The Market for Labor

1. The Market for Labor • Easiest way to understood the market for a kind of labor is to think of it as analogous to the market for a good. • Good: the kind of labor being studied. • Producers (Suppliers): people who can provide that kind of labor. • Consumers (Demanders): firms who may wish to hire that kind of labor. • Price: wage or salary paid by firms to people for that kind of labor.

2. How do we define labor? • Economists often study a particular kind of labor • Kind of labor might be defined by the kind of person providing the labor: labor of teenagers, of married women, of black college graduates between ages 25-34, etc. • Kind of labor might be defined by the kind of work performed by the labor: labor of electricians, of junior lawyers, of professionals and managers in general. • Several ways to quantify labor: by number of people employed, of hours worked by people employed, etc. • Quantification often depends on availability of data.

3. Quantifying Labor • Employment: No. of workers with jobs • Ex.: If 6,837,000 employed 16-19 year olds in U.S. in Dec. 2001, quantity of labor of 16-19 year olds in U.S. in Dec. 2001 is 6,837,000 employed • Employment/population ratio: No. of workers with jobs / No. of individuals • Ex.: If 16,146,000 total 16-19 year olds in U.S. in Dec. 2001, emp./pop. ratio of 16-19 year olds is 6,837,000 / 16,146,000 = .43, quantity of labor of 16-19-year olds in U.S. in Dec. 2001 is .43

4. Quantifying Labor • Average weekly hours per worker: Average hours worked per week per worker • Ex.: If average private production worker in U.S. in Dec. 2001 worked 34.2 hours per week, quantity of labor of private production workers in U.S. in Dec. 2001 is 34.2 hours per week • Average total weekly hours: Total hours worked per week by workers with jobs = Average weekly hours per worker x No. of workers • Ex.: If 110.7M private production workers were employed in U.S. in Dec. 2001, then 110.7M private production workers x 34.2 hours per worker per week = 3.79B hours per week, quantity of labor of private production workers is 3.79B hours per week

5. Who are labor’s suppliers? • Suppliers of kind of labor are workers who can provide it. • If kind of labor is defined by kind of person providing it, defining the suppliers is straightforward (ex.: the suppliers of the labor of teenagers is the population of teenagers.) • If kind of labor is defined by kind of work performed, defining the suppliers is less easy (ex.: the suppliers of the labor of fast-food workers includes virtually everyone.) • The quantity of kind of labor (number of hours, etc.) that its suppliers wish to work is the quantity supplied of labor.

6. Who are labor’s demanders? • Demanders of kind of labor are firms that wish to hire it. • If kind of labor is defined by the kind of work performed, defining the demanders is straightforward (ex.: demanders of the labor fast-food workers are fast-food restaurants.) • If kind of labor is defined by the kind of person providing it, defining the demands is less easy (ex.: demanders of the labor of teenagers include nearly all firms.) • The quantity of kind of labor (number of employees, etc.) that firms wish to hire is the quantity demanded of labor.

7. What is labor’s price? • The price of a kind of labor is its wage. • The employer wage is the amount a firm must pay to acquire a unit (hour, employee, etc.) of a kind of labor. • The employee wage is the amount a person receives for providing a unit (hour, employee, etc.) of a kind of labor. • Employer wage can differ from employee wage because of taxes, subsidies, tips, etc. • The wage can include non-money kinds of compensation: perks, health benefits, pension benefits, etc.

8. Measuring the Wage • Average hourly wage: Average money compensation per worker per hour • Ex.: If average mining worker earned $17.63 per hour before taxes in Dec. 2001, employer wage of mining workers is $17.63 per hour • Average weekly wage: Average money compensation per worker per week • Ex.: If average mining worker earned $766 per week before taxes in Dec. 2001, employer wage of mining workers is $766 per week • Average weekly compensation: Average total compensation per worker per week, incl. health benefits, pension benefits, etc.

9. Nominal and real wages • The nominal wage is the wage in current-year dollars. • The real wage is the wage in inflation-adjusted dollars: real wage = nominal wage / price index (if price index = 1 in base year) real wage = nominal wage x 100 / price index (if price index = 100 in base year) • Consumer Price Index (CPI) most common price index • Calculated by Bureau of Labor Statistics • Implicit GDP deflator also common • Calculated by Bureau of Economic Analysis

10. The Consumer Price Index • Consumer Expenditure Survey • Finds out what typical household purchases in typical month • Survey year called “base year,” last 1982-84, next to last 1967 • What typical household buys in typical month in base year called a “market basket” • BLS uses detailed price data to find out what that “market basket” costs in every year before and after the base year • CPI for a given year = (cost of market basket in given year / cost in base year) x 100 • Ex.: Suppose typical household’s monthly purchases in 1982-84 was 5 loaves of bread, 2 containers of milk, 1 stick of butter • If 5 loaves bread etc. cost $8 in 1982-84 and $10 in 2001, then the CPI in 2001 (base 1982-84) is ($10 / $8) x 100 = 1.25 x 100 = 125

11. Nominal and real wages • The CPI can be used to easily calculate real wages • Ex.: Avg. hourly wage, mining workers, Nov. 2001: $17.73 is a nominal wage measured in Nov. 2001 dollars • CPI, Nov. 2001, base year 1982-84: 177.4 • Avg. real hourly wage. mining workers, Nov. 2001: $17.73 x 100 / 177.4 = $9.99 in 1982-84 dollars • Means that what the average mining worker earns per hour in Nov. 2001 buys as much in Nov. 2001 as $9.99 did in 1982-84 • Note that average mining worker in 1982-84 earned an hourly wage between $10.77 (1982) and $11.63 (1984) • Average miner in Nov. 2001 earns more money per hour, but earns less purchasing power per hour than the average miner in 1982-84

12. Nominal and real wages • The entire CPI series can be used to easily convert entire series of nominal wages into a series of real wages • Nominal hourly wage of miners increased over 1970-2000, real hourly wage (purchasing power of wage) decreased

13. The Labor Demand Curve • As the employer wage of a kind of labor increases, the quantity demanded of that kind of labor decreases. • As the cost of hiring a kind of labor increases, firms wish to hire fewer hours, fewer employees of that kind of labor. • Substitution Effect: • Increase in wage creates incentive for firms to substitute other kinds of labor and other factors of production for kind of labor in question. • Ex.: Increase in wage of junior lawyers will decreases the premium paid to more experienced senior lawyers, increasing the incentive to law firms to hire more senior lawyers and fewer junior lawyers.

14. The Labor Demand Curve • Scale Effect: • Increase in wage increases cost of producing goods • Increase in production cost forces firms to increase their prices • Increase in prices leads consumers to buy less of the firms’ goods • Decrease in sales causes firms to decrease production of goods • Decrease in production causes firms to need less of all kinds of labor and other factors of production. • Ex.: Increase in wage of junior lawyers makes providing legal services more costly to law firms. To cover the increase in costs, law firms increase their fees and lose clients. With fewer clients, law firms need fewer employees of all kinds—incl. junior lawyers.

15. Negative relationship between employer wage and quantity of labor demanded is illustrated by labor demand curve Tells us what quantity of labor demanded will be at each employer wage Analogous to product demand curve: ceteris paribus assumption holds The Labor Demand Curve W(emp) L(D) L(D)

16. Ex.: Fast food workers When employer* wage of fast-food workers is $6.75, all fast-food restaurants in market wish to hire 500 workers. If employer* wage drops to $5.75, all fast-food restaurants in market wish to hire 600 workers. The Labor Demand Curve Fast Food Workers W(emp) $6.75 $5.75 L(D) 500 600 L(D)

17. The more sensitive the quantity of labor demanded to the employer wage… The stronger the sum of the substitution and scale effects… the flatter the labor demand curve. The Labor Demand Curve W(emp) L(D) L(D) L(D) sensitive to W(emp) W(emp) L(D) L(D) L(D) insensitive to W(emp)

18. The Elasticity of Labor Demand • The sensitivity of the quantity of labor demanded to the employer wage is measured with the elasticity of labor demand. • Several ways to think of the elasticity of labor demand: • % change in L(D) / % change in W(emp) • % change in L(D) caused by a 1% increase in W(emp) • 1 / slope of labor demand curve x W(emp) / L(D) • [Change in L(D) / Change in W(exp)] x W(emp) / L(D) • If | e of labor demand | > 1, labor demand is elastic. • If | e of labor demand | = 1, labor demand is unit elastic. • If | e of labor demand | < 1, labor demand is inelastic.

19. A change in the quantity of labor demanded from 500 to 600 workers is approx. 18% A change in the employer wage from $6.75 to $5.75 is approx. -16% Elasticity of labor demand = -18 / -16 = -1.125 | -1.125 | = 1.125 > 1, so labor demand is elastic. The Elasticity of Labor Demand Fast Food Workers W(emp) $6.75 $5.75 L(D) 500 600 L(D)

20. A straight-line labor demand curve has elastic and inelastic ranges: Inelastic range to right of elastic range; as L(D) increases, percentage change in L(D) diminishes. Labor demand is unit elastic at transition point. Elastic range larger on flatter labor demand curves, which can be characterized as “more elastic.” The Elasticity of Labor Demand W(emp) Elastic Inelastic “Relatively Inelastic” L(D) W(emp) Elastic Inel. “Relatively Elastic” L(D)

21. Other Determinants of L(D) • Product Demand • Positive scale effect: Increase in product demand results in increased production by firms, increased need by for workers. • Ex.: An increase in environmental regulations increases demand by corporations for legal services, production of legal services by law firms, quantity of labor demanded of junior lawyers. • Ex.: A boom in the stock market increases demand by consumers for everything, production by firms of everything, quantity of labor demanded of all workers.

22. Other Determinants of L(D) • Employer wage of substitute kinds of labor • Positive substitution effect: an increase in the wage of a substitute kind of labor creates an incentive to firms to hire substitutes. • Ex.: increase in the employer wage of senior lawyers increases the cost savings to law firms from hiring junior lawyers instead, and increases the quantity of labor demanded of junior lawyers. • Negative scale effect: an increase in the wage of any kind of labor increases the production costs of the firms that hire it, resulting in higher prices, reduced sales, and less need for all types of labor. • Ex.: increase in the employer wage of senior lawyers forces the firms to charge higher fees and lose clients, and decreases the quantity of labor demanded of all lawyers, junior lawyers included.

23. Other Determinants of L(D) • Employer wage of complementary kinds of labor • Negative substitution effect: an increase in the wage of a complementary kind of labor creates an incentive to firms to hire fewer complements. • Ex.: if junior lawyers need law librarians more than senior lawyers, an increase in the employer wage of law librarians increases the associated cost of hiring junior lawyers, reducing the cost savings to law firms of hiring junior lawyers instead of senior lawyers and decreasing the quantity of labor demanded of junior lawyers. • Negative scale effect: increase in the wage of any kinds of labor increases firms’ production costs and prices, decreases sales and quantity demanded of all kinds of labor.

24. Other Determinants of L(D) • Cost of substitute kinds of non-labor factors of production • Positive substitution effect: an increase in the cost of a substitute kind of capital, etc. creates an incentive to firms to hire substitutes • Ex.: increase in cost of ATMs decreases cost savings to banks from installing ATMs rather than hiring tellers, increases* quantity of labor demanded of bank tellers. • Ex: increase in cost of electricity decreases cost savings to restaurants of using automatic rather than manual dishwashers, increases* quantity of labor demanded of manual dishwashers. • Negative scale effect: an increase in the cost of any factor of production increases the production costs of the firms that use it, resulting in higher prices, reduced sales, and less need for all labor

25. Other Determinants of L(D) • Cost of complementary kinds of non-labor factors of production • Negative substitution effect: an increase in the cost of a complementary kind of capital, etc. creates an incentive to firms to hire fewer complements • Ex.: if junior lawyers use Lexis-Nexis more than senior lawyers, then an increase in the cost of subscribing to Lexis decreases the cost savings from hiring junior lawyers rather than senior lawyers and decreases the quantity of labor demanded of junior lawyers. • Negative scale effect: an increase in the cost of any factor of production increases the production costs of the firms that use it, resulting in higher prices, reduced sales, and less need for all labor

26. Other Determinants of L(D) • Improvements in Production Technology • Economists often view technological improvements as equivalent to decreases in price because both involve getting more for less. • Ex.: A doubling of a $1,000 computer’s power is the same as a halving of its price to $500 because, in each case, $1,000 will buy you the twice as much computing power as before. • If the improvement is in a substitute kind of capital or other factor of production, there will be a negative substitution effect and a positive scale effect. • If the improvement is in a complementary kind of capital or other factor of production, there will be both a positive substitution effect and a positive scale effect.

27. When the quantity of labor demanded increases for some reason other than a decrease in the employer wage, the labor demand curve shifts right. Expresses the fact that the quantity of labor demanded increases regardless of the wage. Shifts in Labor Demand W(emp) L(D) L(D) L(D)

28. When the quantity of labor demanded decreases for some reason other than a increase in the employer wage, the labor demand curve shifts left. Expresses the fact that the quantity of labor demanded decreases regardless of the wage. Shifts in Labor Demand W(emp) L(D) L(D) L(D)

29. The Labor Supply Decision • The advantage to working more hours is consumption: • The more hours you work, the more income you earn, the more goods and services you can buy • Price is CPI, or implicit consumption deflator • The advantage to working fewer hours is leisure: • The fewer hours you work, the more time outside work you enjoy • Leisure includes all non-market activity (school, childraising, etc.) • Price is opp’y cost of not working, the nominal employee wage. • Price of leisure relative to consumption is the real employee wage. • Goal is to choose best combo of consumption and leisure

30. The Labor Supply Curve • If the employee wage of a kind of labor increases, the quantity of labor demanded may increase or decrease. • If what people receive in exchange for working a kind of labor increases, the number of persons who wish to work that kind of labor and the number of hours they wish to spend working that kind of labor may increase or decrease. • Ambiguity exists because of 3 kinds of effects at work: • Substitution Effect • Entry Effect • Income Effect

31. The Labor Supply Curve • Positive Substitution Effect: • Increase in employee wage of a kind of labor increases price of leisure relative to consumption • Creates incentive for people to substitute consumption for leisure by working more hours and earning more income • Ex.: Increase in wage of freelance authors increases opp’y cost of relaxing on weekends, number of hours writers spend freelancing. • Ex.: Increase in wage of young workers increases opp’y cost of forgoing work to attend college, number of high school grads who forgo or postpone college to go straight to work. • Ex.: Increase in wage of women increases opp’y cost of forgoing work to raise children, number of women who work instead.

32. The Labor Supply Curve • Positive Entry Effect: • Increase in employee wage of a kind of labor increases its employee wage relative to employee wage of other kinds of labor • Creates incentive for people to work fewer hours in other kinds of labor and more hours in the kind of labor in question • Ex.: Increase in the employee wage of telemarketers may cause data entry workers to want to quit to become telemarketers even if they have no plans to work longer hours in total • Ex.: Increase in wage of backup singers may cause singers with acts of their own to work more hours as backup singers, fewer hours on their own act. • Technically another version of substitution effect

33. The Labor Supply Curve • Negative Income Effect: • Increase in employee wage of a kind of labor allows people who work that kind of labor to reduce their hours but still earn more income than before, enjoy more leisure and consumption. • Ex.: A plumber who works 50 hours a week at a $15 wage can consume 50 x $15 = $750 in goods; if plumbers’ wage increases to $18, he can reduce to 45 hours but can consume 45 x $16 = $810. • Economists believe people prefer a balanced mix of consumption and leisure, will tend to use a wage increase to both increase consumption and reduce quantity of labor supplied. • Ex.: An increase in wage of plumbers may be used to help afford both more spending and more free time.

34. The Labor Supply Curve • Sum of substitution, entry, and income effects determine relationship between employee wage of a kind of labor and the quantity supplied of that kind of labor. • If substitution and entry effects dominate income effect, relationship between employee wage and quantity of labor supplied is positive. • If income effect dominates substitution and entry effects, relationship between employee wage and quantity of labor supplied is negative.

35. If substitution and entry effects dominate, positive relationship between employee wage and quantity of labor supplied. Illustrate relationship with upward-sloping labor supply curve. Tells us what quantity of labor supplied will be at each employee wage The Labor Supply Curve W(eme) L(S) L(S)

36. If income effect dominates, negative relationship between employee wage and quantity of labor supplied. Illustrate relationship with downward-sloping labor supply curve. Tells us what quantity of labor supplied will be at each employee wage The Labor Supply Curve W(eme) L(S) L(S)

37. The labor supply curve is always upward-sloping at low employee wages. Always some low wage at which no one will work, L(S) = 0 Income effect reduces L(S), cannot exist when L(S) = 0 because L(S)  0 Substitution and entry effects must dominate, L(S) must increase with W(eme). The Labor Supply Curve L(S) W(eme) Labor supply curve must slope upward L(S)

38. At higher wages, the income effect may start to dominate the substitution and entry effects, bending the L(S) curve backwards. Or, the substitution and entry effects may dominate at all wages, so the L(S) curve always slopes upward. The Labor Supply Curve L(S) W(eme) Labor supply curve may bend backward Labor supply curve must slope upward L(S)

39. The magnitude of the response of L(S) to W(eme) also differs: At low wages, an increase in W(eme) causes a large increase in L(S) At higher wages, an increase in W(eme) causes a small increase in L(S) At yet higher wages, an increase in W(eme) causes a decrease in W(eme) The Labor Supply Curve L(S) W(eme) L(S)

40. The Elasticity of Labor Supply • Response of the quantity of labor supplied to the employee wage is quantified with the elasticity of labor supply. • Several ways to think of the elasticity of labor supply: • % change in L(S) / % change in W(eme) • % change in L(S) caused by a 1% increase in W(eme) • 1 / slope of labor supply* curve x W(eme) / L(S) • [Change in L(S)* / Change in W(eme)] x W(eme) / L(S) • If e of labor supply > 1, labor supply is elastic. • If e of labor supply = 1, labor supply is unit elastic. • If 0 < e of labor supply < 1, labor supply is inelastic. • If e of labor supply < 0, labor supply is negative elastic.

41. Labor supply curves may have an elastic range… response of L(S) to W great L(S) curve flat …and/or an inelastic range… response of L(S) to W slight L(S) curve steep …and/or a negative elastic range… response of L(S) to W neg. L(S) curve backward sloped The Elasticity of Labor Supply L(S) W(eme) L(S) neg. elastic L(S) inelastic L(S) elastic L(S)

42. A popular labor supply curve in macro is the perfectly inelastic labor supply curve: Income effect perfectly cancels out substitution and entry effects Elasticity of L(S) is zero Another is the perfectly elastic labor supply curve: Elasticity of L(S) is infinite The Elasticity of Labor Supply W(eme) L(S) L(S) W(eme) L(S) L(S)

43. Other Determinants of L(S) • Nonlabor income of workers • Negative income effect: Increase in income from nonlabor sources (capital, transfer payments) allows both* increase in consumption and reduction in work hours • Ex.: Extra $100 allows person earning $5/hr. to reduce work hours by 10 and still increase consumption by $50 ($100 - 5 x $10 = $50) • People prefer a balanced mix of consumption and leisure, will tend to do as above, reduce quantity of labor supplied

44. Other Determinants of L(S) • Employee wage of other kinds of labor • Negative entry effect: Increase in employee wage of other kinds of labor creates incentive to work more at other kinds of labor and less at kind of labor in question • Ex.: Increase in employee wage of retail workers will cause fast-food workers to want to quit jobs in fast food and acquire jobs in retail, decreasing quantity of labor supplied of fast-food workers • Ex.: Increase in employee wage of weekday work creates incentive for workers who work both weekdays and weekends to work more hours on weekdays and fewer hours on weekends, decreasing quantity of labor supplied of weekend work.

45. Other Determinants of L(S) • Preference for consumption over leisure • Positive substitution effect: increase in relative preference for consumption over leisure creates incentive to substitute consumption for leisure by working more hours and earning more income, increasing quantity of labor supplied. • Ex.: Labor-saving devices such as microwave, electric washer and dryer decreases need for time for household tasks, increases preference for consumption over leisure*, increases* quantity of labor supplied. • Ex.: Change from winter to summer weather improves quality of leisure time, decreases preference for consumption over leisure*, decreases quantity of labor supplied.

46. Other Determinants of L(S) • Preference for kind of work over others • Positive entry effect: increase in relative preference for a kind of labor over other kinds of labor creates incentive to work fewer hours at other kinds of labor and more at kind of labor in question, increases quantity of labor supplied of kind of labor in question. • Ex.: Improvement in factory worker safety standards increases preference for factory work over other kinds of work, increases quantity of labor supplied of factory work. • Ex.: Increase in terrorism decreases preference for airline work over other kinds of work, decreases quantity of labor supplied of airline labor.

47. When the quantity of labor supplied increases for some reason other than a change in the employer wage, the labor supply curve shifts right. Expresses the fact that the quantity of labor supplied increases regardless of the wage. Shifts in Labor Supply L(S) L(S) W(eme) L(S)

48. When the quantity of labor supplied decreases for some reason other than a change in the employer wage, the labor supply curve shifts left. Expresses the fact that the quantity of labor supplied decreases regardless of the wage. Shifts in Labor Supply L(S) L(S) W(eme) L(S)

49. Labor demand curve tells us how much labor firms want to hire at each employer wage Labor supply curve tells us how much labor people want to work at each employee wage How much labor actually hired and worked? Review of Curves Employer wage L(D) Qty. of labor demanded Employee wage L(S) Qty. of labor supplied

50. Amount of labor actually worked, the quantity of labor transacted, can be found using the L(S) and L(D) curves together. When employer wage is equal to employee wage, the labor demand and labor supply curves can be drawn on the same axes. Labor Market Equilibrium L(S) Employer wage = Employee wage L(D) Qty. of labor demanded, Qty. of labor supplied