CHAPTER 4

1. CHAPTER 4 “Order is not pressure which is imposed on society from without, but an equilibrium which is set up from within.” -Jose Ortega y Gasset

2. Introduction Labor market equilibrium coordinates the desires of firms and workers, determining the wage and employment observed in the labor market. Market types: Monopsony: one buyer of labor Monopoly: one seller of labor These market structures generate unique labor market equilibria.

3. 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.

4. Pareto Efficiency Pareto Efficiency exists when all possible gains from trade have been exhausted. An allocation of resources is (Pareto) Efficient if a re-allocation improving one person’s welfare necessarily requires decreasing another person’s welfare. We are interested in determining if a change in resource allocation can make anyone better off without harming anyone else. If the answer is yes, then the re-allocation of resources is said to be “Pareto-improving.”

5. Static Competitive Equilibrium Dollars S D0 P w* Q E* EH EL Employment The labor market is in static 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 ‘s surplus; the triangle Q gives the worker’s surplus. A competitive market maximizes the gains from trade, or the sum P + Qand is, therefore, Pareto efficient.

6. Competitive Equilibrium Across Labor Markets If workers are mobile and entry to and exit from labor markets are costless, then there will be a single wage paid to all workers of a given skill across labor markets. An equilibrium allocation of workers to firms equates the wage to the value of marginal product across all worker-firm pairs. This allocation maximizes the value of the output produced, and is socially efficient. Self-interested workers and firms achieve social efficiency as if guided by Adam Smith’s “invisible hand.”.

7. 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 with the same skills will have the same value of marginal product 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.

8. Wages and International Trade: NAFTA NAFTA created a free trade zone in North America. Free trade reduces 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.

9. Dynamic Competitive Equilibrium Dollars Dollars s SN SS SS A wN B w* w* wS C DS DN Employment Employment (b) The Southern Labor Market (a) The Northern Labor Market Suppose the wage in the Northern region (wN) exceeds the wage in the Southern region (wS). Southern workers will move North, shifting the Southern supply curve to the left and the Northern supply curve to the right. In equilibrium, wages are equated across the two regions at w*.

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

11. Payroll Tax and Mandated Benefits 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 result in deadweight (efficiency) losses. Payroll taxes increase total costs of employment, so these taxes reduce employment in the economy. Firms and workers share the cost of payroll taxes, with their incidence depending on the relative size of the elasticities of labor demand and labor supply.

12. The Impact of a Payroll Tax Assessed on Firms Dollars S w1 + 1 A w0 w1 B w0 1 D0 D1 E1 E0 A payroll tax of $1 assessed on employers shifts down the demand curve (from D0 to D1). The payroll tax decreases the wage that workers receive from w0 to w1, and increases the cost of hiring a worker from w0 to w1 + 1. Employment

13. The Impact of a Payroll Tax Assessed on Workers Dollars S1 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 whether the firm or the worker is taxed. S0 w0 + 1 w1 w0 w1 1 D0 D1 E1 E0 Employment

14. The Impact of a Payroll Tax put on Firms with Inelastic Supply Dollars S D0 A w0 B w0 – 1 D0 D1 Employment E0 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 down to D1, and the wage falls to w0 – 1.

15. 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 (up). Total employment will increase as the cost of hiring has fallen.

16. The Impact of an Employment Subsidy S w0 + 1 B w1 w0 A w1 – 1 D1 D0 Employment E0 E1 An employment subsidy of $1 per worker hired shifts up the labor 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.

17. The Impact of a Mandated Benefit S0 S0 Dollars Dollars S1 w* + C P P S1 w0 w0 w* + B Q w1 R w* R w* w0C D0 D0 D1 D1 Employment Employment E0 E1 E* E0 (a) Cost of mandate exceeds worker’s valuation (b) Cost of mandate equals worker’s valuation

18. Immigration As immigrants enter the labor market, the labor supply curve shifts to the right. Total employment increases. Equilibrium wage decreases.

19. Effect on Native-born Workers Immigration reduces the wages and employment of similarly-skilled native-born workers, but native-born workers may be able to increase their productivity by specializing in tasks better suited to their skills. Competing native workers will have lower wages; complementary native workers will have higher wages.

20. The Short-Run Impact of Immigration When Immigrants and Natives Are Perfect Substitutes Dollars Supply w0 w1 Demand Employment E1 N1 N0 As immigrants and natives are perfect substitutes, the two groups are competing in the same labor market. Immigration shifts out the labor supply curve. As a result, the wage falls from w0 to w1, and total employment increases from N0 to E1. At the lower wage, the number of natives who work declines from N0 to N1.

21. The Short-Run Impact of Immigration when Immigrants and Natives are Complements Dollars Supply w1 w0 Demand Employment N0 N1 If immigrants and natives are complements, they do not compete in the same labor market. The labor market here denotes the supply and demand for native workers. Immigration makes natives more productive, shifting out the labor demand curve. This leads to a higher native wage and to an increase in native employment.

22. The Long-Run Impact of Immigration When Immigrants and Natives Are Perfect Substitutes Dollars Supply w0 w1 Demand N0 + Immigrants Employment N0 Immigration initially shifts out the labor supply curve so 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 and restoring the original wage and level of native employment.

23. The Native Labor Market’s Response to Immigration Originally, both markets pay equilibrium wages of w0. After immigration into Los Angeles, both markets eventually converge to a new equilibrium wage at w*, which is less than w0. Dollars Dollars S0 S3 S0 S2 S1 PLA PPT w0 w0 w* w* wLA Demand Demand Employment Employment (b) Pittsburgh (a) Los Angeles

24. The Short-Run Labor Demand Curve Implied by Different Natural Experiments Dollars Dollars D Demand curve implied by minimum wage natural experiment Demand curve implied by Mariel natural experiment w* D Employment Employment E* (a)Mariel (b) NJ-Pennsylvania minimum wage (a) The analysis of data resulting from the Mariel natural experiment implies that increased immigration does not affect the wage, so that the short-run labor demand curve is perfectly elastic. (b) The analysis of data resulting from the NJ-Pennsylvania minimum wage natural experiment implies that an increase in the minimum wage does not affect employment, so that the short-run labor demand curve is perfectly inelastic.

25. California’s Population, 1950-1990(% U.S. Population Living in California)

26. Scatter Diagram Relating Wages and Immigration for Native Skill Groups

27. The Immigration Surplus Dollars Dollars S S ¢ ¢ S S A A B B w w 0 0 C C w w 1 1 F D D 0 0 N N M M Employment 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.

28. 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. The cobweb pattern arises when people are misinformed. The model assumes 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.

29. The Cobweb Model in the Market for New Engineers Dollars S w1 w3 w* w2 w0 D D Employment E2 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 mis-judge future opportunities in the market, a cobweb is created as the market adjusts to the increase in demand.

30. Hurricanes and the Labor Market Hurricanes generate exogenous economic shocks that can changes in wages and employment in affected and neighboring areas. Use data on Florida hurricanes and difference-in-difference calculations to estimate the impact on wages and employment in affected Florida counties relative to unaffected and neighboring counties. 19 hurricanes hit Florida between 1988 and 2005.

31. Changes in Employment and Earnings in Florida Counties by Hurricane Intensity

32. Hurricanes and the Labor Market Is the theory of dynamic competitive equilibrium in the labor market supported by the data on Florida hurricanes? Cat 1-3: ∆E = (-1.5%) – (0.2%) = -1.7% ∆W = (1.3%) – (-4.5%) = 5.8% Cat 4-5: ∆E = (-4.5%) – (0.8%) = -5.3% ∆W = (4.4%) – (-3.3%) = 7.7% Labor supply decreased, and earnings rose, more in the counties hit directly by the strongest hurricanes. The in-migration from the most-affected counties decreased earnings and increased employment in the neighboring counties.

33. Noncompetitive Labor Markets: Monopsony Monopsony market exists when a firm is the only buyer of labor. Monopsonists must increase wages to attract more workers. Two types of monopsonist firms: Perfectly discriminating Nondiscriminating

34. Perfectly Discriminating Monopsonist Discriminating monopsonists are able to hire different workers at different wages. To maximize firm surplus (profits), a perfectly discriminating monopsonist “perfectly discriminates” by paying each worker his or her reservation wage.

35. 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.

36. The Hiring Decision of a Perfectly Discriminating Monopsonist Dollars S A w* w30 VMPE w10 30 E* 10 Employment A perfectly discriminating monopsonist faces an upward-sloping labor supply curve and can hire different workers at different wages. Therefore 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 is paid his or her reservation wage.

37. The Hiring Decision of a Nondiscriminating Monopsonist 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 all a wage of wM.

38. The Impact of the Minimum Wage on a Nondiscriminating Monopsonist Dollars MCE S A w* w wM VMPE Employment EM E The minimum wage may increase both wages and employment when imposed on a nondiscriminating monopsonist. A minimum wage set at w increases employment to E.

39. Monopoly in the Product Market:A Review 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 and an even lower downward sloped marginal revenue curve.

40. The Output Decision of a Monopolist A monopolist faces a downward-sloping demand curve for her 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 where the monopolist produces qM units of output and sells each unit of output at a price of pM dollars.

41. The Labor Demand Curve of a Monopolist 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 where the monopolist hires fewer workers (EM) than would be hired in a competitive market.