Modelling the labour market Labour supply decisions The effect of a minimum wage.

Modelling the labour market

Labour supply decisionsThe effect of a minimum wage


There is one type of “commodity” that hasn’t been analysed yet Labour !!

Although it can be analysed using the same tools as other markets, the labour market has some particularities In terms of the properties of this “commodity”:

welfare aspects are important. In terms of asymmetric information: it is not a

homogenous good, markets are “segmented”. Therefore, it is important in terms of policy


The labour supply decision

The classical labour market

Efficiency wages

Monopsony power and the minimum wage


Framework similar to the approach used for consumer choice and producer decisions Labour is treated like a regular commodity

Based on an agent deriving utility from consumption and leisure Indifference curve based on preference for

consumption (which requires income) and leisure (free time)

Budget constraint based on working (which uses up free time but provides and income)


Consumption

(C)

Leisure (Λ)

The labour supply decision indifference curve

1. Is strictly convex and decreasing 2. Corresponds to an utility function U(C,Λ) defined over

consumption (of an aggregate basket) and leisure3. Leisure brings utility ⇔ labour brings disutility


The labour supply decision budget constraint First of all: Workers can earn an income

independently of supplying labour (unearned income).

Labour generates a disutility, but this is compensated by a wage.

maxwIPC u

Unearned income

Labour supplied (defined as leisure not taken)

Cost of consumption


A

BMaximum consumption strategy

Maximum leisure strategy

Consumption

(C)

Leisure (Λ)

The labour supply decision budget constraint

Λmax

Iu

P

wIu max

P

wIC u

max


A

Consumption

(C)


Leisure (Λ) Λmax

The optimal point is given by the tangency between the budget constraint and the indifference curve

Leisure

Labour

w

mU

P

mUC


Consumption

(C)

A

Effect of an increase in unearned income

B

Leisure (Λ) Λmax

An increase in unearned income increases consumption and leisure (reduces labour supply)


Consumption

(C)

A

Effect of an increase in the wage rate

B

Leisure (Λ) Λmax

An increase in the wage rate usually increases consumption and reduces leisureBUT this depends on the income/substitution effects !!An increase can reduce labour supply




Efficiency wages



The supply of labour is given by the decision process shown aboveAggregated as for other commodities

The demand for labour is known as a derived demandIt comes from the cost minimisation

decision of the firms, and is derived from the optimal level of output

Remember that TCQP


Simplification : Labour is the only input becomes

Maximisation w.r.t labour gives:

On a classical market, the firm is a price taker on all markets (including labour)

LLwLQP TCQP

0

LL

LwLw

L

LQP

L

w

L

LQP

Marginal revenue product of labour wage


w

LL*

w*

Labour Supply

Labour Demand (mRPL)

Equilibrium on a classical market


w

LLd

wmin

Deadweight loss

Ls

Labour Supply

Unemployment

L*

w*

Labour Demand (mRPL)

Minimum wage on a classical market




Efficiency wages


Efficiency wages

Like other markets, the labour market is far from competitive. It is in fact one of the most “imperfect” markets

1. Large number of agents (not for all types of labour)2. Differentiated “product”: variation in skill /ability3. Entry / exit is costly/complicated on both sides4. Imperfect information on skill/ability5. Imperfect mobility of inputs

Has given birth to “labour economics”

Efficiency wages

An example of such developments is the theory of efficiency wages

The theory of efficiency wages attempts to explain why: Some wages can be higher than the market

equilibrium There is an equilibrium unemployment I.e. the “minimum wage diagram” seen above

occurs spontaneously on some segments of the labour market

Efficiency wages

This theory integrates the imperfect information principal/agent theory seen in week 12 into the labour market. The producer has limited information on the skills

/abilities of the agents. The producer’s ability to monitor the agent is limited. The agent clearly has an incentive to “shirk”, i.e.

produce below his ability.

In such a situation, the producer can raise wages above the market level and increase efficiency of production at the same time !!

Efficiency wages

Why would wages above market equilibrium benefit the producer ? “Worker health” argument (only really valid for low

wages): a higher wage increases the ability to work Motivation argument: workers feel rewarded, and

more motivated. Opportunity cost argument (important): workers will

not want to lose the job, and hence shirk less. Smaller turnover ⇒ lower cost of replacing workers Signal to market argument: Paying higher wages

allows the producer to attract the more productive workers




Efficiency wages



On a classical market a minimum wage causes unemployment This is a typical argument in the media against

minimum wages This argument depends on the existence of

a competitive market for labour But is the labour market competitive ?

There are much less demanders (firms) than suppliers)...

This raises the possibility of Monopsony power mentioned in week 8.


Just like a price ceiling can be used to reduce monopoly power, a price floor (minimum wage) can reduce Monopsony power

The following assumes a single firm employing all the workforce This is a simplification However, it illustrates the potential positive

effect of a minimum wage in this case

LwLL

LwLwmCL


Wages

Labour

mCL Labour Supply

Marginal Revenue Product of Labour

L

Monopsony equilibrium

1st

2nd

1st : mCL=mRPL gives L2nd : given L, the supply curve gives w

mPL

w


Important property of this unemployment Compared to efficiency wages, here the wage

is below the equilibrium level ! This corresponds to a “worker exploitation”

idea As a result, it is relatively easy to differentiate

the two models.

Also corresponds to different types of labour: skill-intensive or “homogeneous” This applies to different labour markets


Wages

Labour

mCL Labour Supply

L

w

Minimum wage

Wmin >w gives a constant mCL

For mCL = MRPL, L increases

Lmin

wmin



Wages

Labour

mCL Labour Supply

L

w

Optimal Minimum wage

Workers are paid at the MPL

No remaining unemployment

L*min

w*min

Problem: this optimal point is difficult to find



Wages

Labour

mCL Labour Supply

Marginal Product of Labour

L

w

“Overdoing” the minimum wage

Setting wmin > w*min creates unemploymentThis is because the market power is over-compensated: classical unemployment

Lmin

wmin

Modelling the labour market Labour supply decisions The effect of a minimum wage.

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