The Economics of Information and Labor Markets

1. The Economics of Information and Labor Markets • Markets coordinate through prices, rather than central planners • The action of the “invisible hand” of markets • Markets enable “price discovery” of the relative value of items in trade • Markets act to produce more of those goods that are most demanded and produce less of those that are passé.

2. Land Use Questions Should we raise cattle, hops, or extract energy from land? In market economies the price of the land moves in line with what it can be used to produce Even very wise land-use commissioners, who try to assign the best use, are unlikely to have all information Social planners are unlikely to have the measures of the “social opportunity costs” of their decisions. Prices Convey Information

3. The Military Draft:A nightmare of allocation • Conscription is a cheap source of labor to a government • The exact opposite of the use of markets • Take people away from their best use and coerce them into tasks they may be unsuited for. • Make brain surgeons into foot soldiers? • Governments and Generals tend seriously to under-value their cost.

4. All volunteer service where S=D at QV and Wv Social Welfare = A+B+F Draft at lower wage WD and greater quantity QD The government gets surplus A+B+C+D and conscripts get F but lose C + D + E Net surplus is A+B+F - E Deadweight Loss is “E” Consumer & Producer Surplusand the Military Draft S A E Wv B C D WD F D QV QD

5. Signaling in Educationand the Job Market • A. Michael Spence, “Job Market Signaling” QJE 1973 • Education is costly • Class rank and GPA give little info. • Why hire people with degrees? Why not just years of schooling? • Sheepskin effectsvs.years of education effects • Sort those who are quick at learning certain complex ideas

6. Signaling & Asymmetric Information • The problem is to determine truth through questions or actions. • Applicants to positions know more about themselves than they reveal • How can we sort between risk-takers and risk averse candidates? Ask them? • Used car:Asymmetric Information-- unequal or dissimilar knowledge among market participants. • But if someone is selling his or her car, isn't it likely that the car is no good: a lemon? • George Akerlof “The Market for Lemons: Quality, Uncertainty, and the Market Mechanism, Journal of Economics, 1970.

7. Types of Equilibria • Ask prospective CEOs: Are you willing to take risks? • Pooling equilibrium -- cannot distinguish among applicants. [Used cars as pooling equilibrium] • Separating equilibrium -- distinguishes among applicants • A risk averse person would tend to select an offer which primarily paid a base salary • Whereas the risk-loving individual would tend to select an offer with more profit sharing. • Hence, an offer with a substantial performance premium creates a separating equilibrium.

8. Adverse Selection • Adverse selection in health insurance the sick (or likely to be sick) want the most insurance • Game: A firm may decide to produce a HighorLow Qualityproducts and buyers pay a High Price or a Low Price. • They will tend to produce Low Quality products and receive Low Prices. • Adverse selection another lemon’s case  only low quality items become available

9. Adverse SelectionGame Analysis BUYER • Maximin decision by seller firm is Low Quality product • Best for the buyer is a low price, but a high quality good. Worst is a High price but a Low quality good. • End in Low Quality, Low Price trap. High Price Low Price High Low 130 70 150 90 SELLER Payoffs are for the Seller only

10. Moral Hazard • Because most contracts are not complete, people can alter their behavior • Moral Hazard = the incentive for an individual to take more risks when insured. • Motorcycles and Helmets • Wisconsin has no helmet law • Michigan has a helmet law • In which state do cyclists drive more carefully? • Fire insurance vs Property Insurance rates? • Fire is easier to verify than theft

11. Labor Markets • Our chief asset isn’t our home. • It’s our human capital! • suppose salary now is $70,000. • Suppose it rises at 4% per year for 30 years (age 35 to 65). This is a growing perpetuity. • Suppose the discount rate is 6.5% (long bond rate) • PVA = {70,000/(.065-.04)}•[ 1 - (1.04/1.065)30 ] = or$1.4 million dollars !!! • Expected salary in year 2035 based on these assumptions would be $227,000. Human Capital

12. Factors of Production Total Product and Marginal Product More capital TP • Total product rises in labor • Marginal product diminishes • Increases in capital increase the marginal product of labor • TP shifts up to dashed line as does MP L MP Higher MP of labor MP of Labor L

13. Hire if DTR > DTC Where DTR is the marginal revenue product of labor Px is price of the output in a competitive product market MPL is the amount produced Where DTC is the marginal factor cost of labor, usually the wage rate. The Hiring Decision MRPL = Px MPL W MPL L MRP = marginal revenue product of labor

14. The Optimal Employment • Hire until the MRPL = w “the workers receive their MRP” • Therefore, the MRPL is the DEMAND FOR LABORcurve • The SUPPLY OF LABOR tends to rise with the wage rate • There may be a backward bending supply of labor, but usually at very high wages

15. Labor Market Equilibrium S • Market clears where D = S for labor • There exists various imperfections in labor markets • Notice: Improvements in productivity would increase the demand for labor W D L

16. If Labor is MORE productive, demand for labor increases If Labor is LESS productive, demand for labor decreases Suppose an earthquakedestroys capital, then the marginal product of labor must fall MP L declines with less capital, wages and labor are HURT Capital and labor are complements. MRP L is the Demand for Labor S L W D L D’ L L’ L

17. Monopolistic Product Markets • Hire labor in competitive labor markets, but sell output in markets with monopoly power • Reduces the MRPL, and reduces labor hiring Px MPL w MRPL = MR•MPL L

18. Monopsony in Labor Markets • Monopsony -- One Buyer • Wants to hire at LOW wages • a big hirer of labor must attract labor from greater distances • Monopsonists realize that the more they hire, the HIGHER must be the wage rate • The marginal expenditure, hence, is ABOVE the supply curve

19. Marginal Expenditure on Labor Example

20. Monopsonists restrict hiring Monopsonists pay lower wages than even under competition There is some Dead Weight Social Loss Redistributes income form workers to employers Monopsonistic Employers Pay Low Wages RESULTS MLC SL W DL L

21. Labor Supply U3 U2 U1 Consumption • We work to eat, but some are on the margin between working and leisure. • Labor supply is foregone leisure. • Use of indifference curves to explore labor supply. happiness Work per day

22. Income has two components Wage Income (Line A) Nonlabor Income (C0) Dividends Interest Royalties Highest possible indifference curve at point P. If nonlabor income rises to C1, then it’s optimal to work less! U3 U2 U1 The Worker’s Optimum A’ P’ A P C1 C0 Labor Illustrates an income effect.

23. Suppose wage rates rise from W to W’ Highest possible indifference curve at point P. But with the Higher Wage W’, it is optimal to work more at Q. Labor supply generally rises in wage rates. U3 U2 U1 The Worker’s Optimum W’ Q W P C0 Labor Illustrates a substitution effect.

24. Unions and Labor Markets A Union is an organized “seller” of labor services An effective union is a Monopoly -- a single seller Unionization has tended to be counter-cyclical Unionization grows in economic downturns Unionization lags in economic upturns Solidarity Forever

25. We want $25 per hour ! Collective Bargaining • Typically, firm management and a union negotiates a labor contract for the firm • Other times, negotiations occur on an industry wide basis • industrial negotiating teams act as monopsonists • industrial unions act as the monopolist • The fits the model of Bilateral Monopoly • One factory town and a union • Avis (buyer) and G.M. (monopolistic seller of cars) • Hockey players union and the owners of the NHL teams

26. 1. Bilateral Monopoly Diagram There is just the union • At point a, the union monopolist wants the firm to hire LU • If the Union acts like a monopolist, it creates DWSL DWSL SL a W DL MRL Lu

27. 2.Bilateral Monopoly Diagram There is just the power of the Big Firm in town MLC • At point b, monopsonist wants to hire Lm • There is also DWSL if the industrial team is effective SL DWSL W b DL Lm

28. Full Bilateral Monopoly Diagram MLC • The solution can be close to what the union wants • The solution can be close to what management wants • Or, somewhere in between SL a W { W b DL MRL Lu Lm

29. Bilateral Monopoly Solution isIndeterminate • The Solution depends on the power of the two sides • Theories on Union Behavior in Bargaining 1. Take It or Leave It • Ultimatumssometimes win concessions • But brinkmanship is dangerous game • Baseball Strike in 1994-1995 ended the season • Patco Air traffic Controller strike in 1983 led to the firing of workers • National Hockey League 2005 perhaps will kill the NHL • Take of leave it is most like the problem of war • Wars tend to occur only when the two sides view their prospects differently

30. Brinkmanship: A Risky Strategy • Cuban missile crisis • A deliberate creation of risk -- provocative, a threat • Essay by JRR Tolkien, a “eucatastrophe” -- coming to the edge of disaster, and somehow achieving the “happy ending” of fairytales. • Should it be “uncertain” or a “compellent” threat? • Fail-safe is “compellent” -- M.A.D. • Small steps of escalating response • “Naval blockage” as an act of commitment, with uncertain consequences. • Maltese Falcon: “in the heat of action where best interest lies”

31. More Theories on Union Behavior • 2. Split the Difference • Solution may be better than if either wins • Arbitrators often prevented from taking this Solomonic option. Why? MEL SL a W SPLIT W b DL MRL Lu Lm L

32. Theorem of the Second Best Theorem: In the presence of more than one“distortion”, elimination of one of them MAY NOT improve welfare • Bilateral Monopoly as Counter-Veiling Powers • The two “distortions” cancel out • Thought -- two wrongs make it right ?! • Two distortions can be better than one.

33. 3. Cooperation Both parties can be “owners” Solution make the joint effort greatest Germany: Mitbestimmungen Labor union representatives have seats on the Board of Directors of firms Scanlan Plan: Labor’s pay is a function of firm’s profits or objectives More Theories on Union Behavior

34. 1. Unions may wish to maximize the Wage Bill = W • L Pickunit elastic point at L1 2. Unions may wish to max the number of workers Pick wage so all worker get jobs at L2 What Are Union’s Objectives? Linear Labor Demand Curve UNIT ELASTIC W1 W2 D L1 L2

35. 3. Unions may max wages to a CORE group pay W3 to Core pay W4 to others Minimum Wage Law -- as another example of Theorem of Second Best What Are Union’s Objectives? Linear Labor Demand Curve W3 W4 UNIT ELASTIC D L3 L4

36. Minimum Wage Law & Monopsony MLC • Without a Min Wage Law, employment at LM (monopsony) • With Min Wage Law, then employment CAN increase to LMinWage • Often the impact is mostly in the South SL b Wmonopsony DL Lm MRL

37. Minimum Wage Law & Monopsony MLC • Without a Min Wage Law, employment at LM (monopsony) • With Min Wage Law, then employment CAN increase to LMinWage • Often the impact is mostly in the South SL unemployment Min Wage b Wmonopsony DL LMinWage Lm MRL