cost than to
revenue
– Profit falls
• When firm exploits every opportunity to increase profit it will arrive at
the point at which MRP = MFC
14
The Firm’s Employment Decision
When Only Labor Is Variable
• The Firm’s MRP in a Competitive Product Market
– When output is sold in a competitive product market
• MRP for any change in employment will equal price of output
(P) times marginal product of labor (MPL)
– MRP = P x MPL
• The Firm’s MFC in a Competitive Labor Market
– When labor is hired in a competitive labor market, MFC
for any change in employment will equal market wage
rate (W)
• MFC = W
15
The Profit-Maximizing Employment
Level
• Marginal approach to profit
– A firm should take any action that adds more to
its revenue than to its cost
• Hire another worker when MRP > W, but not
when MRP < W
• To maximize profit, the firm should hire the
number of workers such that MRP = W
– Where the MRP curve intersects the wage line
16
Figure 2: The Profit-Maximizing
Employment Level
Dollars
$200
150
100
Wage
60
50
MRP
1
2
3
4
5
6
7
8
Number
of Workers
17
The Two Approaches to Profit
Maximization
• Two different approaches for the firm to follow to maximize profit
– MR and MC approach to find profit-maximizing output
– MRP and MFC approach to find profit-maximizing employment
• Can these two approaches lead to different decisions?
– No, because these two “different” approaches are actually the same
method viewed in two different ways
– Remember that hiring another worker increases the firm’s output and
therefore changes both its revenue and its cost
• Whenever MRP > MFC for a change in employment, MR > MC for
associated rise in output
• Whenever MRP < MFC for a change in employment, MR < MC for
associated rise in output
• If MRP = MFC for a change in employment, MR = MC for associated
change in output
18
The Firm’s Labor Demand Curve
• When labor is the only variable input,
downward-sloping portion of MRP curve is
firm’s labor demand curve
– Tells us how much labor firm will want to
employ at each wage rate
19
Figure 3: The Firm’s Labor
Demand Curve
Dollars
W1
Firm’s
Labor Demand
Curve
A
B
W2
n1
n2
W1
W2
Number of Workers
20
The Firm’s Employment Decision
When Several Inputs are Variable
• Whether the firm can vary just labor, or
several inputs simultaneously
– Optimal level of employment will satisfy the
MRP = W rule
• Firm’s labor demand curve will slope
downward
• Decrease in wage rate will cause an
increase in employment
21
Figure 4: The Employment Decision with
Several Variable Inputs
Dollars
A
W1
W1
B
C
W2
W2
MRP
n
1
n
2
MRP
1
n
2
Firm’s
Labor
Demand
Curve
Number of Workers
3
22
The Market Demand For Labor
• Market Labor Demand Curve
–Indicates total number of workers all
firms in a labor market want to
employ at each wage rate
–Found by horizontally summing
across all firms’ individual labor
demand curves
23
Figure 5: The Market Demand For
Labor
24
Figure 6: A Shift in the Labor
Demand Curve
(a)
Typical Firm
Hourly
Wage
$10
(b)
Labor Market
Hourly
Wage
A
B
n2
Number
of Workers
B
D
L2
D
L1
l 2d
l 1d
n1
A
N1
N2
Number
of Workers
25
Shifts in the Market Labor Demand
Curve
• A change in any variable that affects
quantity of labor demanded—except for the
wage rate—causes labor demand curve to
shift
• Specific variables that shift the labor
demand curve include a change in
– Demand for the firm’s product
– Technology
– Prince of another input
– Number of firms
26
A Change in Demand for the Firm’s
Output
• Effect of a change in output price on labor
demand depends on whether many firms in
the labor market also share the same
product market
• When they do
– A rise in output price will shift market labor
demand curve rightward
– A fall in output price will shift market labor
demand curve leftward
27
A Change in Technology
• Complementary Input
– An input whose utilization increases
marginal product of another input
• Substitute Input
– An input whose utilization decreases
marginal product of another input
28
A Change in Technology
• When many firms in a labor market
acquire a new technology, the market
labor demand curve will shift
– Rightward if technology is complementary
with labor
– Leftward if technology is substitutable for
labor
29
Figure 7: Introducing a New
Input
Hourly
Wage
More
of a
More
of a Complementary
Input
Substitutable
Input
l d2
l d1
l d3
Number
of Workers
30
A Change in the Price of Another
Input
• When price of some other input
decreases, market labor demand
curve may shift
–Rightward if the input is
complementary with labor
–Leftward if the input is substitutable
for labor
31
Individual Labor Supply
• Individuals as wage takers
– No single labor seller can affect the
market wage
– In a competitive labor market
• Each seller is a wage taker
– He or she takes market wage rate as given
32
The Income-Leisure Trade-off
• Wage rate determines exact nature
of the income-leisure trade-off
–Higher the income »» higher the
expense of leisure time
33
The Labor Supply Decision
• Individuals who are able to choose their
own hours may
– Choose optimal combination of income and
leisure
• Individuals who are not able to choose their
own hours
– Only make the choice of whether to offer their
labor in a particular market or not
34
Reservation Wages
• Lowest wage rate at which an
individual would supply labor to a
particular labor market
• When wage rate in a market exceeds
an individual’s reservation wage for
that market
– Individual will decide to work there
35
Market Labor Supply
• Curve indicating the number of
people who want jobs in a labor
market at each wage rate
–The higher the wage rate, the greater
the quantity of labor supplied
36
Figure 8: The Market
Labor Supply Curve
37
Shifts in the Market
Labor Supply Curve
• A market labor supply curve will shift when
– Something other than a change in wage rate causes a
change in number of people who want to work in a
particular market
• Factors causing a labor supply curve to shift
include
–
–
–
–
Change in market wage rate in other labor markets
Changes in cost of acquiring human capital
Number of qualified people
Changes in tastes
38
A Change in the Market Wage Rate
in Other Labor Markets
• As long as some individuals can
choose to supply their labor in two
different markets
– A rise in wage rate in one market will
cause a leftward shift in labor supply
curve in other market
39
Changes in the Cost of Acquiring
Human Capital
• An increase in the cost of acquiring human
capital will shift the labor supply curve
leftward
• A decrease in the cost of acquiring human
capital will shift the labor supply curve
rightward
40
Number of Qualified People
• Population growth causes labor supply
curves in both national and local labor
market to shift rightward over time
• Labor supply curves can also shift due
to migration within a country
• If new people entering a field exceeds
number of retirees in that field
– Increase in supply results
41
Changes in Tastes
• Different types of jobs attract
different people with different
tastes
–Danger and excitement vs. safety
and routine
• Women entering the workforce
• Social contribution to community
42
Short-Run vs. Long-Run Labor
Supply
• Short-run
– Labor supply response to a wage-rate change comes
from those who already have skills and geographic
location needed to work in a market
• Long-run
– Labor supply response to a wage-rate change comes
from those who will acquire skills and move into
geographic location needed to work in a market
43
Short-Run vs. Long-Run
Labor Supply
• Long-run labor supply curve indicates
how many (qualified) people will want
to work in a labor market
– After full adjustment to a change in the
wage rate
• Long-run labor supply response is
more wage elastic than short-run labor
supply response
44
Figure 9: The Long-Run Labor
Supply Curve
Hourly
Wage
S
S
L1
S
LLR
B
$40
25
L2
C
A
30,000
60,000
90,000
Number of Workers
45
Labor Market Equilibrium
• Supply and demand will drive a
competitive labor market to its
equilibrium point
–Point where the labor supply and
labor demand curves intersect
46
Figure 10: Labor Market Equilibrium
47
What Happens When Things
Change?
• Events that can cause labor demand
curve and labor supply curve to shift
include
– Change in labor demand
– Change in labor supply
– Labor shortages and surpluses
48
A Change in Labor Demand
• In short-run, shift in labor demand
moves along a short-run labor
supply curve
• In long-run, resulting increase in
wage rate will cause short-run
labor supply curve to shift also
49
Figure 11: A Change in
Labor Demand
Labor Market
Typical Firm
Dollars
S
L1
Wage
S
L2
B
$40
C
30
20
b
$40
c
30
D
A
L2
20
W2
a
W3
W1
l2d
l1d
D
L1
5,000 8,000 12,000
Number
of Workers
50
80
120
Number
of Workers
50
Change in Labor Supply
• Shifts in labor supply typically happen
slowly
• When a long-run change in labor
supply is the cause of changes in the
labor market
– No separate short-run change in
equilibrium to investigate
51
Figure 12: The Market For Finance
Professors (1995-2002)
Annual
Wage
S
L2
S
L1
B
$91,200
66,900
A
D
L2
D
L1
N1N2
Number
of New Finance
52
Labor Shortages and Surpluses
• Labor Shortage
– Quantity of labor demanded exceeds
quantity supplied at prevailing wage rate
• Labor Surplus
– Quantity of labor supplied exceeds
quantity demanded at prevailing wage
rate
53
Labor Shortages and Surpluses
• Shortages and surpluses in a labor market
are not natural consequence of shifts in
supply and demand curves
– Labor shortage will occur only when wage rate
fails to rise to its equilibrium value
– Labor surplus will occur only when wage rate
fails to fall to its equilibrium value
54
Using the Theory: Understanding the
Market for College-Educated Labor
• Students have many motives for attending college
• One of the most important motives is to invest in
their own human capital
– Going to college will enable you to earn a higher
income than you would otherwise be able to earn
– Economists track the college wage premium
• Percentage by which average college graduate’s income
exceeds average high school graduate’s income
– Wage premium was relatively stable in 1960s and 1970s, at
around 40 to 50%
– But premium began to rise sharply in 1980s and continued its rise
through 1990s
– By 2001 college wage premium reached 76% for men and 97%
for women
55
Using the Theory: Understanding the
Market for College-Educated Labor
• Why did labor supply shift rightward each
year?
– An increase in proportion of young people
attending college
– Population itself increased
• Why did labor demand curve shift rightward
each year?
– Partly due to normal growth in economy
– Technological change
• Increase skill requirements for many types of work
56
Figure 13: The Market for CollegeEducated Labor
57
Using the Theory: Understanding the
Market for College-Educated Labor
• An increase in yearly wage rate has resulted over
last two decades
– Because demand curve for college graduates shifted
rightward faster than supply curve
• What will happen in the future?
– Competing trends
• Acceleration in rightward shift of labor supply curve for college
graduates
– Will work to decrease college wage premium
• Acceleration in rightward shift of labor demand curve for
college graduates
– Due to further changes in technology
58
Using the Theory: Understanding the
Market for College-Educated Labor
• Most labor market economists predict
– For college-educated labor
• Labor demand curve will shift rightward more rapidly
than labor supply curve over next several years
• Wage rate for college graduates is expected to rise
– For high school graduates
• Shifts in labor supply curve are expected to outpace
shifts in demand curve
– Wage premium for college students is expected to increase
59