Economics of Labor Econ 355 Professor Hedrick SS 424

Why Study Labor Economics? Largely ignored during principles class except for the minimum wage in microeconomics and wage flexibility in macroeconomics In the U.S., 67% of the population participates in labor markets. A major decision that household members make is the decision to work (career decisions, the amount of hours or effort, human capital acquisition, location) One of the most important decisions that businesses make are employment decisions.

Income distribution remains a major issue in most societies. Hence, society and governments are heavily involved in creating and modifying market outcomes in labor markets. Labor is the input that generates the greatest income for households. Therefore, it is important in determining final demands in output markets.

Basic Outline of the Course The Economic Approach: positive versus normative A descriptive view of labor markets The labor market –Labor demand Firm demand for labor Demand elasticities Quasi-fixed costs –Labor supply The decision to work Household production Factors affecting the choice of employment

Issues in labor economics –Pay and Productivity –Discrimination –Collective Bargaining –Income inequality

Economic Analysis The positive economic approach –Economist as social scientists understanding how society copes with scarcity –Economic and the scientific method Building models –An important assumption is that people act rational in pursuit of their self-interest. Rationality implies consistency and responsiveness to incentives and leads economists to use incremental or marginal reasoning. –The goals of models is ultimately to predict behavior not to be as realistic as possible –Example: modeling flight Hypothesis testing –A positive statement is one that can, or at least theoretically could be, put to the test. –Economists test theoretical predictions made by models by appealing to data. –Data are generally gathered from ongoing behaviors not through an experimental approach common to many of the natural sciences..

The normative approach –While positive economics is fascinating, particularly to economists, most people are interested in how it can be used to produce an outcome that they desire. –This creates a problem for economists. When one moves from what is (positive economics) to what should be (normative economics) one ceases to be objective and one begins moves to making value judgments. –Welfare economics, pioneered by the Italian economist, Vilfredo Pareto, is an attempt to give economists a way of addressing normative economic questions in a more generally accepted way.

Economic efficiency is an attempt to define economic outcomes in terms of human satisfaction, well-being, or welfare. Voluntary transactions (VT) versus involuntary transactions (IT). Most all economists believe that VT improve economic welfare because both parties must agree to the transaction and therefore both must benefit from the transaction. VT is definitely a positive sum game. IT most likely involve one party who gains and another who loses. In this case, one must make a value judgment about whether the transaction should proceed.

Pareto Efficiency If all possible mutually beneficial trades have taken place, Pareto efficiency has been achieved. What happens when a trade reduces someone’s welfare? Can a unambiguous improvement in welfare still be identified? A change is Pareto-improving if: –All parties affected by the transaction gain, –Some gain and no one loses, or –Some gain and some lose, but those that lose are fully compensating by those that gain In practice, Pareto –improvement is often expanded to situations where gainers could hypothetically compensate losers. However, this requires coercive and not voluntary trade. Kaldor-Hicks Criteria

Market Success versus Failure In the principles classes, we have learned that competitive markets encourage voluntary trades and thus promote economic efficiency. More intuitively, competition directs resources to the production of goods and services that consumers most highly value and firms are forced to produce those goods at least possible cost (compete or be obsolete). In certain cases, markets fail to promote efficiency and the power to coerce, which is inherent in a government, may be used to increase efficiency.

Market Failures in Goods and Services Market vs. Labor Markets Goods and Services Markets Rules of the Game Public Goods Externalities Monopoly Power Equity Labor Markets Information failures Transaction Barriers Distortions in Prices Non-existence of Markets Equity

Efficiency loss can be demonstrated in two ways: –The number of transactions is below or above the maximum number of voluntary transaction that would occur in competitive markets with no market failure –Resources are allocated in a way that marginal social benefits is not equal to marginal social costs. Therefore consumer and producer surplus are not maximized. Graphical and numerical demonstration of efficiency loss

The Efficient Level of Output Copyright © 2004 South-Western Quantity 0 Price MSB or Demand (value to buyers) MSC=Marginal cost Supply Value to buyers is greater than cost to seller. Value to buyers is less than cost to seller. Cost to seller Cost to Seller Value to buyers Value to buyers Efficient quantity

Figure 8 The Inefficiency of Monopoly Copyright © 2004 South-Western Quantity 0 Price Deadweight loss Demand Marginal revenue Marginal cost Efficient quantity Monopoly price Monopoly quantity

Labor Markets LaborMax Wage paid by Firm LaborMin Wage Accepted by Labor Efficiency Gain

Graphical Presentation Supply and demand for labor and “consumer” and “producer” surplus revisited Monopsony and inefficiency.

Labor Market Failures Information failures – ignorance of the “true” costs and benefits of a transaction. (e.g. hearing protection) Transaction barriers – institutional restrictions or ability to pay considerations that prevent mutually beneficial transactions from occurring (worker mobility, laws restricting workers or firms prerogatives). Distortions in Prices – prices reflect preferences and opportunity costs. However, such things as taxes and price controls may distort prices. (L and I taxes). Nonexistence of markets – it may not be possible for voluntary trades to take place because of the lack of an established market. (smoke-free work environment)

Government, Market Failure and Normative Economics When markets fail, can government improve welfare? Good question, the possibility exists in the following examples. Public goods – are goods that are not subject to the exclusion principle and are non-rival. Therefore, the markets do not have an incentive to produce public goods in optimal amounts, Capital market imperfections – workers cannot afford to move or invest in human that would like have a good payoff, but they cannot borrow in the market place because they lack capital. Establishing market substitutes – if markets do not exist or do not function properly, the government can attempt to impose a solution that mimics what markets would do.

Efficiency versus equity – even after market failures are corrected, markets still may not provide an equitable distribution of income. –An infinite number of Pareto efficient outcomes –Equity often requires reductions in efficiency (taxes and regulations distort market outcomes) –Initial endowments are important determinants of the distribution of income, but are the distribution of these endowments fair?

When attempting to correct market failures and a transaction does not unambiguously increase economic efficiency, value judgments must be made about the relative importance of gainers and losers. Therefore, government policy is often normative. The role of the economist is really to identify the efficiency costs of possible government policies, so that policymakers/society can be fully informed of the consequences of their actions. Doing so requires an understanding of how markets work and consumers and businesses behave and respond, both individually and collectively.

Economic Theory and Models Economics employs the scientific method Observation facts → Theories → Data Gathering → Empirical Testing: (1) → theory rejected → modify theory (2) → theory not rejected Theories cannot be proved only rejected Good theories are those that predict

Econometrics Econometrics covers tools used in the empirical testing of economic theories Regression analysis is an important tool that attempts to test and provide measures of the relationships between variables within a theoretical framework Linear or straight-line relationships: Y is related, or caused by X, in the following way: Y = m + bX ‘m’ is the intercept or Y when X=0 ‘b’ is the slope and measures the ΔY/ ΔX or the marginal relationship between Y and X

Different ways of constructing linear relationships –Goodness of fit –Eye-ball –Minimize residuals –Ordinary least squares – minimize squared residuals Intercept, slope and statistical tests….. Multiple regression Y = a + bX + cY + dZ

Linear versus non-linear lines Problems with OLS –Omitted variable bias –Multicollinearity –Heteroskedasticity