Overheads on Labor Markets
ECON 201 -4
November 29, 2001

Resource Markets
Use of resources (labor, human capital, land and capital) is exchanged for money (wages, rent, interest).
• Firms are the buyers and households are the sellers.
• As before, people will try to further their personal goals. The miximizing principle applies to these markets as well as to product markets.
• The market determines how many resources are purchased and their price; i.e., how many workers are hired and their wage rate.

Value of Labor
• A profit-maximizing firm will hire additional resources as long as the extra benefit (extra revenue) that results from adding a unit of the resource is greater than the extra opportunity cost.
• The marginal revenue product of labor (MRP) is the additional revenue the firm gets as a result of hiring an additional worker. It equals the change in total revenue dividied by the change in labor input. This is the value of labor to the firm.
• In the short run, the marginal revenue product of labor will decline as more workers are hired because of diminishing returns in production.

Example
The price of the product (competitive market) is \$10.
 Labor 0 1 2 3 4 5 6 Output 0 10 17 23 28 32 35 MP - 10 7 6 5 4 3 MRP - TR 0 1000 1700 2300 280 320 350

Note that MRP = p x MP for a competitive firm.

Profit-Maximizing level of Employment
• The firm will maximize profits by adding labor as long as the MRP is greater than the marginal cost of a unit of labor.
• In a competitive resource markets, the firm is just one of a very large number of employers and is too small to influence the market wage rate. It is a price-taker in this market.
• In competitive markets, the marginal cost of a unit of labor to the firm is the market wage rate.
• The profit-maximizing rule: increase the nubmer of workers as long as the MRP is greater than the wage rate. Stop where MRP = wage rate.

Example
The price of the product is \$10.
 Labor 0 1 2 3 4 5 6 MP - 10 7 6 5 4 3 MRP - 100 70 60 50 40 30 MCL = w - 68 68 68 68 68 68
• The firm hires 2 workers at a wage of \$68 per day.
• At a wage of \$58, the firm hires ( ).
• How many does the firm hire at a wage of \$48? A wage of \$38?

Short-run Demand for Labor
• At a high market wage, only a few workers have a marginal revenue product large enough that it's profitable for the firm to hire them.
• Due to diminishing returns, additional workers add too little to revenues to make hiring him profitable.
• At a low market wage, the cost of hiring additional workers is now low enough to make it profitable to hire even those with low MRPs.
• Quantity demanded increases as the wage falls.
• The competitive firm's demand curve for labor is the same as its marginal revenue product curve.

Market demand curve
• The market demand curve is the sum of the individual firms' demand curves (number of firms is fixed in the short run).
• The short-run market demand curve for labor (or any other resource) is downward-sloping due to diminishing returns.
• The demand curve will shift if there's a change in "other things" (other than the wage) that affect MRP or the opportunity cost of labor.
• demand for the product
• productivity of labor
• other (non-wage) labor costs such as the cost of health insurance benefits
• prices of other inputs.

Long run
• In the long run, all inputs are variable.
• An increase in the wage rate will affect the amount of labor the firm demands in the long run in 2 ways:
• The input substitution effect: The firm will substitute other inputs (capital) for labor to lower its costs.
• The output effect: The firm's costs of production will increase as the wage rises; as the marginal cost of producing a unit of output increases, the firm will cut back output. The firm uses les labor when producing a smaller output.
• Both effects cause quantity demanded to fall as the wage rises in the long run.

Allocation of time
• Individuals allocate their time among alternative uses to maximize their satisfaction.
• Individuals compare the benefits of working (the real after-tax wage) with the opportunity cost of working (the value of their time in its next best use, such as leisure or housework).
• People maximize satisfaction by increasing the hours they offer to work as long as the marginal benefit (the wage rate) is greater than the marginal cost (the value of their time in its next best use).

Effects of an increase in the wage rate
An increase in the wage rate will have two effects on workers:
• The income effect: An increase in the wage rate leads to an increase in household income. With an increase in income, people can afford more leisure time (a normal good).
• The substitution effect: An increase in the wage rate raises the opportunity cost of leisure. As with any other good, as the opportunity cost increase, people buy les. Less leisure time means more worktime.
• The income and substitution effects lead in opposite directions. Depending on which is larger, an increase in the wage rate could cause the individual to supply more or less labor.

Supply of Labor
• The market supply curve is the sum of the individual supply curves for all those in a given labor market defined by occupation and/or location.
• An increase in the wage rate will affect both the number of hours individuals want to work and the number of people in the market.
• Empirical studies have found that an increase in the wage will lead most people to work the same or more hours.
• An increase in the wage rate will attract more people into this market. Some may leave school early or delay retirement. Some may switch jobs.
• Therefore, the supply curve of labor in a given market is upward-sloping.

Supply shifts
The supply curve for labor will shift if other things (NOT the wage rate) change. These include:
• A change in incomes from other sources (not the person's work)
• A change in the value people put on their leisure (or other non-work) time.
• A change in the other (than wage) benefits from work.
• A change in the other costs of working to the individual -- transportation, child care, risk, etc.
• A change in tax rates.
• A change in the working-age population
• And, for individual labor markets, a change in the wages and working conditions in alternative labor markets.

Labor markets
• We usually examine individual labor markets defined by occupation and location using only those workers and firms in direct competition. Examples: electrical engineers or the Portland, OR market for unskilled labor.
• We can also analyze the overall labor market because all workers and jobs are substitutes to some degree. The supply and demand curves reflect the decisions of all workers and all firms and determine the general level of wages.

Wage determination
• The market will establish the equilibrium wage rate: the wage rate at which quantity of labor dmeanded euqals the quantity of labor supplied.
• A shift in either the demand curve or the supply curve (due to a change in "other things") will cause a change in the real wage rate and the amount of labor employed.
• Minimum wage laws and imperfect information may keep the market from reaching equilibrium.

Changing demand for labor
• Causes of increased demand for labor (shift the demand curve to the right):
• Increased demand for the product
• Increased productivity of labor
• Increased price of substitute inputs or decreased price of complementary inputs in production.
• Decrease in other costs (not wage) of hiring labor such as a decrease in fringe benefits.
• An increase in the demand for labor will cause an increase in both the wage rate and employment.
• A change in the opposite direction in any of the above will lead to a decrease in demand for labor which will cause a decrease in both the wage rate and employment.

Changing Supply of labor
• Caused of increased supply of labor (shifts the supply curve to the right):
• Decrease in non-work incomes
• Decreased value of leisure and other non-work activities
• Decreased costs of going to work (decreased transportation costs, for example)
• Non-monetary costs of working fall or benefits rise (for example, working conditions become more comfortable).
• Decreased wages in other labor markets (other occupations or areas).
• An decrease in the cost of the training to enter this market.
• An increase in the supply of labor will cause an increase in employment and a decrease in the wage rate.
• A change in the opposite direction of any of the above will lead to a decrease in the supply of labor which will cause wages to rise and employment to fall.

Economy-wide Wage Trends
• Real hourly wages in the US increased during 1946-1973. Demand increased as productivity and population (bably boom) grew; the labor force grew relatively slowly.
• Real hourly wages in the US fell in 1973-1993
• Demand for labor grew more slowly as population and productivity growth slowed.
• Supply of labor was growing rapidly as baby boomers entered the labor force and immigration rates were high.
• Real wages have been rising since 1995 as a result of increased productivity and a general increase in demand (expansion).

Predicting changes: cooks
• Suppose the market is in equilibrium. Then food contamination scares make people become more fearful of eating in restaurants.
• Because the demand for the product (restaurant meals) has decreased, the demand for cooks will also decrease as some restaurants operate with fewer cooks or close down altogether.
• The decrease in demand creates a temporary surplus (unemployment).
• Competition for the remaining jobs lowers wages. As the wage rate falls, restaurants will increase the quantity of cooks demanded somewhat (move along the demand curve).
• The decline in the wage rate also discourages some people from continuing to look for work in this market. They retire or switch to other careers or locations.
• The end result is a new equilibrium at a lower wage and less labor employed.

Labor Markets are Linked
• Workers are free to move between labor markets. They can switch careers (retraining if necessary) or move to a new location.
• Workers will switch if the benefits of moving (higher real after-tax earnings over the rest of their working life) outweigh the cost of making the change (expense and effort to locate the new job and to move plus any costs of retraining.)
• As workers move out of low-wage markets, labor supply decreases, causing real wages to rise.
• As workers move into the higher-wage markets, labor supply increases, causing real wages to fall.
• The gap between the wage rates in the two markets narrows until there is no advantage to switching.

Wage differences
• Not all wage differences are eliminated by movement between labor markets.
• Long-term wage differentials reflect:
• Differences in the innate skills required and the relative supply of those skills or combination of skills.
• Differences in education and the cost of training for different occupations
• Differences in the non-monetary aspects of jobs-- differences in risk, differences in working conditions, work shift (time of day), etc. These differences are called "equalizing" or "compensating" wage differences
• Discrimination on the basis of race, gender, or nationality that excludes women and minorities from some jobs.
• Market power by employers (monopsony) or workers (unions)
• Artificial barriers to entry such a law that requires people to have a license to work in certain occupations.

Compensating Differences in Wages
• People dislike risk, dirt, hot temperatures, etc. and would not take jobs that exposed them to these conditions over jobs that pay the same but are safer, cleaner, and more comfortable.
• To get people to take the unpleasant jobs, the wage rate must be higher so that the extra earnings are enough to offset or compensate for the bad working conditions.
• Other things being equal (including skill level) unpleasant, risky jobs pay more.

Investment in Human Capital
• The benefit of investment in education include:
• Higher wages and lower unemployment = higher income for many years
• Nicer working conditions
• Satisfaction from knowledge, enjoyment of learning
• The costs of education to the worker include:
• Tuition minus any scholarships or other grants
• Cost of books and lab fees
• Opportunity cost of time (foregone earnings)
• Workers invest if the present value of benefits > present value of costs.

Wage Difference by Education
• Employers will prefer workers with extra education if the extra revenues they generate (compared to a workers with less education) outweigh the extra cost in wages and benefits.
• Workers will be willing to acquire the education as long as the increase in wages and benefits with education is greater than the cost of the education.
• Wage differentials will exist as long as the cost of education is greater than the consumption benefits (satisfaction from learning). The wage differential will be greater the more education costs and the more productivity differs.
• Wage differentials between those with college degrees and those without have been increasing over the last 25 years primarily as a result of technological change.

Household Incomes
• Household incomes, and therefore claims over goods and services, are a function of the number of resources the household owns and the prices paid for the services of each.
• Household incomes differ because:
• Wages differ among jobs
• The number of workers and hours per worker differ among households
• A small number of households own property (land, capital, businesses) and receive rent, interest, or profit.

US Income Inequality
• To measure inequality, economists order households from lowest to highest income then divide the population into 5 groups of equal size.
• The quintile distribution of income looks at each group's income as a percent of the total. Complete equality = each quintile gets 20% of the income.
• QuintileLowest2ndMiddle4thHighest
% income3.68.914.923.049.7
• Median household income in 2000 = \$42,100

Increasing income inequality
• Income inequality in the US has been increasing since the later 1960s.
• The combined shares of the two lowest quintiles have fallen from 14.8% in 1967 to 12.5% in 2000.
• The share of the top quintile has risen from 43.8% in 1967 to 49.7% in 2000.
• The two main causes are increasing wage differences by education and changes in household composition (more single moms and DINKs).