The Labor Market Slides by John Pamela Hall

Product Markets • Markets in which firms sell goods and services to households or other firms • Products made from the economy’s resources 2

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 3

Figure 1: Product and Factor Markets 4

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 5

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 6

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 7

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 8

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 9

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 10

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” 11

Marginal Revenue Product (MRP) • The change in firm’s total revenue divided by change in its employment of a resource When firm thinks about changing resource by one unit at a time MRP is the change in the firm’s revenue when it employs one more unit of the resource 12

Marginal Factor Cost (MFC) • To track changes on the cost side, we use the term marginal factor cost The MFC tells us the rise in cost per unit increase in the resource When Δ Quantity of Resource = 1 MFC is increase in cost from employing one more unit of resource 13

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 14

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 15

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 16

Figure 2: The Profit-Maximizing Employment Level Dollars $200 150 100 Wage 60 50 MRP 1 2 3 4 5 6 7 8 Number of Workers 17

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 18

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 19

Figure 3: The Firm’s Labor Demand Curve Dollars W 1 Firm’s Labor Demand Curve A B W 2 n 1 n 2 W 1 W 2 Number of Workers 20

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 21

Figure 4: The Employment Decision with Several Variable Inputs Dollars A W 1 B C W 2 MRP n 1 n 2 MRP 1 n 2 Firm’s Labor Demand Curve Number of Workers 3 22

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 23

Figure 5: The Market Demand For Labor 24

Figure 6: A Shift in the Labor Demand Curve (a) Typical Firm Hourly Wage $10 (b) Labor Market Hourly Wage A B n 2 Number of Workers B D L 2 D L 1 l 2 d l 1 d n 1 A N 1 N 2 Number of Workers 25

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 26

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 27

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 28

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 29

Figure 7: Introducing a New Input Hourly Wage More of a Complementary Input Substitutable Input ld 2 ld 1 ld 3 Number of Workers 30

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 31

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 32

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 33

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 34

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 35

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 36

Figure 8: The Market Labor Supply Curve 37

Shifts in the Market Labor 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 38

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 39

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 40

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 41

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 42

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 43

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 44

Figure 9: The Long-Run Labor Supply Curve Hourly Wage S S L 1 S LLR B $40 25 L 2 C A 30, 000 60, 000 90, 000 Number of Workers 45

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 46

Figure 10: Labor Market Equilibrium 47

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 48

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 49

Figure 11: A Change in Labor Demand Labor Market Dollars S L 1 Wage S L 2 B $40 b $40 C 30 20 Typical Firm c 30 D A L 2 20 W 2 a W 3 W 1 l 2 d l 1 d D L 1 5, 000 8, 000 12, 000 Number of Workers 50 80 120 Number of Workers 50

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 51

Figure 12: The Market For Finance Professors (1995 -2002) Annual Wage S L 2 B $91, 200 66, 900 S L 1 A D L 2 D L 1 N 1 N 2 Number of New Finance 52

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 53

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 54

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 1960 s and 1970 s, at around 40 to 50% – But premium began to rise sharply in 1980 s and continued its rise through 1990 s – By 2001 college wage premium reached 76% for men and 97% for women 55

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 56

Figure 13: The Market for College. Educated Labor 57

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 58

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 59