Chapter 8

THE LABOR MARKET: WAGES, EMPLOYMENT, AND UNEMPLOYEMENT

1. Factor Markets The circular-flow diagram of Chapter 2 showed

that firms operate simultaneously in two types of markets. In the product market, they solve the what problem—what to produce and, if a price searcher, how much to charge.

In the factor market, firms solve the how problem—how to combine the factors of production effectively to produce output.

A factor (input) market is one in which firms purchase land, labor, or capital inputs.

The price-taking buyer, with a small share of total market, must simply pay the going market rate.

1. Factor Markets – cont. The price-searching buyer, with a sufficiently

large share of the market, can affect the price by buying more or less of it.

There is less price searching in factor markets than in product markets.

A firm must thus compete for inputs with all firms that use the same inputs.

E.g. New York City’s, universities, foundations, major corporations, etc. all compete against each other for secretaries, computer programmers, etc.; they do not compete against each other in product markets, but they do compete in factor markets.

2. Supply and Demand in Factor Markets

Just like prices in product markets, the prices of labor, capital, and land are determined by supply and demand.

As there are market supply and demand for curves for goods, so there are market supply and demand curves for the factors of production.

This chapter focus on labor, but the principles apply to all three factor productions.

2.1 The Supply Factor The supply of all the factors of

production—labor, land and capital—depends on their opportunity costs.

For example the amount of unskilled labor offered at different wage rates depends on the alternatives sacrificed in other lines of employment.

If the wage rate offered for garbage collection is low, fewer unskilled workers will conclude that garbage collection is superior to their next-best alternative.

2.1.1 The Supply Curve The supply curve of a factor of

production is the quantity offered at different factor prices; all other things remaining the same.

The opportunity cost principle reveals a normal shape to this supply curve.

The higher the factor price (the wage), the larger the quantity of the factor typically supplied, ceteris paribus.

2.2 The Demand for a Factor

The demand for the factors of production depends on the productivity of the factor and the demand for the product the factor is used to produce.

2.2.1. The Factor Demand Curve

The demand curve for a factor shows the quantities of that factor that would be purchased (demanded) at different prices, ceteris paribus.

In most general terms, this demand depends on two forces: the demand for the product the factor produces (derived demand) and the productivity of the factor.

2.2.2. Derived Demand Firms purchase inputs because they

produce goods and services that can be sold.

No matter how productive an input, it will not be hired unless it produces a good demanded in the marketplace.

Labor and Derived Demand: The Case of the Handwritten Bible: Example

2.2.2. Derived Demand – cont. The demand for a factor of production is

a derived demand because it results (is derived) from the demand for the goods and services the factor of production helps to produce.

There is a clear linkage between the demand for the product the factor produces and the demand for the factor.

When the demand for new houses falls, there is unemployment in the lumber-producing states.

2.2.3. Marginal Productivity

The marginal product of a factor of production (MP) is the increase in output that results from increasing the factor by one unit.

The law of diminishing returns states that as ever larger quantities of a variable factor will eventually decline; as the firm expands its output, MP will fall in the short run.

The marginal product of any factor depends on the quantity and quality of the cooperating factors of production (farm worker with modern farm machinery).

2.2.4. Marginal Revenue Product

On the output, side, the firm maximizes profit by producing that output at which MR=MC.

The marginal revenue product (MRP) of a factor of production (P) is the extra revenue generated by increasing the factor by one unit. MRP = MR x MP

The MRP curve is the firm’s demand curve for that factor.

2.3. Factor Market Equilibrium

The demand for a factor increases whenever MRP increases. MRP increases when the price of the product rises or when the marginal productivity increases.

Increases in the product’s price and in MP raise factor prices.

An increase in productivity has the same effect: MRP increases and the demand for the factor increases, and again the factor prices rises.

3. Labor Markets The prices (wages) of labor of different grades

and types are determined in a labor market. A labor market brings buyers and sellers of

labor services together to agree on conditions of work and pay. They can be local, national, or international.

The labor market differs from other factor markets in four respects:1) people cannot be bought and sold (no slavery); 2) different job preferences; 3) we have alternative use of time (leisure vs. work); 4)workers can join unions.

3.1. Wage Differentials1. Jobs Are Different Compensating wage differentials are the

higher rewards that must be paid to compensate for undesirable job characteristics.(Offshore oil workers vs. food processing workers)

2. People Are Different Noncompeting groups are those groups of

people differentiated by natural ability and education, training, and experience to the extent that they do not compete with another for jobs. (Dig ditcher vs. brain surgeon vs. basketball player)

3.2. Human Capital, Productivity, and Income Distribution

Human capital is investment in schooling, training, and health that raises productivity.

Any activity that raises the productivity of a resource is an investment; e.g. any expenditure on human capital is as much an investment as those of a firm building a new plant or acquiring new machinery.

People acquire additional human capital until marginal costs and marginal benefits are equal.

4. The Macroeconomic Labor Market The Employment Act of 1964 commits the

federal government to create and maintain “useful employment opportunities … for those able, willing, and seeking to work.”

The Great Depression of the 1930’s with its high unemployment has left a lasting imprint on the American consciousness.

In 1929, less than 3 percent of the labor force was unemployed; by 1933, 25 percent was unemployed.

4.1 The Definition on Unemployment

According to the Bureau of Labor Statistics, a person is unemployed if he or she:

1. Did not work at all during the previous week.2. Actively looked for work during the previous four weeks.3. Is currently available for work.

The labor force equals the number of persons employed plus the number unemployed. (People not in labor force are full-time homemakers or students and retirees)

The unemployment rate equals the number of unemployed divided by the labor force (the sum of employed and unemployed persons). Unemployment is an indicator of the labor market.

4.2 Frictional and Cyclical Unemployment The unemployed search for jobs; the employed

look for better jobs. Frictional unemployment is the

unemployment associated with the changing of jobs in a dynamic economy.

Cyclical unemployment is unemployment associated with general downturns in the economy.

During cyclical downturns, fewer goods and services are purchased, employers cut back on jobs, and people find themselves without jobs.

4.3 Macroeconomic Supply and Demand for Labor The entire economy’s demand for labor depends

on its marginal productivity, which fall as more and more people are hired; willingness to work depends on the wage rate.

Real wages are measured by money wages, W, divided by the price level, P—that is, W/P.

The natural rate of employment is that rate at which the number of available jobs (V) is equal to the number of qualified unemployed workers (U).

The natural rate of unemployment is when there is an approximate balance between the number of unfilled jobs and the number of qualified job seekers.

4.4 Wage Flexibility and Unemployment

If the labor market is like other markets, the wage should fall whenever there is a gap between the number of people wishing to work and the number of jobs available at the prevailing wage.

Much of macroeconomics focuses on why wages are less flexible than other prices; an explanation is that labor is often hired under long-term contracts.

If normal wages are inflexible, and the demand for labor falls, unemployment in excess of the natural rate can be created.

5. Unions, Layoffs, and Inflexible Wages

A labor union is a collective organization of workers and employees whose goal is to affect conditions of pay and unemployment.

Currently, about one in nine members of the American labor force belongs to a union (↓since 1950—1 out of 4).

Collective bargaining is union bargaining with management.

5. Unions, Layoffs, and Inflexible Wages – cont. A strike occurs when unionized employees

cease work until management agrees to specific union demands.

Union’s objectives—higher pay and high employment of union member are not compatible; unions must balance these two.

When laid-off union workers want to be recalled, their unemployment does not cause wages to fall generally in the economy.