Competitive Labor Market Equilibrium

1. Competitive Labor Market Equilibrium Dollars Supply whigh w* wlow Demand ED ES ES ED E* Employment In a competitive labor market, equilibrium is attained at the point where supply equals demand.

2. Competitive Labor Market Equilibrium Dollars Supply wmin w* Demand E ED LF E* ES Employment U The minimum wage creates unemployment (u = U/LF).

3. Competitive Labor Market Equilibrium • 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 • 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

4. The Cobweb Model in the Market for New Engineers Competitive Labor Market Equilibrium Dollars S w1 w3 w* w2 w0 D D Employment E2 E3 E0 E* E1 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.

5. Competitive Labor Market Equilibrium S0 Dollars We don’t observe all of the shifts S1 We observe only the first and the last equilibriums w0 w2 w1 D1 This looks like a demand curve but it is not. It is the equilibrium path D0 E1 E0 E2 Employment

6. Competitive Labor Market Equilibrium • It is important to note the technical meaning of efficiency • If a change in policy can make any one better off without harming anyone else, the change is said to be “Pareto-improving” • Corollary: If the state of the world is Pareto Efficient, then improving a person’s welfare necessarily means another’s is decreased • The “single wage” property of a competitive equilibrium has important implications for efficiency. • Recall that in a competitive equilibrium the w= VPL = p∙MPL • 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.

7. Competitive Labor Market Equilibrium Dollars S (workers) D0 (firms) P w* W E* Employment In equilibrium, E* workers are employed at a wage of w*. All persons who are looking for work at that wage can find a job. Triangle P gives the producer surplus, Triangle W gives the worker surplus. A competitive market maximizes the gains from trade (sum P + W)

8. The Impact of a Payroll Tax Assessed on Firms Competitive Labor Market Equilibrium Dollars S Total payroll tax paid by employers 15.50 (135m)(0.5) = $67.5m 15 Total payroll tax paid by employees $1 tax 14.50 (135m)(0.5) = $67.5m 14 D0 D1 Employment (millions) 135 150 A payroll tax of $1 assessed on employers shifts the demand curve down by $1. The payroll tax cuts the wage that workers receive from 15 to 14.50 and increases the cost of hiring a worker from 15 to 15.50

9. The Impact of a Payroll Tax Assessed on Workers Competitive Labor Market Equilibrium S1 Total payroll tax paid by employers S 16 $1 tax (135m)(0.5) = $67.5m 15.50 15 Total payroll tax paid by employees 14.50 (135m)(0.5) = $67.5m D0 135 150 A $1 payroll tax assessed on workers shifts the supply curve to the left. The payroll tax has the same impact on w* and E* regardless who it is assessed on.

10. S1 D1 The Impact of a Payroll Tax Assessed on Firms and Workers Competitive Labor Market Equilibrium Total payroll tax paid by employers S 15.50 $1 tax (120m)(1) = $120m 15 Total payroll tax paid by employees $1 tax (120m)(1) = $120m 14.50 D0 120 150 A $1 payroll tax assessed on both firms and workers shifts the demand and supply curves to the left.

11. The Impact of Payroll Tax Assessed on Firms with Inelastic Labor Supply Competitive Labor Market Equilibrium Dollars S Total payroll tax paid by employees 15 (140m)(1) = $140m 14 D0 D1 Employment 140 The $1 payroll tax shifts the demand curve down, lowering w to $14 A payroll tax assessed on the firm is shifted completely to workers when the labor supply curve is perfectly inelastic.

12. The Impact of Employment Subsidies Competitive Labor Market Equilibrium Dollars S Total subsidy received by employers 15.50 $1 sub (145m)(0.5) = $72.5m 15 Total subsidy received by employees 14.50 D1 (145m)(0.5) = $72.5m D0 Employment (millions) 130 145 An employment subsidy of $1 per worker hired shifts up the demand curve. The subsidy raises the wage that workers receive from 15 to only $15.50 and decreases the cost of hiring a worker from 15 to 14.50

13. Competitive Equilibrium in Multiple Labor Markets Dollars Dollars SS SN SS SN wN wS w* w* DN DS Employment Employment (b) The Southern Labor Market (a) The Northern Labor Market Initially, the wage in the northern region exceeds the wage in the southern region. Southern workers want to move North, equating wages across regions at w*.

14. Competitive Equilibrium in Multiple Labor Markets 1.05 1.85 Source: Olivier Jean Blanchard and Lawrence F. Katz, “Regional Evolutions,” Brookings Papers on Economic Activity 1 (1992): 1-61. Slope = (5.5 – 4.7)/(1.05 – 1.85) = –1

15. Short-Run Impact of Immigration (Immigrants and Natives Are Perfect Substitutes) Dollars S0 S1 10 7 50 million D0 110 60 80 If 50 (million) immigrants cross the border to work, and they and native workers are perfect substitutes, LS increases by 50 (million) workers. Immigration increases overall employment but decreases w. Immigration decreases the number of natives working from 80 million to 60 million because w fell.

16. Long-Run Impact of Immigration (Immigrants and Natives Are Perfect Substitutes) Dollars S0 S1 10 7 D0 D1 110 130 80 Immigration initially shifted out the supply curve, which raised E but lowered w. Over time, capital expands as firms take advantage of cheaper labor, shifting out the labor demand curve. The 20 million native workers reenter the labor market at the higher (previous) w

17. Short-Run Impact of Immigration (Immigrants and Natives Are Perfect Complements) Dollars Dollars SI SI SN wN wI wN wI DN DI DN Immigrant E Native E I0 I1 N0 N1 If immigrants and natives are production complements, they don’t compete in the same labor market. More immigration lowers the immigrant w, increasing production because immigrant employment increases Increased production shifts native labor demand out, increasing native w and E

18. Wages versus immigrant share of population 0.032 –0.088 –.075 .175 Slope = [-.088 – .032] / [.175 – (-.075)] = -.48

19. Immigration Surplus Dollars S S A w0 w1 D 0 N N+I Employment Prior to immigration, there are N native workers in the economy and national income is given by the blue trapezoid. Immigration increases the labor supply to N + I, lowering w However, national income increases by the pink trapezoid. Immigrants are paid a total salary given by the pink rectangle. The immigration surplus is given by the pink triangle. This represents the increase in national income that accrues to natives.

20. Noncompetitive labor markets Perfectly Discriminating Monopsonist Dollars S w* w30 VMPE w10 w1 Employment 1 E* 30 10 The perfectly discriminating monopsonist hires the same number of workers as a competitive market, but each worker gets paid his reservation wage. This allows it to take all of the workers’ surplus. Firms in a competitive market hire a total of E* employees at wage w*, which maximizes the profits of all firms in the market. Worker surplus is given by the grey triangle, while the pink triangle gives firm surplus.

21. Noncompetitive labor markets Perfectly Nondiscriminating Monopsonist Dollars w = 5 + 2E MCE LS TCE = (w)(E) TCE = (5 + 2E)(E) VMPM TCE = 5E + 2E2 w* MCE = 5E1-1 + 2E2-1(2) wM MCE = 5E0 + 4E1 MCE = 5 + 4E VMP Employment EM E* A nondiscriminating monopsonist pays the same wage to all workers and has estimated their labor supply equation. Hence, the monoposonist knows the lowest wage workers are willing to accept to work at the factory in a one-factory town. Profit maximization occurs where the marginal cost of hiring = VMP Even though the monopsonist is willing to pay w equal to VMPM it only pays workers wM because it hires only EM of the workers since it is the only game in town.

22. Noncompetitive labor markets Perfectly Nondiscriminating Monopolist Dollars VMP = 25 – 3E w = 25 – 3E LS RU = (w)(E) RU = (25 – 3E)(E) wM RU = 25E – 3E2 w* MRP = 25E1-1 – 3E2-1(2) MRPM MRP = 25E0 – 6E1 MRP = 25 – 6E MRP VMP EM E* Since the union has a pretty good idea how much firms value laborers, it can estimate the VMP of the firms. Since the labor union “sells” laborers to firms, total earnings of its members can be thought of as the union’s revenue (RU) The monopolist (union) restricts the numbers of laborers it allows to become members so that it can negotiate up the wage up to VMP.