Chapter 6

1. Chapter 6 Wage Determination and the Allocation of Labor

2. 1. Theory of a Perfectly Competitive Labor Market

3. Perfectly Competitive Labor Market • Perfectly competitive labor marketshave the following characteristics: • Large number of firms trying to hire an identical type of labor • Numerous qualified people independently offering their services • Neither firms nor workers have control over the market wage • Perfect, costless information and labor mobility

4. Market Labor Supply • Though individuals have backward-bending labor supply curves, market supply curves are usually positively sloped over normal wage ranges. S Wage rate • High relative wages attract workers away from household production, leisure, or their previous jobs. • The height of the market supply curve measures the opportunity cost of using the marginal labor hour in this employment. • The shorter the time period, the less elastic is the labor supply curve. Quantity of Labor Hours

5. Wage and Employment Determination Wage rate S • The equilibrium wage rate W0 and level of employment Q0 occur at the intersection of labor supply and demand. Wes W0 • An excess demand of Q2- Q1 would occur at a wage rate of Wed. Wed D • An excess supply of Q2- Q1 would occur at a wage rate of Wes. Q0 Q1 Q2 Quantity of Labor Hours

6. Labor Supply Determinants Labor Supply will change if there are changes in the following factors: • Other wage rates • Nonwage income • Preferences for work versus leisure • Nonwage aspects of job • Number of qualified suppliers

7. Labor Supply Determinants • Other wage rates • If wages in other occupations rise (fall), then labor supply will fall (rise). • Nonwage income • If nonwage income rises (falls), then labor supply will fall (rise). • Preferences for work versus leisure • If preferences for work increase (decrease), then labor supply will increase (decrease).

8. Labor Supply Determinants • Nonwage aspects of job • If the nonwage aspects of a job improve (worsen), then labor supply will increase (decrease). • Number of qualified suppliers • An increase (decrease) in the number of qualified workers will increase (decrease) labor supply.

9. Labor Demand Determinants Labor Demand will change if there are changes in: • Product demand • Productivity • Prices of other resources • Gross substitutes • Gross complements • Number of employers

10. Labor Demand Determinants • Product demand • Changes in product demand that increase (decrease) the product price, will increase (decrease) labor demand. • Productivity • An increase (decrease) in productivity will increase (decrease) labor demand, assuming that it does not cause an offset in the product price.

11. Labor Demand Determinants • Prices of other resources • For gross substitutes, an increase (decrease) in the price of a substitute input will increase (decrease) labor demand. • For gross complements, an increase (decrease) in the price of a complement input will decrease (increase) labor demand.

12. Labor Demand Determinants • Prices of other resources • For pure complements, an increase (decrease) in the price of a complement input will decrease (increase) labor demand. • Number of employers • An increase (decrease) in the number of employers will increase (decrease) labor demand.

13. Changes in Labor Demand Wage rate S • Assume that the productivity of workers rises due to computer innovations. W1 W0 • This will raise the marginal product and thus shift the labor demand curve to the right (D0 to D1). D1 D0 • The equilibrium wage rate will rise to W1 and equilibrium quantity will rise to Q1. Q0 Q1 Quantity of Labor Hours

14. Changes in Labor Supply Wage rate S0 • Assume that the number of working-age immigrants increases substantially. S1 W0 • This will shift the labor supply curve to the right (S0to S1). W1 D0 • The equilibrium wage rate will fall to W1 and equilibrium quantity will rise to Q1. Q0 Q1 Quantity of Labor Hours

15. Labor Market Demand & Supply Elasticities • Wage Elasticity of Labor Demand • Inelastic: very little change in the number of jobs if wages change • Elastic: a large change in the number of jobs if wages change • Wage Elasticity of Labor Supply • Inelastic: very little change in the number of job seekers if wages change • Elastic: a large change in the number of job seekers if wages change

16. Digression: Labor Supply Elasticity Determinants Key: • Are individuals willing & able to enter and exit an occupation if wages either increase or decrease? • Elastic Supply: workers are willing & able to enter if wages increase and leave if wages decrease • Inelastic Supply: workers are unwilling & unable to enter if wages increase and leave if wages decrease

17. Digression: Labor Supply Elasticity Determinants • Labor Supply will be more/less elastic if: • Relative wages are low/high • Relative training/skills are low/high • Training/skills can/can’t be transferred from other occupations • Nonwage benefits of the job aren’t/are important • Typical jobs require relatively few/many hours per week (Income vs. Substitution Effect)

18. Digression: Labor Demand Elasticity Determinants Key: • Are employers willing & able to increase or decrease the number of persons hired in an occupation if wages either decrease or increase? • Elastic Demand: firms are willing & able to decrease employment if wages increase and increase employment if wages decrease • Inelastic Demand: firms are willing & able to decrease employment if wages increase and increase employment if wages decrease

19. Digression: Labor Demand Elasticity Determinants • Labor demand will be more/less elastic if • Customers do/don’t care about product price • Labor costs are a large/small part of total costs • Substitutes for labor do/don’t exist • Supplies of labor substitutes are ample/scarce

20. Equilibrium Changes and the Labor Demand Elasticity • If labor supply increases and labor demand is inelastic • Wages will decrease a lot • Employment will increase a little • Total wages to workers will decrease • If labor supply increases and labor demand is elastic • Wages will decrease a little • Employment will increase a lot • Total wages to workers will increase

21. Equilibrium Changes and the Labor Demand Elasticity

22. Equilibrium Changes and the Labor Demand Elasticity • If labor demand increases and labor supply is inelastic • Wages will increase a lot • Employment will increase a little • If labor demand increases and labor supply is elastic • Wages will increase a little • Employment will increase a lot • Rising labor demand increases total wages and falling labor demand decreases total wages

23. Equilibrium Changes and the Labor Supply Elasticity

24. Wage and Employment for Firms with Competitive Product & Labor Markets Wage rate • Assume wages are the only cost • a firm hiring in a perfectly competitive labor market is a “wage taker.” Its labor supply curve, SL=MLC=PL, is perfectly elastic at W0. SL=MLC=PL W0 • A firm will hire another worker if the additional revenue the worker generates, marginal revenue product(MRP), is greater than the cost of hiring an additional worker, marginal labor cost(MLC). DL=MRP=VMP Q0 Quantity of Labor Hours • The firm maximizes its profits by hiring Q0 units of labor (MRP=MLC).

25. Allocative Efficiency • An efficient allocation of labor is obtained when society gets the largest possible amount of output from a given amount of labor. • Efficient allocation requires the VMP of labor for each product be equal to the price of labor. • Perfect competition in the product and labor markets creates allocative efficiency.

26. 1. What effect will each of the following have on the market demand for a specific type of labor: Questions for Thought (a) An increase in product demand that increases the product price. (b) A decline in the productivity of this type of labor. (c) An increase in the price of a gross substitute of labor. (d) An increase in the price of a gross complement of labor. (e) The demise of several firms that hire this type of labor. (f) A decline in the market wage for this type of labor.

27. 2. Wage and Employment Determination: Market Power in the Product Market

28. Wage and Employment for Firms with Non-Competitive Product Markets Wage rate • Assume wages are the only cost • Because a monopolist faces a downward sloping demand curve, increased hiring of labor and the resulting larger output force the firm to lower its price. b c SL=MLC=PL W0 a • Because it must lower its price on all units, its marginal revenue (MR) is less than the price. DC=VMP (MP*P) • The firm’s MRP curve (MP * MR) lies below the VMP curve (MP * P), and thus firm hires QM rather than QC. DM=MRP (MP*MR) QM QC Quantity of Labor Hours • An efficiency loss of abc results.

29. 1. Complete the following table for a firm operating in labor market A and product market AA. Questions for Thought (a) What can we conclude about the degree of competition in the labor market and product market? (b) What is the profit maximizing level of employment?

30. 3. Market Power in the Labor Market: the Case of Monopsony

31. Monopsony • A monopsony is a labor market where a single firm is the sole hirer of a particular type of labor. • A monopsonist has control over the wage rate workers are paid by hiring more or less labor.

32. Wage (2) Units of Labor (L)(1) (VMP)MRP(5) MLC(4) TLC(3) $ 10 $1.00 --- 0 ----- $2.00 $ 2 $ 2 $ 9 1 2 $ 4 $ 6 $3.00 $ 8 3 $ 6 $12 $ 7 $4.00 $ 8 4 $20 $5.00 $ 6 $10 5 $30 $ 5 $6.00 $7.00 $12 6 $42 $ 4 7 $14 $56 $ 3 $8.00 Monopsony • A monopsonist faces an upward sloping labor curve. It has to pay a higher wage to get more workers. • The total labor cost (TLC) to the firm is calculated as the number of units of labor times the wage rate (assuming no other costs when hiring). • The firm maximizes profits by hiring MRP =MLC at 3 units. • The marginal labor cost (MLC) is the additional cost of hiring the last worker.

33. Wage and Employment for a Monopsonist MLC Wage rate • The firm’s MLC lies above the SL. • The monopsonist equates its MRP with its MLC at point a and hires QM units of labor. SL=PL a • To attract these workers, it need only pay WM. WC c WM • The firm thus pays a lower wage (WM rather than WC) and hires fewer units of labor (QM instead of QC) than firms in a competitive labor market. b DL=MRP=VMP • An efficiency loss of abc results. QM QC Quantity of Labor Hours

34. Baseball Free Agency • Before 1976, baseball players were bound to single teams = monopsony power. In 1976, players could become “free agents” after 6 years • Theory says that pre 1976 players should have been paid far less than MRP • Studies confirm, with star pitchers only receiving 21% of their MRPs, bad pitchers receiving 54% and bad hitters receiving 37%.

35. After free-agency, market competition reduced monopsony power • Wages soared to more closely match MRP

36. 4. Wage Determination: Delayed Supply Responses

37. S Wage rate W1 W2 W0 D1 D0 Q0 Q2 Q1 Quantity of Labor Hours Cobweb Model • The market for highly trained professionals such as nurses has delayed supply responses to changes in demand and wage rates. • Because the quantity of labor supplied is temporarily fixed at Q0, the wage rate rises to W1 when demand changes from D0 to D1. • At wage rate W1, Q1 nurses are attracted to the profession. • With supply fixed at Q1, the wage rate falls to W2. • With this wage rate, the quantity of nurses falls over time to Q2. • The cycle repeats until equilibrium is achieved at the intersection of S and D.

38. Evidence • Some evidence exists for cobweb adjustments in markets such as lawyers and engineers. • Critics argue that: • Students make choices on the basis of the lifetime earnings stream rather than starting salaries. • Students make a forecast of the long-run outcome of a change in demand or supply and make the right choice.