Prepared by: Jamal Husein C H A P T E R 9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Labor Market

© 2005 Prentice Hall Business Publishing© 2005 Prentice Hall Business Publishing Survey of Economics, 2/eSurvey of Economics, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Prepared by: Jamal Husein

C H A P T E R

99

The Labor Market

© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2

The Labor MarketThe Labor MarketThe Labor MarketThe Labor Market

The model of supply and demand can be used to study the determination of wages & 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


A Perfectly Competitive Input MarketA Perfectly Competitive Input MarketA Perfectly Competitive Input MarketA Perfectly Competitive Input Market

A perfectly competitive firm: Takes the prices of its inputs as

given (price taker in the input market);

Is one of so many hiring firms in the market;

Can hire as many workers as it wants as long as it pays the market wage rate.


Diminishing Returns and the Optimal Diminishing Returns and the Optimal Quantity of LaborQuantity of LaborDiminishing Returns and the Optimal Diminishing Returns and the Optimal Quantity of LaborQuantity of Labor

The firm uses the marginal principle to decide how many workers to hire.

The firm will pick the quantity of labor at which the marginal benefit of labor equals the marginal cost of labor.

Marginal PRINCIPLEIncrease 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.

Marginal PRINCIPLEIncrease 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 Marginal Cost of LaborThe Marginal Cost of LaborThe Marginal Cost of LaborThe 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.


The Marginal Benefit of LaborThe Marginal Benefit of LaborThe Marginal Benefit of LaborThe Marginal Benefit of Labor

The marginal benefit of labor is called marginal revenue product (MRP), or the extra revenue generated by one additional worker.

The marginal benefit of labor equals the monetary value of the output produced with an additional hour of labor.

MRP = price of output × marginal productMRP = price of output × marginal product


The Firm Faces Diminishing Returns The Firm Faces Diminishing Returns in the Short Runin the Short RunThe Firm Faces Diminishing Returns The Firm Faces Diminishing Returns in the Short Runin 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 ReturnsSuppose 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.

PRINCIPLE of Diminishing ReturnsSuppose 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.


Marginal Benefit and Diminishing Marginal Benefit and Diminishing ReturnsReturnsMarginal Benefit and Diminishing Marginal Benefit and Diminishing ReturnsReturns

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.


The Marginal Benefit (Demand) and the The Marginal Benefit (Demand) and the Marginal Cost (Supply) of LaborMarginal Cost (Supply) of LaborThe Marginal Benefit (Demand) and the The Marginal Benefit (Demand) and the Marginal Cost (Supply) of LaborMarginal Cost (Supply) of Labor

Numberof

workers

Ballsper hour

Marginalproduct

PricePerBall

Marginal Benefit =

MRP

Profit (Total

Approach

Marginal Cost = Wage

1 26 26 $0.5 $13 $5,090 $8

2 50 24 $0.5 $12 $5,760 $8

3 72 22 $0.5 $11 $6,165 $8

4 92 20 $0.5 $10 $6,300 $8

5 108 16 $0.5 $8 $6,165 $8

6 120 12 $0.5 $6 $5,740 $8

7 128 8 $0.5 $4 $5,000 $8

The Marginal Principle for Labor Decision


How Many Workers Will the Firm Hire?How Many Workers Will the Firm Hire?How Many Workers Will the Firm Hire?How Many Workers Will the Firm Hire?

Marginal Revenue Product orMarginal Revenue Product ormarginal benefit curvemarginal benefit curve

Mar

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Number of workersNumber of workers3 5 6

6

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8 Marginal cost when Wage=$8Marginal cost when Wage=$8

At an hourly wage of $8, how many workers should the firm hire? Why?

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Marginal revenue product equals marginal cost when the

firm hires five workers.

Marginal revenue product equals marginal cost when the

firm hires five workers.

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How Many Workers Will the Firm Hire?How Many Workers Will the Firm Hire?How Many Workers Will the Firm Hire?How Many Workers Will the Firm Hire?

Marginal Revenue Product orMarginal Revenue Product ormarginal benefit curvemarginal benefit curve

Mar

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Number of workersNumber of workers3 5 6

6

11

8 Marginal cost when Wage=$8Marginal cost when Wage=$8

At $8 an hour, the firm hires 5 workers. If the wage goes up to $11 an hour, how many workers should the firm hire? Why?

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Marginal revenue product equals marginal cost when the firm hires

three workers.

Marginal revenue product equals marginal cost when the firm hires

three workers.nn

Marginal cost when Wage=$11Marginal cost when Wage=$11


Shifts in the Demand for Labor CurveShifts in the Demand for Labor CurveShifts in the Demand for Labor CurveShifts 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.

At each wage, the firm will hire more workers.


The SR Market Demand for LaborThe SR Market Demand for LaborThe SR Market Demand for LaborThe SR 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.


Labor Demand in the Long RunLabor Demand in the Long RunLabor Demand in the Long RunLabor 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.


Labor Demand in the Long RunLabor Demand in the Long RunLabor Demand in the Long RunLabor 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


Short-run Versus Long-run Labor Short-run Versus Long-run Labor DemandDemandShort-run Versus Long-run Labor Short-run Versus Long-run Labor DemandDemand

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.


The Supply of LaborThe Supply of LaborThe Supply of LaborThe 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.


The Individual Decision: How Many The Individual Decision: How Many Hours?Hours?The Individual Decision: How Many The Individual Decision: How Many Hours?Hours?

The decision to work is based on the principle of opportunity cost.

PRINCIPLE of Opportunity CostThe opportunity cost of something is what you sacrifice to get it.

PRINCIPLE of Opportunity CostThe 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.


The Demand for LeisureThe Demand for LeisureThe Demand for LeisureThe 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



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.



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.


The Market Supply CurveThe Market Supply CurveThe Market Supply CurveThe 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.


Reasons for the Positive Slope of the Reasons for the Positive Slope of the Labor Supply CurveLabor Supply CurveReasons for the Positive Slope of the Reasons for the Positive Slope of the Labor Supply CurveLabor 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.


Market EquilibriumMarket EquilibriumMarket EquilibriumMarket 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.

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Market Supplycurve

Market demand curve

Hours of nursing per day

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Market EquilibriumMarket EquilibriumMarket EquilibriumMarket 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.

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Market Supplycurve

Market demand curve

New demand curve


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Explaining Differences in Wage and Explaining Differences in Wage and IncomeIncomeExplaining Differences in Wage and Explaining Differences in Wage and IncomeIncome

When the supply of workers is small relative to the demand for those workers, the wage will be high.

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

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Market Supplycurve

Marketdemandcurve


HourlyWage ($) Supply with

few workers


Gender DiscriminationGender DiscriminationGender DiscriminationGender 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.


Race DiscriminationRace DiscriminationRace DiscriminationRace Discrimination Studies about the gender gap have found that:

In 1995, 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.


Why Do College Graduates Earn Why Do College Graduates Earn Higher Wages?Higher Wages?Why Do College Graduates Earn Why Do College Graduates Earn Higher Wages?Higher Wages?

In 2001, the typical graduate earned 76% 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.)


Public Policy and Labor Markets: Public Policy and Labor Markets: Effects of the Minimum WageEffects of the Minimum WagePublic Policy and Labor Markets: Public Policy and Labor Markets: Effects of the Minimum WageEffects 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.51


Public Policy and Labor Markets: Public Policy and Labor Markets: Occupational LicensingOccupational LicensingPublic Policy and Labor Markets: Public Policy and Labor Markets: Occupational LicensingOccupational Licensing

Government-sanctioned licensing boards require a person to:

Complete an educational program. Pass an examination. Have a certain amount of work

experience.


Public Policy and Labor Markets: Public Policy and Labor Markets: Occupational LicensingOccupational LicensingPublic Policy and Labor Markets: Public Policy and Labor Markets: Occupational LicensingOccupational 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


Labor UnionsLabor UnionsLabor UnionsLabor 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


Unionization Rates in the United StatesUnionization Rates in the United StatesUnionization Rates in the United StatesUnionization Rates in the United States

Unionization Rates in the United States, 1997

14.1

9.7

37.2

0

5

10

15

20

25

30

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All wage & salaryworkers

Public sector workers Private sector workers

Statistical Abstract of the United States, 1998

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Important Pieces of Labor LegislationImportant Pieces of Labor LegislationImportant Pieces of Labor LegislationImportant 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.


Labor Unions and WagesLabor Unions and WagesLabor Unions and WagesLabor 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”


Imperfect Information in the Imperfect Information in the Labor MarketLabor MarketImperfect Information in the Imperfect Information in the Labor MarketLabor 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.


Efficiency WagesEfficiency WagesEfficiency WagesEfficiency 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.

Documents

Prepared by: Jamal Husein C H A P T E R 9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Labor Market