Labor Topics

1. Labor Topics

2. Human Capital

3. In economics we talk about the 4 basic resource groups Land, Labor, Capital (things made to make other things), and Entrepreneurship. Note labor and entrepreneurship deal with people. Human capital relates to the skills and talents people have developed over time. Here we want to explore the economic theory that people may decide to “invest” in human capital. Examples of this type of investment are formal education (college) and on-the-job training.

4. Investment in college Here we will work with a graph that lists years of experience on the horizontal axis and earnings on the vertical axis. The earnings are $ benefits net of costs of various options, or choices, over time. Example: person finishes high school and is thinking about college, Choice 1: enter job market right after high school – no real costs and earnings begin. Choice 2: go to a 4 year school. We assume years of college mean no earnings. Direct cost is tuition and books and the like. Indirect cost is forgone income could have made if working in that “high school” job. After 4 years job is obtained.

5. $ The graph is called the experience (or age) earnings profile graph. Note earnings rise over most of the time. High school Experience – 0 means right at high school graduation 0

6. $ Note that if we put a rectangle in each year the rectangle represents the earnings that year. The earnings are really more than the area under the curve, but we focus on that to make the graph easier to work with. Experience – 0 means right at high school graduation 0 4

7. $ College 4 years Additional earnings of college High school Indirect costs Experience – 0 means right at high school graduation 0 Direct costs 4

8. The college decision, in a sense, has a plus and a minus in relation to just a high school diploma. The plus side, as seen in the graph, is the additional income one would earn over the lifetime after college. In this graph I have assumed to additional earnings is positive and a certain amount. This is different, potentially, for each person. On the minus side we have two major ideas. 1) When in college the individual can not earn the high school income, so we have an opportunity cost of college as the forgone income. This is labeled the indirect cost of college. 2) The direct cost of college is the tuition and books and the like. If the additional earnings of college are greater than the costs of going to college (IN PRESENT VALUE TERMS), then the individual will choose college. Otherwise, the college decision will not pan out.

9. Changes over time The model seems as though we could go without the graph. We probably could, but it is a shorthand way of remembering the details. Plus the visual in the graph helps us think about changes in the environment. For example, say the earnings to the college degree increase, given all other factors the same. Then the benefit side grows and we would expect more folks to have college pay off. As another example, it seems the college experience is moving to a five year endeavor. Given all else this makes the cost area bigger and thus the more likely college will not pay off.

10. Job, or work experience, interruptions: When it is expected that a person will have periods of time of no job, then there will be no earnings. It may be the case that during a job interruption that some skills may be lost – the old use it or lose it idea. Thus, the earning profile is interrupted and may shift down due to an absence from work for a period of time. Let’s see this in the graph on the next screen.

11. After the work interruption we have the earnings profile shift down. Later benefits are lower then. $ Benefits of college College 4 years High school Indirect costs Experience – 0 means right at high school graduation 0 Direct costs 4 Job interruptus

12. Folks who expect job interruptions in their work life will see the benefits of college shrink, and thus college may no longer be a “profitable” investment. In the US, women have traditionally been the ones with a career of starts and stops in the work world. This model helps us understand why women have been less of the population of colleges and universities in the past. Now, in more modern times we see that the culture of the US has changed such that women are experiencing fewer work interruptions and thus the college decision pays off. We see greater percentages of women in college today.

13. Human Capital 2

14. Example based on last section: Assume for a person there is just two years after high school. The individual could work in both years or go to school in the first year and work in the second. Say the individual works both years after high school and earns 20,000 each year. Then the present value is 20,000 + [20,000/(1+r)] (assuming a beginning of year convention and r = .05) = 39,048 If the individual goes to school the first year the cost is 5,000 but income the second year is then 47,000 for a present value = -5,000 +[47,000/(1+r)] = 40,238.

15. Since the present value for the school series is higher the person would choose school. Another way to see this is the way I mentioned at the end of the previous section - basically the differential cost in the first year has to be outweighed by the addition earning to make college pay off. Here we have -5,000 - 20,000 + [(47,000-20,000)/(1+r)] = 1,190. So, the year of schooling generates enough additional earnings in the second year to overcome the cost of school and forgone income in the first year. Now, in this example the interest rate was assumed to be 5%. But if the interest rate was 15% the year in school would not pay off. (please check the calculation)

16. The value of r is really determined in the market. Let’s call it the bank rate of interest you would earn if you put your money into a bank in some form (CD’s or something). Now, in reality each of us can choose between many different years of schooling. We next turn to a graph and analysis where years of schooling and yearly income are studied. On the next slide you will see the wage-schooling locus – a line showing the salary that employers are willing to pay a particular worker for every level of schooling. Note 12 on years of schooling is a high school diploma.

17. $ 25000 23000 20000 Years of schooling 12 13 14

18. Note three ideas in the graph on the previous slide: 1) The curve is upward sloping – more schooling translates into more yearly income. 2) The slope of the curve is change in income/change in school. If we take the change in school one year at a time then the slope is the change in income. For example, from 12 to 13 years of school we have (23000 – 20000)/(13-12) = 3000, and From 13 to 14 years of schooling we have (25000 – 23000)/(14 – 13) = 2000.

19. Note 3 – the curve is concave reflecting the fact that more schooling yields more income, but the additional income each year is less and less – the proverbial diminishing returns. From the three points in the graph I will put the values in a table and add some details. Year Income slope MRR 12 20000 xxx xxx 13 23000 3000 3000/20000 = .15 or 15% 14 25000 2000 2000/23000 = .087 or 8.7% So, the slope can be used to calculate the MRR, the marginal rate of return to schooling.

20. Notice that when the person considers the 13th year of school they will give up making 20000 after the 12th year in the anticipation of making 23000 after the 13th year. The additional 3000 on the 13th year is the return on the 20000 given up, for a marginal rate of return of 15%. Since there are diminishing returns to school the marginal rate of return will be a curve that slopes downward from left to right, as seen on the next screen. I have included the values from our running example.

21. Rates 15% 8.7% MRR Years of Schooling 13 14

22. Decision rule on how much school to take: Add years of schooling as long as the MRR is greater than rate you can earn on funds in the bank (or other investment vehicles), stop adding when the MRR = bank rate and never add years when MRR < bank rate. On the next graph you see the general MRR graph with a bank rate added in horizontally. The amount of schooling to take is s*. The reason you would not take more than s* is that if you did you would give up money from working to be in school. But since the bank rate is higher than the MRR on that year of schooling if you work and put the money in the bank then you can have more than what you would have earned after the additional year of school. Plus you wouldn’t stop short of s* because schooling has the best return you can make at that point.

23. Rates Bank rate MRR Years of Schooling S*

24. Differences in “bank rates” Say you have two people who face the same wage schooling locus, and thus the same MRR curve. If they have different “bank rates” (really rates of return in other areas), then they will not take the same amount of schooling. The person who has lower alternatives elsewhere will take more schooling. With this scenario in mind, we have been talking theory but practice, or reality, can be used. If people only differ in their rates of return in other areas, then the person with more schooling and higher income can be compared with the person with less schooling and less and income and we can observe different points of the wage schooling locus. We get the extra income earned by the extra schooling.

25. But what if people have the same “bank rates” and differ in their abilities – in other words people have different wage schooling loci and hence different MRR’s to schooling? If person A gets more out of schooling than person B, then A’s wage schooling locus sort of rotates counterclockwise around the bottom left point on the locus (and is thus steeper and higher at every year of schooling) and the MRR curve would be farther to the right. Let’s see these graphs on the next screen. Person B takes less schooling and gets a lower wage.

26. $ rates Person A Person A Person B Person B Years of schooling Years of schooling

27. Conundrum When we observe different people having different years of schooling and different wages, we might want to fall into a line of thinking that says, well if we just get the lower wage earner more schooling they would have higher wages. They probably would, but not as much higher as we expect. Think back to person A and person B. In the real world we observe person A make more and have more schooling. What we may not observe is the differences in what each gets out of school. If we think person B, if encouraged to get as much schooling as person A, will have the same income as A after the additional schooling, we are wrong. Person B does not get as much out of schooling as person A. Person B will end up short of the income of person A

28. Public policy problem If there really is an ability bias in the data of the real world (meaning that the difference in earning comes from not only differences in schooling but also difference in what one gets out of school), then spending tax dollars to encourage more schooling 1. May leave some disillusioned because they won’t get as much as they had hoped, 2. May cost more than the benefits received – the encouragement will likely cost dollars and may be justified in that it will generate more income taxes. But the more income taxes may be overestimated.

29. On the Job Training

30. Weekly earnings College grad Some college High school grad High school drop out age

31. On the previous slide we see information on weekly earnings. At a certain date a survey was done and folks told their age, education level and weekly earnings. What we see is 1) More education means higher weekly earnings, 2) As workers age earnings rise, but at a decreasing rate, and 3) Those with more education tend to get higher increases in earnings – in other words the lines in the graph diverge. In a previous section we studied the schooling decision and saw there that schooling can lead to differences in earnings. Here we study on the job training and how that can contribute to differences in earnings.

32. In the Human Capital model we studied the decision that individuals make concerning how much education to take. We saw that from an ECONOMIC POINT OF VIEW, individuals take more education, and thus enhance their human capital, so long as the net present value of the education choice is positive. Here is a quick story to remember the general results of that story (really a theory). When you graduate from high school you can go to college and incur costs now in the hope of attaining higher income than without the college. The additional income has to be enough to overcome the expense of college for the individual to actually go to college. Now we want to study another human capital enhancer – on the job training.

33. On the job training • On the job training comes in two varieties: • General training • Firm specific training. • General training refers to training that enhances a person’s productivity in many firms. Firm specific training enhances a person’s productivity only at the firm that provides the training. • Examples: • General – learning to use basic Window’s software, perhaps, • Specific – learning to use firm based solution software.

34. The training decision earnings Training earnings profile B No training earnings profile A experience

35. On the previous slide we see a horizontal line that represents the earnings over the working life of a person who does not take job training. We also see an s type sort of looking curvular shaped line that represents the earnings over the working life of a person who actually takes training. Why is the training line lower at the beginning? Presumably the earning is lower during the training period and then after training the earning increases. You have heard of the phenomenon of a training period, have you not? Area A in the graph on the previous screen thus represents the cost of the training to the worker in the form of lower earnings during the training period. Area B is then the enhanced earnings over the rest of the working life.

36. If the present value of B > present value of A then the individual will “accept” the training by taking a job that would require it. Otherwise the individual would not take a job that required training.

37. Does everyone take training? Explain using this graph. (this is NOT an assignment at this time.) earnings No training earnings profile Training earnings profile experience

38. We will consider a model where the relationship between a worker and a firm lasts two periods. The total labor costs to the firm each period are TC1 and TC2. The contribution the worker makes each period, the marginal revenue product, is MRP1 and MRP2. Earlier this term we saw the profit maximizing firm demands labor up to the point where the wage equals the marginal revenue product. When we include more costs than just the wage and we consider more than one time period, then the profit maximizing firm will want labor up to the point where TC1 + [TC2/(1+r)] = MRP1 + [MRP2/(1+r)].

39. Now, say on the job training (OJT) occurs in the first period and costs H dollars. Plus in the first period the worker gets paid w1. No training occurs in the second period and the worker gets paid w2. So TC1 = w1 + H and TC2 = w2 and our profit maximizing firms employment decision becomes w1 + H + [w2/(1+r)] = MRP1 + [MRP2/(1+r)]. General Training Remember general training is training that can be used at any firm. If a firm provides training in the first period then the workers MRP in the second period for that firm and all other firms is enhanced. Since other firms would try to entice the worker away from the firm in the second period if the firm did not pay a wage equal to MRP in that period, we see w2 = MRP2.

40. When w2 = MRP2, w1 + H + [w2/(1+r)] = MRP1 + [MRP2/(1+r)] becomes w1 + H = MRP1 and we can see w1 = MRP1 - H. The wage the worker gets in the first period is less than the marginal revenue product by the amount of the general training cost. Firms will offer general training only if the worker pays for it in the form of a lower wage.

41. Specific Training If a worker leaves a firm where specific training has occurred the worker’s alternative wage would return to their pretraining productivity. What if the firm pays for the training in the first period and makes w1 = MRP1? The firm would be making an investment and would hope that with the MRP2 enhanced by the training it could pay w2 < MRPS and recover its investment. But the firm might feel queasy about this because maybe the worker will quit before the second period and the firm will be out the investment. What if the worker pays for the training? The worker would get a lower wage in the first period in the hopes of getting paid more in the second period. But if the worker is not assured the firm will keep them in the second period, then they would lose

42. out in the second period and have to go work somewhere else where they would not benefit from their training – and get just wage wbar. Their investment would not pan out. With the second period commitment unsure on both sides, it seems a compromise would be that the worker would be likely to stay if more than wbar is paid in the second period and the firm would likely want to keep the worker if they could pay less than the MRP in the second period. This suggests w2 would be greater than wbar, but less than MRP2 – and thus both the worker and the firm pay for the training. They share the cost and the gain.

43. Reserve Clause As we have seen, the reserve clause in baseball meant a player had to play for his current team until the team no longer wanted the player or the player wanted to quit. Of course, the player could be traded by the current team. For many players the alternative to playing their sport is a career that perhaps you and I would get. These typically pay less than what is paid in pro sports. With this in mind, pro teams only had to pay a little above what the player could make elsewhere. This is not to say teams didn’t give raises and the like, but it does point out that under this system players were likely paid less than their MRP.

44. Free Agency Free agency gives the player the ability to negotiate with other teams once the current contract is up, provided the player has been in the league for a minimum number of years. Owners have claimed they have had to give wages above MRP in the age of free agency. Players say they have to have free agency to overcome monopsonistic exploitation. I could be wrong, but I say get rid of the antitrust exemption and you won’t have to worry about either claim.

45. Empirical Evidence Some guy named Scully did early work in the area of player ability and impact on team revenue. The logic goes something like this: The more wins a team has the more revenue it can generate. Wins are determined by player ability and managerial skill. Thus, revenue ultimately depend on player ability and managerial skill. On page 272 you see an equation where pctwin is a function of many items. One is TSA, or team slugging average. The .92 coefficient on TSA means that if the slugging average goes up 1 point then the winning percentage will go up .92 of a point (like from 50% to 50.92%). This tells us about the contribution of TSA to winning percentage.

46. Evidence The second equation shows how various factors have an impact on revenue. (SMSA stands for population in the area surrounding a team and you and I saw that the higher the population the greater the revenue.) The 10330 on the pctwin variable means if pctwin goes up 1% revenue goes up by $10,330. As a hitter over the course of a year, Scully assumed about 12 players really contributed to the team slugging average. Thus each player contributed 1/12 to this average. Scully said if you take 1/12 of TSA times .92 times 10330 you would have the MRP of a hitter. Here it would be (1/12)(340)(.92)10,330 = about 270,000.

47. evidence In table 8.2 page 273 you see Scully’s evidence that under the reserve clause in baseball actual salaries are much less than the MRP’s suggested by his statistical work. Zimbalist showed in his studies with data from the 1986 to 1989 period that players who were not yet free agents also had salaries below MRP and thus the players were exploited. ON page 275 you see a model predicting player contribution in basketball. In table 8.3 you see that players not yet able to be free agents are paid way less than what the model would predict based on their ability.

48. evidence At various times existing pro leagues have been forced to compete for players with the emergence of rival leagues (ABA for NBA, WHA for NHL and USFL for NFL). During the period of rivalry player salaries went up considerably as the player now had more teams competing for services. Baseball owners in the period 1986 to 1988 were found to have colluded against the players by agreeing not to bid on each others free agents. The owners were fined huge bucks

49. Tournaments and Superstars Note that on the PGA Tour (pro golf) of the total money paid out to the players (the purse) the breakdown starts out as 1st place 18% of purse 2nd place 10.8 3rd 6.8% and when you get down to 22nd and 23rd place the difference is only 0.1% of the total purse. Why is the difference between 1st and 2nd much bigger than between 22nd and 23rd? Well, these tournaments are rank-order tournaments, meaning all you have to be is a little better in the rank than the next guy to increase your pay. What is important is relative pay in that context. But the absolute level of play is also an important idea.

50. Effort In order to play golf at a high level (or do anything at a high level) takes a great deal of effort. As you know, effort comes at a cost. And, not all effort costs the same. We note two things about the cost of effort as effort rises: 1) more effort requires more cost – if nothing else you just have to give up more stuff (watching TV, veging on the couch, etc...) to give more effort, and 2) additional effort comes at increases in the increment to cost – let’s use an example of golf. If you have never played before you probably go out and shoot a 55 for nine holes. If all you do is go out and play nine holes more often you probably can get down to 45. But to go from 45 to 35 you have to practice on various parts of the game and this takes a great deal of time. So, you have to give up a great deal to make that effort.