ECONOMICS: Principles and Applications 3eHALL & LIEBERMAN© 2005 Thomson Business and Professional Publishing

Slides by: John & Pamela Hall

The Labor Market

2

Product Markets

• Markets in which firms sell goods and services to households or other firms

• Products made from the economy’s resources

3

Factor Markets

• Markets in which resources are sold to firms –Resources include

• Capital, land, labor, and natural resources

• Resources are sometimes called factors of production

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Figure 1: Product and Factor Markets

Households Firms

S

D

Demand for Goodsand Services

Supply of Goodsand Services

Demand forResources

Supply of Resources

Factor Markets

Product Markets

S

D

5

Labor Markets in Particular

• Determining a worker’s wage rate– Groups of economic decision makers come

together in markets in order to trade– Each decision maker tries to maximize

something and faces constraints– Observe equilibrium price determined in those

markets– Explore how various changes affect that

equilibrium price

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Special Meaning

• The special meaning of the price in the labor market—the wage rate– Income people earn over their lifetime will

determine how they will be able to provide for themselves and their families

– Adds a special moral dimension to events in labor markets

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Defining a Labor Market

• How broadly or narrowly we define a market depends on the specific questions we wish to answer– Broadly defined markets may look at markets

that draw on labor from all over the world– Narrowly defined markets may look at markets

that draw on labor on a very localized level

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Competitive Labor Markets

• Market with many indistinguishable sellers of labor and many buyers

– Involves no barriers to entry or exit

– Perfectly competitive labor markets must satisfy three conditions

• Great many buyers (firms) and sellers (households) of labor in market

• All workers in market appear the same to firms• No barriers to entering or leaving labor market

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Firms in Labor Markets

• Sometimes firms that compete in the same product market also compete in the same labor markets, but– Some firms that compete in the same product market operate in

different labor markets– Some firms that operate in different product markets compete in

the same labor market

• The demand side of a labor market includes all firms hiring labor in that labor market– These firms may (but not necessarily) compete in the same

product market

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Derived Demand

• The demand for labor is a derived demand―it arises from, and will vary with—the demand for the firm’s output– The phrase “will vary with” is important

• The demand for labor by a firm will change whenever demand for the firm’s product changes

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Resource Demand: A General Rule

• Marginal approach to profit– Firm should take any action that adds more to its revenue than it adds to

its cost

• When we view firm as a buyer in a resource or factor market, we use same principle of marginal decision making– This time action under consideration is “increase employment of the

resource by another unit” – Rule becomes

• Increase employment of any resource whenever doing so adds more to revenue than it adds to cost

– To avoid confusion between decisions about resources and decisions about output, we don’t use terms “marginal revenue” and “marginal cost” when discussing factor markets

• To track changes on the revenue side, use term “marginal revenue product”

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Marginal Revenue Product (MRP)

• The change in firm’s total revenue divided by change in its employment of a resource

)( resource ofquantity in change

)( revenue total in change(MRP) Product Revenue Marginal

L

TR

When firm thinks about changing resource by one unit at a timeMRP is the change in the firm’s revenue when it employs one more unit of the resource

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Marginal Factor Cost (MFC)

• To track changes on the cost side, we use the term marginal factor cost

)( resource ofquantity in change

)( cost total in change(MFC) Cost Factor Marginal

L

TC

The MFC tells us the rise in cost per unit increase in the resourceWhen Δ Quantity of Resource = 1 MFC is increase in cost from employing one more unit of resource

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Marginal Approach to Profit

• To maximize profit firm should increase its employment of any resource whenever MRP > MFC– But not when MRP < MFC

• Profit-maximizing quantity of any resource is quantity at which MRP = MFC

• If MRP > MFC, employing more of resource increases revenue more than cost– Profit will rise

• When MRP < MFC, using more of resource adds more to cost than to revenue– Profit falls

• When firm exploits every opportunity to increase profit it will arrive at the point at which MRP = MFC

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The Firm’s Employment Decision When Only Labor Is Variable

• The Firm’s MRP in a Competitive Product Market – When output is sold in a competitive product market

• MRP for any change in employment will equal price of output (P) times marginal product of labor (MPL)

– MRP = P x MPL

• The Firm’s MFC in a Competitive Labor Market– When labor is hired in a competitive labor market, MFC

for any change in employment will equal market wage rate (W)

• MFC = W

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The Profit-Maximizing Employment Level

• Marginal approach to profit– A firm should take any action that adds more to

its revenue than to its cost

• Hire another worker when MRP > W, but not when MRP < W

• To maximize profit, the firm should hire the number of workers such that MRP = W– Where the MRP curve intersects the wage line

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Figure 2: The Profit-Maximizing Employment Level

MRP

60 MFC = Wage

2Number of Workers

Dollars

$200

1 3 4 5 6 7 8

150

50

100

1. Hiring another worker adds more to revenue . . .

2. than it adds to cost . . .

3. until profits are maximized at five workers.

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The Two Approaches to Profit Maximization

• Two different approaches for the firm to follow to maximize profit– MR and MC approach to find profit-maximizing output– MRP and MFC approach to find profit-maximizing employment

• Can these two approaches lead to different decisions? – No, because these two “different” approaches are actually the same

method viewed in two different ways– Remember that hiring another worker increases the firm’s output and

therefore changes both its revenue and its cost

• Whenever MRP > MFC for a change in employment, MR > MC for associated rise in output

• Whenever MRP < MFC for a change in employment, MR < MC for associated rise in output

• If MRP = MFC for a change in employment, MR = MC for associated change in output

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The Firm’s Labor Demand Curve

• When labor is the only variable input, downward-sloping portion of MRP curve is firm’s labor demand curve– Tells us how much labor firm will want to

employ at each wage rate

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Figure 3: The Firm’s Labor Demand Curve

n1

B

A

n2

W2

W1

W2

W1

Number of Workers

Dollars

MRP

Firm's Labor Demand Curve

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The Firm’s Employment Decision When Several Inputs are Variable

• Whether the firm can vary just labor, or several inputs simultaneously– Optimal level of employment will satisfy the

MRP = W rule

• Firm’s labor demand curve will slope downward

• Decrease in wage rate will cause an increase in employment

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Figure 4: The Employment Decision with Several Variable Inputs

n1

B

A

Firm' Labor Demand Curve

n2

W2

W1

W2

W1

n3

C

MRPMRP

Number of Workers

Dollars

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The Market Demand For Labor

• Market Labor Demand Curve–Indicates total number of workers all

firms in a labor market want to employ at each wage rate

–Found by horizontally summing across all firms’ individual labor demand curves

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Figure 5/b/c: The Market Demand For Labor

100

ld

80

$12

10

4050 30 90

ld

ld

Number of Workers

Hourly Wage

Firm A Firm B Firm CHourly Wage

Hourly Wage

if we add the number of workers demanded by Firm A . . .

At any wage rate (such as $10) . . .

and by Firms B, C, and all other firms as well . . .

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Figure 5d: The Market Demand For Labor

LD

Hourly Wage

Number of Workers

Labor Market

$12

10

we get the market quantity of labor demanded at that wage rate.

N2 = 80 + 40 + 30 + …. N1 = 100 + 50 + 90 + …

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Figure 6: A Shift in the Labor Demand Curve

n1

Number of Workers

Hourly Wage

BA

n2

$10 B

Typical Firm Labor Market

A

N1 N2

Hourly Wage

d1

d2 D

iL D2L

Number of Workers

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Shifts in the Market Labor Demand Curve

• A change in any variable that affects quantity of labor demanded—except for the wage rate—causes labor demand curve to shift

• Specific variables that shift the labor demand curve include a change in– Demand for the firm’s product– Technology– Prince of another input– Number of firms

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A Change in Demand for the Firm’s Output

• Effect of a change in output price on labor demand depends on whether many firms in the labor market also share the same product market

• When they do– A rise in output price will shift market labor

demand curve rightward– A fall in output price will shift market labor

demand curve leftward

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A Change in Technology

• Complementary Input– An input whose utilization increases

marginal product of another input

• Substitute Input– An input whose utilization decreases

marginal product of another input

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A Change in Technology

• When many firms in a labor market acquire a new technology, the market labor demand curve will shift – Rightward if technology is complementary

with labor

– Leftward if technology is substitutable for labor

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Figure 7: Introducing a New Input

Number of Workers

Hourly Wage

More of a Substitutable

Input

More of a Complementary

Input

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A Change in the Price of Another Input

• When price of some other input decreases, market labor demand curve may shift–Rightward if the input is

complementary with labor

–Leftward if the input is substitutable for labor

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Individual Labor Supply

• Individuals as wage takers– No single labor seller can affect the

market wage

– In a competitive labor market• Each seller is a wage taker

– He or she takes market wage rate as given

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The Income-Leisure Trade-off

• Wage rate determines exact nature of the income-leisure trade-off–Higher the income »» higher the

expense of leisure time

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The Labor Supply Decision

• Individuals who are able to choose their own hours may– Choose optimal combination of income and

leisure

• Individuals who are not able to choose their own hours– Only make the choice of whether to offer their

labor in a particular market or not

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Reservation Wages

• Lowest wage rate at which an individual would supply labor to a particular labor market

• When wage rate in a market exceeds an individual’s reservation wage for that market– Individual will decide to work there

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Market Labor Supply

• Curve indicating the number of people who want jobs in a labor market at each wage rate–The higher the wage rate, the greater

the quantity of labor supplied

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Figure 8: The Market Labor Supply Curve

1,0001,000 1,200 1,800

$1210 $10

DC

S1L

S1L S

2L

(b)

Number of Workers

HourlyWage

HourlyWage

(a)

Number of Workers

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Shifts in the MarketLabor Supply Curve

• A market labor supply curve will shift when – Something other than a change in wage rate causes a

change in number of people who want to work in a particular market

• Factors causing a labor supply curve to shift include– Change in market wage rate in other labor markets– Changes in cost of acquiring human capital– Number of qualified people– Changes in tastes

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A Change in the Market Wage Rate in Other Labor Markets

• As long as some individuals can choose to supply their labor in two different markets– A rise in wage rate in one market will

cause a leftward shift in labor supply curve in other market

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Changes in the Cost of Acquiring Human Capital

• An increase in the cost of acquiring human capital will shift the labor supply curve leftward

• A decrease in the cost of acquiring human capital will shift the labor supply curve rightward

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Number of Qualified People

• Population growth causes labor supply curves in both national and local labor market to shift rightward over time

• Labor supply curves can also shift due to migration within a country

• If new people entering a field exceeds number of retirees in that field– Increase in supply results

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Changes in Tastes

• Different types of jobs attract different people with different tastes–Danger and excitement vs. safety

and routine

• Women entering the workforce

• Social contribution to community

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Short-Run vs. Long-Run Labor Supply

• Short-run– Labor supply response to a wage-rate change comes

from those who already have skills and geographic location needed to work in a market

• Long-run– Labor supply response to a wage-rate change comes

from those who will acquire skills and move into geographic location needed to work in a market

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Short-Run vs. Long-Run Labor Supply

• Long-run labor supply curve indicates how many (qualified) people will want to work in a labor market – After full adjustment to a change in the

wage rate

• Long-run labor supply response is more wage elastic than short-run labor supply response

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Figure 9: The Long-Run Labor Supply Curve

30,000 60,000 90,000 Number of Workers

HourlyWage

B

25

$40

A

C

2. When the wage rate rises to $40, employment rises to 60,000 in the short run.

.

3. In the long run, the wage rate of $40 attracts new entrants and employment rises to 90,000.

4.The long-run labor supply curve connects points A and C.

1. Initially, the wage is $25 and 30,000 people supply labor.

D1L D

2L DLRL

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Labor Market Equilibrium

• Supply and demand will drive a competitive labor market to its equilibrium point–Point where the labor supply and

labor demand curves intersect

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Figure 10: Labor Market Equilibrium

1. The market labor supply and labor demand curves determine the equilibrium wage rate and equilibrium employment.

LS

2,000 3,000 4,500

16

20

$24

LD

W

10

$20

Number of Paralegals

HourlyWage

DollarsLabor Market Typical Firm

ld

3. hires up to where its MRP curve crosses the $20 wage line.

2. Each law firm, taking the market wage of $20 as a given,

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What Happens When Things Change?

• Events that can cause labor demand curve and labor supply curve to shift include– Change in labor demand

– Change in labor supply

– Labor shortages and surpluses

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A Change in Labor Demand

• In short-run, shift in labor demand moves along a short-run labor supply curve

• In long-run, resulting increase in wage rate will cause short-run labor supply curve to shift also

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Figure 11: A Change in Labor Demand

S1L

5,0008,000

12,000

30

$40

a

b

c

W

W

WB

A

C

50 80 120

20

30

$40

20

(a) (b)

Numberof Workers

HourlyWage

Number of Workers

Labor Market Typical Firm

DollarsS2L

D2L

D1L

d2

d1

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Change in Labor Supply

• Shifts in labor supply typically happen slowly

• When a long-run change in labor supply is the cause of changes in the labor market– No separate short-run change in

equilibrium to investigate

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Figure 12: The Market For Finance Professors (1995-2002)

66,900

$102,400B

A

N1 N2Number of New

Finance Professors

Annual Wage S2L

S1L

D2L

D1L

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Labor Shortages and Surpluses

• Labor Shortage– Quantity of labor demanded exceeds

quantity supplied at prevailing wage rate

• Labor Surplus– Quantity of labor supplied exceeds

quantity demanded at prevailing wage rate

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Labor Shortages and Surpluses

• Shortages and surpluses in a labor market are not natural consequence of shifts in supply and demand curves– Labor shortage will occur only when wage rate

fails to rise to its equilibrium value– Labor surplus will occur only when wage rate

fails to fall to its equilibrium value

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Using the Theory: Understanding the Market for College-Educated Labor

• Students have many motives for attending college• One of the most important motives is to invest in

their own human capital– Going to college will enable you to earn a higher

income than you would otherwise be able to earn– Economists track the college wage premium

• Percentage by which average college graduate’s income exceeds average high school graduate’s income

– Wage premium was relatively stable in 1960s and 1970s, at around 40 to 50%

– But premium began to rise sharply in 1980s and continued its rise through 1990s

– By 2001 college wage premium reached 76% for men and 97% for women

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Using the Theory: Understanding the Market for College-Educated Labor

• Why did labor supply shift rightward each year?– An increase in proportion of young people

attending college– Population itself increased

• Why did labor demand curve shift rightward each year?– Partly due to normal growth in economy– Technological change

• Increase skill requirements for many types of work

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Figure 13: The Market for College-Educated Labor

14 31

31,732

$40,479 B

Millionsof Workers

MedianAnnual

Wage 2001 dollars

A

Between 1978 and 2000, the labor supply curve shifted rightward . . .

but the rightward shift in the labor demand curve was even greater.

As a result, the average wage in 2001 rose to $40,479.

S1978L

S2001L

D2001L

D1978L

In 1978, the average wage rate (in 2001 dollars) for college-educated labor was $31,732.

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Using the Theory: Understanding the Market for College-Educated Labor

• An increase in yearly wage rate has resulted over last two decades– Because demand curve for college graduates shifted

rightward faster than supply curve

• What will happen in the future?– Competing trends

• Acceleration in rightward shift of labor supply curve for college graduates

– Will work to decrease college wage premium

• Acceleration in rightward shift of labor demand curve for college graduates

– Due to further changes in technology

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Using the Theory: Understanding the Market for College-Educated Labor

• Most labor market economists predict– For college-educated labor

• Labor demand curve will shift rightward more rapidly than labor supply curve over next several years

• Wage rate for college graduates is expected to rise

– For high school graduates• Shifts in labor supply curve are expected to outpace

shifts in demand curve– Wage premium for college students is expected to increase