Chapter 6 Wage Determination and the Allocation of Labor

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

1. Theory of a Perfectly Competitive Labor Market

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Perfectly Competitive Labor Market

o

Perfectly competitive labor markets

have 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 6-3

Market Labor Supply

• Though individuals have backward-bending labor supply curves, market supply curves are usually positively sloped over normal wage ranges.

• 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.

S Quantity of Labor Hours 6-4

Wage and Employment Determination

Wage rate S • The equilibrium wage rate W 0 and level of employment Q supply and demand.

0 occur at the intersection of labor W es W 0 • An excess demand of Q 2 - Q 1 would occur at a wage rate of W ed .

W ed D • An excess supply of Q W es .

2 - Q 1 would occur at a wage rate of Q 1 Q 0 Q 2 Quantity of Labor Hours 6-5

Labor Supply Determinants

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

Labor Supply Determinants

o Other wage rates • If wages in other occupations rise (fall), then labor supply will fall (rise). o Nonwage income • If nonwage income rises (falls), then labor supply will fall (rise).

o Preferences for work versus leisure • If preferences for work increase (decrease), then labor supply will increase (decrease).

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Labor Supply Determinants

o Nonwage aspects of job • If the nonwage aspects of a job improve (worsen), then labor supply will increase (decrease).

o Number of qualified suppliers • An increase (decrease) in the number of qualified workers will increase (decrease) labor supply.

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Labor Demand Determinants

Labor Demand will change if there are changes in: o Product demand o Productivity o Prices of other resources • Gross substitutes • Gross complements o Number of employers 6-9

Labor Demand Determinants

o Product demand • Changes in product demand that increase (decrease) the product price, will increase (decrease) labor demand.

o Productivity • An increase (decrease) in productivity will increase (decrease) labor demand, assuming that it does not cause an offset in the product price.

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Labor Demand Determinants

o 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. 6-11

Labor Demand Determinants

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

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Changes in Labor Demand

• Assume that the productivity of workers rises due to computer innovations. Wage rate • This will raise the marginal product and thus shift the labor demand curve to the right ( D 0 to D 1 ).

W 1 W 0 S D 0 D 1 • The equilibrium wage rate will rise to W 1 and equilibrium quantity will rise to Q 1 .

Q 0 Q 1 Quantity of Labor Hours 6-13

Changes in Labor Supply

Wage rate • Assume that the number of working-age immigrants increases substantially. • This will shift the labor supply curve to the right ( S 0 S 1 ).

to • The equilibrium wage rate will fall to W 1 and equilibrium quantity will rise to Q 1 .

W 0 W 1 S 0 S 1 D 0 Q 0 Q 1 Quantity of Labor Hours 6-14

Labor Market Demand & Supply Elasticities

o 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 o 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 6-15

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 6-16

Digression: Labor Supply Elasticity Determinants

o 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) 6-17

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 6-18

Digression: Labor Demand Elasticity Determinants

o 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 6-19

Equilibrium Changes and the Labor Demand Elasticity o 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 o 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 6-20

Equilibrium Changes and the Labor Demand Elasticity 6-21

Equilibrium Changes and the Labor Demand Elasticity o If labor demand increases and labor supply is inelastic • Wages will increase a lot • Employment will increase a little o If labor demand increases and labor supply is elastic • Wages will increase a little • Employment will increase a lot o Rising labor demand increases total wages and falling labor demand decreases total wages 6-22

Equilibrium Changes and the Labor Supply Elasticity 6-23

Wage and Employment for Firms with Competitive Product & Labor Markets • Assume wages are the only cost • a firm hiring in a perfectly competitive labor market is a “wage taker.” Its labor supply curve, S L =MLC=P L , is perfectly elastic at W 0 .

• 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 ). • The firm maximizes its profits by hiring Q 0 units of labor (MRP=MLC).

Wage rate W 0 Q 0 S L =MLC=P L D L =MRP=VMP Quantity of Labor Hours 6-24

Allocative Efficiency

o An

efficient allocation of labor

is obtained when society gets the largest possible amount of output from a given amount of labor.

o Efficient allocation requires the VMP of labor for each product be equal to the price of labor.

o Perfect competition in the product and labor markets creates allocative efficiency.

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Questions for Thought

1. What effect will each of the following have on the market demand for a specific type of labor: (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.

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

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Wage and Employment for Firms with Non Competitive Product Markets • 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.

• Because it must lower its price on all units, its marginal revenue (MR) is less than the price.

• The firm’s MRP curve (MP * MR) lies below the VMP curve (MP * P), and thus firm hires Q M rather than Q C .

Wage rate W 0 • An efficiency loss of abc results.

a b Q M c Q C S L =MLC=P L D C =VMP (MP*P) D M =MRP (MP*MR) Quantity of Labor Hours 6-28

Questions for Thought

1. Complete the following table for a firm operating in labor market A and product market AA.

Labor 1 2 3 4 5 6 Wage $10 $10 $10 $10 $10 $10 TLC MLC MRP $16 $14 $12 $10 $8 $6 VMP $16 $15 $14 $12 $10 $8 (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?

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

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Monopsony

o 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.

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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.

Units of Labor (L)

(1)

0 1 2 3 4 5 6 7

Wage

(2)

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$8.00

TLC

(3)

---- $ 2 $ 6 $12 $20 $30 $42 $56

MLC

(4)

-- $ 2 $ 4 $ 6 $ 8 $10 $12 $14

(VMP) MRP

(5)

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 6-32

Wage and Employment for a Monopsonist

• The firm’s MLC lies above the S L . Wage rate MLC • The monopsonist equates its MRP with its MLC at point a and hires Q M units of labor.

• To attract these workers, it need only pay W M.

• The firm thus pays a lower wage (W M rather than W C ) and hires fewer units of labor (Q M instead of Q C ) than firms in a competitive labor market.

W C W M b a c S L =P L D L =MRP=VMP • An efficiency loss of abc results.

Q M Q C Quantity of Labor Hours 6-33

Baseball Free Agency

o Before 1976, baseball players were bound to single teams = monopsony power. In 1976, players could become “free agents” after 6 years o 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%.

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• After free-agency, market competition reduced monopsony power • Wages soared to more closely match MRP 6-35

4. Wage Determination: Delayed Supply Responses

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Cobweb Model

• The market for highly trained professionals such as nurses has delayed supply responses to changes in demand and wage rates. Wage rate W 1 • Because the quantity of labor supplied is temporarily fixed at Q 0 , the wage rate rises to W 1 when demand changes from D 0 to D 1 .

• At wage rate W 1 , Q 1 nurses are attracted to the profession. • With supply fixed at Q 1 , the wage rate falls to W 2 .

• With this wage rate, the quantity of nurses falls over time to Q 2 .

• The cycle repeats until equilibrium is achieved at the intersection of S and D.

W 2 W 0 Q 0 Q 2 S D 0 D 1 Q 1 Quantity of Labor Hours 6-37

Evidence

o Some evidence exists for cobweb adjustments in markets such as lawyers and engineers.

o Critics argue that: • Students make choices on the basis of the

lifetime earnings stream starting salaries

.

rather than • Students make a forecast of the long-run outcome of a change in demand or supply and make the right choice.

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