Chapter 5

Labor Market Equilibrium

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Labor Economics, 4th edition

5 - 3

Introduction

• Labor market equilibrium coordinates the desires of firms and workers, determining the wage and employment observed in the labor market

• Market types:- Monopsonies – where there is one buyer of labor- Monopolies – where there is one seller of labor

• These market structures generate unique labor market equilibriums

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Equilibrium in a Single Competitive Labor Market

• Competitive equilibrium occurs when supply equals demand generating a competitive wage and employment level

• It is unlikely that the labor market is ever in an equilibrium, since supply and demand are dynamic

• The model suggests that the market is always moving toward equilibrium

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Efficiency

• It is important to note the technical meaning of efficiency- Taken as Pareto Efficiency, this is the condition that exists

when all possible gains from trade have been exhausted- A corollary of this condition is that when the state of the

world is Pareto Efficient, to improve one person’s welfare necessarily means another person’s welfare is decreased

- In policy applications, the efficiency criterion asks whether a change can make any one better off without harming anyone else. If the answer is yes, then a change is said to be “Pareto-improving”

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Equilibrium in a Competitive Labor Market

S

D0

w*

P

Q

E* EHEL

Dollars

Employment

The labor market is in equilibrium when supply equals demand; E* workers are employed at a wage of w*. In equilibrium, all persons who are looking for work at the going wage can find a job. The triangle P gives the producer surplus; the triangle Q gives the worker surplus. A competitive market maximizes the gains from trade, or the sum P + Q.

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Competitive Equilibrium Across Labor Markets

• If workers were mobile and entry and exit of workers to the labor market was free, then there would be a single wage paid to all workers

• The allocation of workers to firms equating the wage to the value of marginal product is also the allocation that maximizes national income (this is known as allocative efficiency)

• The “invisible hand” process self-interested workers and firms accomplish a social goal that no one had in mind: allocative efficiency.

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Efficiency Revisited

• The “single wage” property of a competitive equilibrium has important implications for economic efficiency.

- Recall that in a competitive equilibrium the wage equals the value of marginal product of labor. As firms and workers move to the region that provides the best opportunities, they eliminate regional wage differentials. Therefore, workers of given skills have the same value of marginal product of labor in all markets.

• The allocation of workers to firms that equates the value of marginal product across markets is also the sorting that leads to an efficient allocation of labor resources.

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Wages and International Trade: NAFTA

• NAFTA created a free trade zone in North America• The effect of free trade in the zone is to reduce the income

differential between the United States and other countries in the zone, such as Mexico

• Total income of the countries in the trade zone is maximized as a result of equalized economic opportunities across the countries in the zone

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Competitive Equilibrium in Two Labor Markets Linked by Migration

Suppose the wage in the northern region (wN) exceeds the wage in the southern region (wS). Southern workers want to move North, shifting the southern supply curve to the left and the northern supply curve to the right. In the end, wages are equated across regions (at w*).

SS

Dollars

Employment

SS

w*

wS

DS

(b) The Southern Labor Market

Dollars

Employment

SN

wN

w*

DN

(a) The Northern Labor Market

s

A

B

C

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Wage Convergence Across States

Perc

ent A

nnual W

age G

row

th

Manufacturing Wage in 1950.9 1.1 1.3 1.5 1.7 1.9

4.5

4.7

4.9

5.1

5.3

5.5

5.7

AL

AZ

AR

CA

CO

CTDE

FL

GA

ID

ILIN

IA

KS

KY

LA

ME

MDMA

MI

MN

MS

MO

MT

NE

NV

NH

NJ

NM

NY

NC

ND

OH

OK

OR

PA

RI

SC

SD

TN

TX

UT

VTVA

WA

WVWI

WY

Source: Olivier Jean Blanchard and Lawrence F. Katz, “Regional Evolutions,” Brookings Papers on Economic Activity 1 (1992): 1-61.

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Application: Payroll Taxes and Subsidies

• Payroll taxes assessed on employers lead to a downward parallel shift in the labor demand curve

- The new demand curve shows a wedge between the amount the firm must pay to hire a worker and the amount that workers actually receive

- Payroll taxes increase total costs of employment, so these taxes reduce employment in the economy

- Firms and workers share the cost of payroll taxes, since the cost of hiring a worker rises at the same rate the wage received by workers declines

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B

Dollars

w1 + 1

w0

S

D0

D1

w1

w0 1

E1 E0

A

Employment

The Impact of a Payroll Tax Assessed on Firms

A payroll tax of $1 assessed on employers shifts down the demand curve (from D0 to D1). The payroll tax cuts the wage that workers receive from w0 to w1, and increases the cost of hiring a worker from w0 to w1 + 1.

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The Impact of a Payroll Tax Assessed on Workers

Dollars

w1

w0

S0

D0

D1

D0

E1 E0 Employment

S1

w0 + 1

w1 1

A payroll tax assessed on workers shifts the supply curve to the left (from S0 to S1). The payroll tax has the same impact on the equilibrium wage and employment regardless of who it is assessed on.

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The Impact of a Payroll Tax Assessed on Firms with Inelastic Supply

Dollars

w0

D0

S

D0

D1

E0

A

B

Employment

w0 – 1

A payroll tax assessed on the firm is shifted completely to workers when the labor supply curve is perfectly inelastic. The wage is initially w0. The $1 payroll tax shifts the demand curve to D1, and the wage falls to w0 – 1.

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Payroll Subsidies

• An employment subsidy lowers the cost of hiring for firms• This means payroll subsidies shift the demand curve for labor

to the right (down)

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The Impact of an Employment Subsidy

An employment subsidy of $1 per worker hired shifts up the demand curve, increasing employment. The wage that workers receive rises from w0 to w1. The wage that firms actually pay falls from w0 to w1 – 1.

w1

S

D1

D0

w0

E0 E1

B

A

Employment

w0 + 1

w1 – 1

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The Impact of a Mandated Benefit

Dollars

w0

S1

D0

D1

E1 E0

P

Q

Employment

S0

w1

w0 C

E*

w*

w* + B

R

Dollars

w0

S1

D0

D1

E0

P

Employment

S0

w* R

w* + C

(a) Cost of mandate exceeds worker’s valuation (b) Cost of mandate equals worker’s valuation

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Immigration

• Immigrants and natives are perfect substitutes in production• As immigrants enter the labor market, the supply curve shifts to

the right- Total employment increases- The equilibrium wage decreases

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Native-born workers

• Increases in immigration reduce the wages and employment of native-born workers

• However, native-born workers may be able to increase their productivity since they can specialize in tasks better suited to their skills

• Competing native workers will have lower wages; complementary native workers will have higher wages

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The Short-Run Impact of Immigration When Immigrants and Natives Are Perfect Substitutes

Dollars

Supply

w0

w1

Demand

N0EmploymentE1N1

Because immigrants and natives are perfect substitutes, the two groups are competing in the same labor market. Immigration shifts out the supply curve. As a result, the wage falls from w0 to w1, and total employment increases from N0 to E1. Note that at the lower wage, there is a decline in the number of natives who work, from N0 to N1.

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The Short-Run Impact of Immigration when Immigrants and Natives are Complements

w1

w0

Dollars

Supply

Demand

N1N0Employment

If immigrants and natives are complements, they are not competing in the same labor market. The labor market in this figure denotes the supply and demand for native workers. Immigration makes natives more productive, shifting out the demand curve even though capital is fixed. This leads to a higher native wage and to an increase in native employment.

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The Long-Run Impact of ImmigrationWhen Immigrants and Natives Are Perfect Substitutes

Dollars

Supply

w0

w1

Demand

N0 EmploymentN0 + Immigrants

Because immigrants and natives are perfect substitutes, the two groups are competing in the same labor market. Immigration initially shifts out the supply curve. As a result, the wage falls from w0 to w1. Over time, capital expands as firms take advantage of the cheaper workforce, shifting out the labor demand curve.

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The Native Labor Market’s Response to Immigration

Dollars

PPT

w0

Demand

(b) Pittsburgh

Employment

S0 S3

w*

Dollars

w0

PLA

wLA

(a) Los Angeles

Employment

S0 S1

S2

Demand

w*

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Trends in California’s population, 1950-1990 (Percent of U.S. Population Living in California)

6

8

10

12

14

1950 1960 1970 1980 1990

Year

Pe

rce

nt

All persons

Natives

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Scatter Diagram Relating Wages and Immigration for Native Skill Groups

-0.2

-0.1

0

0.1

0.2

-0.1 -0.05 0 0.05 0.1 0.15 0.2

Decadal change in immigrant share

De

ca

da

l c

ha

ng

e in

lo

g w

ee

kly

wa

ge

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The Immigration Surplus

Dollars

Employment

SS

0

C

B

N M

A

w0

w1

D

Prior to immigration, there are N native workers in the economy and national income is given by the trapezoid ABN0. Immigration increases the labor supply to M workers and national income is given by the trapezoid ACM0. Immigrants are paid a total of FCMN dollars as salary. The immigration surplus gives the increase in national income that accrues to natives and is given by the area in the triangle BCF.

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The Cobweb Model

• Two assumptions of the cobweb model:- Time is needed to produce skilled workers- Persons decide to become skilled workers by looking at

conditions in the labor market at the time they enter school• A “cobweb” pattern forms around the equilibrium

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Cobweb Model (continued)

• The cobweb pattern arises when people are misinformed• The model implies naïve workers who do not form rational

expectations• Rational expectations are formed if workers correctly perceive

the future and understand the economic forces at work

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The Cobweb Model in the Market for New Engineers

S

Dollars

w1

E*E2 E1

w3

w*

w2

w0

D

D

E0Employment

The initial equilibrium wage in the engineering market is w0. The demand for engineers shifts to D, and the wage will eventually increase to w*. Because new engineers are not produced instantaneously and because students might misforecast future opportunities in the market, a cobweb is created as the labor market adjusts to the increase in demand.

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Noncompetitive labor markets: monopsony

• Monopsony market exists when a firm is a lone buyer of labor (acting as a sole employer of labor in the market)

• Such a firm must increase wages to attract more workers• Two types of monopsonits firms:

- Perfectly discriminating- Nondiscriminating

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Discriminating Monopsonist

• Able to hire different workers at different wages• When “perfectly discriminating” each worker is paid his or her

reservation wage

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Nondisriminating monopsonist

• Must pay all workers the same wage, regardless of each worker’s reservation wage

• Must raise the wage of all workers when attempting to attract more workers

• Employs fewer workers than would be employed if the market were competitive

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The Hiring Decision of a Perfectly Discriminating Monopsonist

A perfectly discriminating monopsonist faces an upward-sloping supply curve and can hire different workers at different wages. The labor supply curve gives the marginal cost of hiring. Profit maximization occurs at point A. The monopsonist hires the same number of workers as a competitive market, but each worker gets paid his reservation wage.

Dollars

S

VMPE

Employment

w*

w30

w10

3010 E*

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The Hiring Decision of a Nondiscriminating Monopsonist

Dollars

Employment

w *

VMP E

E *

w M

VMP M

MC E S

E M

A

A nondiscriminating monopsonist pays the same wage to all workers. The marginal cost of hiring exceeds the wage, and the marginal cost curve lies above the supply curve. Profit maximization occurs at point A; the monopsonist hires EM workers and pays them a wage of wM.

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The Impact of the Minimum Wage on a Nondiscriminating Monopsonist

MCE

Dollars

S

A

w

w*

wM

VMPE

EEMEmployment

The minimum wage may increase both wages and employment when imposed on a monopsonist. A minimum wage set at w increases employment to E.

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Noncompetitive labor markets: monopoly

• Firms that have monopoly power can influence the price of the product that they sell

• Monopolist faces a downward sloped market demand curve for its output

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The Output Decision of a Monopolist

Dollars

Output

p

MC

D

*

MR

q *

p M

q M

A

A monopolist faces a downward-sloping demand curve for his output. The marginal revenue from selling an additional unit of output is less than the price of the product. Profit maximization occurs at point A; a monopolist produces qM units of output and sells them at a price of pM dollars.

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The Labor Demand Curve of a Monopolist

Dollars

Employment

w

MRPE VMPE

EM E*

A

The marginal revenue product gives the worker’s contribution to a monopolist’s revenues (or the worker’s marginal product times marginal revenue), and is less than the worker’s value of marginal product. Profit maximization occurs at point A; the monopolist hires fewer workers (EM) than would be hired in a competitive market.

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End of chapter 5