Economics 324: Labor Economics 0. Welcome back 1. For next time, please read the assigned paper and rest of Ch Example of 2-page detailed article summary 3. Who wants to lead discussion? Which paper? 4. Who wants to present 2.7 or 2.8? 5. Potentially useful blogs …

Overview of the Labor Market Disputes over efficiency vs. equity Buyers are employers, sellers are workers Size of the market: national, regional, local Formal vs. Informal rules and procedures –Internal labor markets: union firms, govt, large non- union firms –Smaller, non-union companies have less formal guidelines Note that people can be in more than one “labor market” they are not mutually exclusive

Definitions Employed = person working for pay (135 m in 2000) BLS linkBLS link Unemployed = person not working for pay, but actively seeking a job or expecting to be recalled from a layoff (6 m) OLF = not employed and not unemployed (69 m) Labor Force = those  16 who are employed or unemployed Flows –OLF  LF = ? LF  OLF = ? –E  U = ?U  E = ? Labor Force Participation Rate = LF / (Population  16)

Labor Force Participation Labor force participation is on the rise overall LFP rates for men are falling, while those for women are rising dramatically. Avg hours worked per week have also fallen substantially.

Unemployment Rate Unemployment rate = U/LF If u-rate  5%, we call the overall labor market “tight” – hard for employers to fill jobs ; if u-rate  7% is “loose” Loose during Great Depression; Tight during WWII Trends: average u-rate has  (non-war, non-GD years) the variance has  Conclusion: Labor market is more stable now, but at higher level of unemp

Distribution of Employment Major patterns? Agricultural employment has declined dramatically, while services has expanded Size of government has nearly quadrupled Workers and firms adapted, and must continue to adapt (demographic) These are “snapshots” and  miss job transitions that occur between time points , 11% of manuf jobs destroyed annually, 9% created  2% net loss

Earnings and Income Wage rate = price of labor per hour –Money you’d lose per hour if you had an unauthorized absence. So a sick day becomes an “employee benefit”. –e.g., if paid $100 total comp. for 25 hours: 20 spent working, 5 vacation –then we’ll call the wage $4/hour. Not $5/hour. $80 wages, $20 benefit. Structure of Compensation –Wage rate * hours worked = Earnings –Earnings + Employee benefits = Total Compensation –70% of Total Compensation is from earnings, on average –Total Compensation + Unearned income = Income Nominal vs. Real wages –Nominal wage = wage in current dollars –Real wage = nominal wage / some measure of prices it is used to indicate a level of purchasing power, so we can compare across time earn $100/day and book costs $50, real wage = 2 books per day

Real wages of U.S. workers (non-supervisory workers in private sector) What happened to real wages from 1980 to 2003? Nominal & Real wages –Avg hourly earnings$6.84$10.19$15.38 –CPI (base = = 100) –Avg hourly earnings$8.30 $7.80 $8.36 in dollars –Avg hourly earnings$15.27$14.35$15.38 in 2003 dollars Nominal wages rising, but prices of good/services also rising,  need to deflate by CPI (fixed bundle of food, housing, clothing, etc.) Set cost of our “bundle” in the base period ( ) = 100. $1 in 2003 appears to buy less than *one-third* what a 1980 $1 did. Conclusion: Real wages were stagnant from 1980 to Problems with using a fixed bundle?

Labor Supply: Theory and Evidence Model of labor-leisure choice –Goal is to identify factors that determine whether a person works and, if so, how much she works –Representative individual has utility function, U = f (C, L) C is composite consumption good, L is leisure hours Utility function transforms consumption of goods & leisure into an index measuring the level of satisfaction We assume that “more is better” We assume the person endeavors to maximize utility –Indifference curve is the locus of points (C,L) that yield the same level of utility In order that people may be happy in their work, they must not do too much of it. – Herman Melville

Properties of Indifference Curves IC’s are downward-sloping Higher IC indicates higher utility IC’s do not intersect IC’s are convex to the origin Marginal utility of consumption = the change in utility resulting from an additional $1 spent on goods, holding leisure constant Marginal utility of leisure = the change in utility resulting from consuming an additional hour of leisure, holding consumption constant C Leisure (hours) U = 500 U = 750 U = XY U = 10X ½ Y ½ MU X and MU Y ?

Slope of an Indifference Curve Slope measures the rate at which a person is willing to give up leisure time for more consumption, holding U constant Total derivative of U = U(C,L) is Solve for dC/dL In words, the absolute value of the slope of an IC is the ratio of the marginal utilities, and we call this the Marginal Rate of Substitution Slope is steep when lots of C, little L, but flatter when little C & lots of L C U = 500 L A

Time and Budget Constraints Time constraint: T = L + h Ignoring household sector for now V = non-labor income w = hourly wage rate Budget constraint is the boundary of the worker’s opportunity set. C  wh + V … “can’t consume more than your income” Assume w constant, but note that marginal wage rate (wage received for last hour worked) can depend on # hours worked (OT premium is higher, part-time wage often lower) C Leisure (hours) T (wT+V) E V 0

Time and Budget Constraints Combine the budget and time constraints to get : – wT + V = C + wL –This says that “full income” (potential income if worked T hours) is spent on consumption and leisure Rewrite so it’s easier to graph: – C = (wT + V) - wL –Point “E” is the endowment point. This person can consume $V of goods & services even if they use all their time for leisure.

To Work or Not to Work? Reservation wage is the wage at which a worker is indifferent between working and not working. In other words, it is the minimum increase in income that makes a worker indifferent between remaining at point E and working that first hour. A person will work if the market wage > reservation wage Predictions: –a higher reservation wage makes a person less likely to enter LF –the higher your market wage, the more likely you are to work (ceteris paribus, for given tastes and V) This positive correlation between offered wages and LFP rates helps explain the dramatic increase in female LFP What if you commute 30 minutes from Statesville? (time costs) How do monetary commuting costs affect the reservation wage?

Commuting Costs and Reservation Wage How do monetary commuting costs affect the reservation wage? –Start with $V non-labor income –best utility level is U 0 –Monetary commuting costs would be parking, tolls, car insurance, maintenance, gas, etc. –Slope of line aE 1 is the reservation wage in the presence of commuting costs –It’s greater than W RES without commuting costs Conclusion: Commuting costs increase the reservation wage C L T (wT+V) E0E0 V - Costs 0 V E1E1 U0U0 a

Changing Non-labor Income What happens to hours of work when we change V? –Shock =  V due to bigger dividends, beneficiary in a will, bigger unemployment insurance check, etc. Wage is held constant Leisure could be normal or inferior good Income effect = impact on the D for leisure of a change in non-labor income, holding the wage constant (  L/  V) | w > 0 or equivalently, (  h/  V) | w < 0, if Leisure is a normal good (which we will assume) How does  V affect the reservation wage? 2 effects of  V : (1) lowers the probability of working (  W RES ) (2) decreases hours worked, if you work

Changing the Wage Rate What happens to hours of work when we change w ? –Shock =  w due to a raise at work, perhaps Non-labor income (V) is held constant Total effect is ambiguous –Two competing effects (1) Income effect: higher w  greater purch power  demand more L (2) Substitution effect: higher w  higher P leisure  demand less L Isolating the Substitution effect: –Draw the new budget line. Move this new budget line parallel to itself until it is tangent to the old IC (at point Y) SE = (  L/  w) | U,V < 0 Isolating the Income effect: –Draw a new IC tangent to the new budget line at some point.

Individual’s Labor Supply Curve Backward-bending Labor Supply curve (  h/  w) | V > 0  SE > IE (  h/  w) | V < 0  SE < IE SE dominates initially, but IE is stronger eventually Empirically, data shows that female labor supply is backward-bending, while men generally have a positive slope, with a short vertical range ($10-20/hour) Commuting costs and labor supply curve –Won’t work 1 hour per week –Enter LF at h* hours (say 20) w Hours of work SE > IE W reservation 0 IE > SE h*h*

Which Effect Dominates? The size of the income effect depends on where you start bigger at point A than B Z is the extreme, IE = 0 Empirically: Cross-sectional data reveals that IE and SE are small for men (estimates for women are complicated by child care and household work) C Leisure 0 B A Z

Optimal Labor-Leisure Choice example Suppose Jack’s utility function is given by U = L  C  Find the demand function for leisure hours, L* = L (w, V, T) Assuming  = ¾,  = ¼, V = 0, T = 400 and w = $4 what are the initial optimal values? Now suppose welfare program passed giving $200 of income if you don’t work at all. As you earn income benefits are scaled back $0.20 per dollar earned. What is the break-even point and what are the effects on labor supply? Decompose, graphically and numerically, the change in demand due to the subsidy and tax into the substitution and income effects. What if U = L ¼ C ¾ ? C Leisure T (wT+V) E0E0 V 0 U = ? C* = ? L* = ? Work h* = ? hLCU Initial subsidy Tax: SE Tax: IE