5 Frictions in the Labor Market

Chapter Outline Frictions on the Employee Side of the Market The Law of One Price Monopsonistic Labor Markets: A Definition Profit Maximization under Monopsonistic Conditions How Do Monopsonistic Firms Respond to Shifts in the Supply Curve? Monopsonistic Conditions and the Employment Response to Minimum Wage Legislation Job Search Costs and Other Labor Market Conditions Monopsonistic Conditions and the Relevance of the Competitive Model

Chapter Outline Frictions on the Employer Side of the Market Categories of Quasi-Fixed Costs The Employment/Hours Trade-Off Training Investments The Training Decision by Employers The Types of Training Training and Post-Training Wage Increases Employer Training Investments and Recessionary Layoffs Hiring Investments The Use of Credentials Internal Labor Markets How Can the Employer Recoup Its Hiring Investments?

5.1 Frictions on the Employee Side of the Market The Law of One Price (LOP) Workers who are of equal skills within occupations will receive the same wage – there will be no wage differentials. Assumptions underlying the LOP: Every employee has information about available jobs – information is costless. Mobility or job search across employers is costless. Labor supply curve is horizontal.

5.1 Frictions on the Employee Side of the Market Mobility or job search across employers is NOT costless. Job search takes time and effort. Costs of job search include: (a) application – printing résumés and postage (b) interview – buying expensive clothes for interview and roundtrip fares (c) travel – hiring movers if employed (d) psychological costs – missing friends and family members. Costs of job search/mobility make the supply curve to be upward sloping and not horizontal as assumed earlier.

Figure 5.1 The Supply of Labor to Firm A: Worker-Mobility Costs Increase the Slope of the Labor Supply Curve Facing Individual Employers Higher mobility costs will elicit low labor/employment responses if wage changes. Lower mobility costs will elicit high labor/employment responses if wage changes.

Monopsonistic Labor Markets: A Definition 5.1 Frictions on the Employee Side of the Market Monopsonistic Labor Markets: A Definition A labor market monopsonist is the only buyer/employer of labor in its labor market. The employer faces an upward labor supply curve but its MEL (or MCL) is much higher than the wage rate. Profit Maximization under Monopsonistic Conditions Recall that: profit-maximizing firms will hire as long as MRPL > MEL hiring stops when MRPL = MEL when firms face upward sloping supply curves, the MEL exceeds the wage.

Why the Marginal Expense of Labor Exceeds the Wage Rate 5.1 Frictions on the Employee Side of the Market Why the Marginal Expense of Labor Exceeds the Wage Rate The marginal expense of labor (MEL) exceeds the wage rate because: potential employees find it costly to change jobs, so the firm must be willing to pay higher wages to attract workers from other employers, the MEL includes to the wages paid to the extra worker plus the additional cost of raising the wage for all other workers.

Table 5.1

Figure 5.2 A Graph of the Firm-Level Data in Table 5.1

The Firm’s Choice of Wage and Employment Levels 5.1 Frictions on the Employee Side of the Market The Firm’s Choice of Wage and Employment Levels The monopsonist hires workers up to the point where: MRPL = MEL (5.1) The labor market effects caused by MEL > W : A labor market monopsonist hires less workers in comparison to the competitive employer(s). A labor market monopsonist pays a wage that is less than the competitive wage – exploits workers.

Figure 5.3 Profit-Maximizing Employment and Wage Levels in a Firm Facing a Monopsonistic Labor Market

Monopsonistic Conditions and Firms’ Wage Policies 5.1 Frictions on the Employee Side of the Market Monopsonistic Conditions and Firms’ Wage Policies The employers in monopsonistic labor markets must decide on the wage to pay unlike in the perfectly competitive labor markets where firms are wage takers. Firms must make labor market decisions that allow them to remain competitive in their product markets. Product and labor market constraints may cause firms in monopsonistic labor markets to offer different wages to equivalent workers. Due to the unlikelihood that SL and MRPL curves would be exactly the same for different firms in the same labor market, it should be no surprise if exactly comparable workers have different marginal productivities and receive different wages at different firms.

How Do Monopsonistic Firms Respond to Shifts in the Supply Curve? 5.1 Frictions on the Employee Side of the Market How Do Monopsonistic Firms Respond to Shifts in the Supply Curve? The labor market monopsonistic firm does not really have a labor demand curve – it has MRPL curve. The monopsonistic firm is not a wage taker and its MRPL curve shows various levels of employment of which there is only one profit-maximizing level of employment and only one associated wage rate. Shifts in Labor Supply Curve That Increase MEL If fewer workers are willing to work and the labor supply shifts to the left, the short-run effects are: employment level (E) will fall to E’ and the market wage (W) will increase to W’ MEL will also shift to a higher level (ME’L).

Figure 5.4 The Monopsonistic Firm’s Short-Run Response to a Leftward Shift in Labor Supply: Employment Falls and Wage Increases

5.1 Frictions on the Employee Side of the Market In the long run, the monopsonistic firm’s cost minimizing mix of capital (K) and labor (L) would require: Similar to equations: (3.7a) P. MPL = MEL (remember that MEL > W) (3.7b) P.MPK = C (3.8a) (3.8b) (3.8c)

5.1 Frictions on the Employee Side of the Market Effects of a Mandated Wage A mandated wage (Wm) prevents a firm from paying a wage less than Wm – this creates a perfectly elastic labor supply curve facing the firm, thus altering its MEL curve. A profit-maximizing firm will hire labor where the MRPL insects the perfectly elastic labor supply curve (MEL curve) created by Wm – see employment at Em in Figure 5.5. For a monopsonistic firm, Wm can simultaneously increase the average cost of labor and reduce MEL – the decrease in marginal expense will induce the firm to expand output and employment in the short run.

BDS = Labor supply curve based on a mandated Wm Figure 5.5 Minimum-Wage Effects under Monopsonistic Conditions: Both Wages and Employment Can Increase in the Short Run BDS = Labor supply curve based on a mandated Wm BDEM = Marginal expense of labor curve (MEL) based on Wm MRPL = MEL (which is given as BDEM based on Wm) → Em

5.1 Frictions on the Employee Side of the Market Monopsonistic Conditions and the Employment Response to Minimum Wage Legislation Legislated increases in Wmin raise wages. Modest increase in Wmin can reduce MEL. Fall in MEL may cause some firms/employers to experience increases in employment. Higher total labor costs due to Wmin may force some firms/employers to close.

Job Search Costs and Other Labor Market Outcomes 5.1 Frictions on the Employee Side of the Market Job Search Costs and Other Labor Market Outcomes Despite the job search costs, some workers’ high wage levels may be due to luck – they are lucky to be employed by a high-paying/high-productivity employer. Job mobility/search costs for workers may explain why: Wages increase or improve over time with workers’ labor market experience or activity. Wages increase with workers’ length of time (tenure) with their particular employers.

Wage Levels, Luck, and Search 5.1 Frictions on the Employee Side of the Market Wage Levels, Luck, and Search Employee mobility costs can create, other things equal, monopsonistic conditions that result in pay differences among workers who have equal productive capabilities. The implication is that to some extent, a worker’s wage depends on luck – some workers will be lucky to obtain a job offer from high-paying employer. Workers who see their jobs as a poor match (due to low pay) have more incentive to search for other offers than the lucky ones who have good matches with high wages. Labor-market studies have observed that workers’ wages tend to increase both with overall labor market experience, and holding labor market experience constant, the length of time with one’s employer (“job tenure”).

Wage and Labor Market Experience 5.1 Frictions on the Employee Side of the Market Wage and Labor Market Experience Workers who have spent more time in the labor market have had more chances to acquire better offers and thus improve upon their initial job matches – that is, workers’ wages improve the longer they are active in the labor market. Wages and Job Tenure With costly job searches, workers who are fortunate enough to find jobs with high-paying employers will have little incentive to continue searching. Those who have longer job tenure with their employers also tend to have higher wages.

Monopsonistic Conditions and the Relevance of the Competitive Model 5.1 Frictions on the Employee Side of the Market Job Search Costs and Unemployment Job search costs can help to explain the existence (and level) of unemployment – the longer it takes for a worker to receive an acceptable offer, the longer the unemployed worker will remain unemployed. Monopsonistic Conditions and the Relevance of the Competitive Model The competitive model may offer predictions that are at least partially contradicted by evidence but it does not mean that it is irrelevant, especially in the long run. The major difference between the competitive and monopsonistic models is the assumption about employee mobility costs.

5.2 Frictions on the Employer Side of the Market Categories of Quasi-Fixed Costs The frictions on the employer side of the market cause firms to bear “quasi-fixed costs” that are difficult to cut in the short run. Quasi-fixed costs fall into two categories: investments in their workforce and certain employee benefits. Labor Investments Costs of hiring replacements such as advertising the position, screening, interviewing, “wine and dine”, and terminating – severance pay, and (2) Costs of formal or informal training – firms incur explicit and implicit costs of training employees.

Table 5.2 The Marginal Product of Labor in a Hypothetical Car Dealership (Capital Held Constant)

5.2 Frictions on the Employer Side of the Market Employee Benefits Workers also receive other fringe benefits in addition to their wage and salary earnings. These other benefits fall under the following categories: (1) legally required payments such as social security, workers’ compensation, and unemployment insurance retirement – defined benefit plans depend on years of service years, and defined contribution plans (3) Insurance – medical and life (4) Paid vacations, holidays, and sick leave (5) Others See Table 5.3, p.149 for these categories.

Table 5.3

The Employment/Hours Trade-Off 5.2 Frictions on the Employer Side of the Market The Employment/Hours Trade-Off The fact that certain labor costs (quasi-fixed costs) are not hours-related, while others are, will lead employers to think of “workers” and “hours-per-worker” as two substitutable inputs in the production process, therefore, L is divided into: Number of “workers” hired – denoted as M (b) “Hours-per-worker” on the average – denoted as H. Then, let: MPM = ∆Q/∆M|K and H constant → added output associated with each added worker. MPH = ∆Q/∆H|K and M constant → added output generated by increasing average hours per worker.

5.2 Frictions on the Employer Side of the Market Determining the Mix of Workers and Hours Using the profit-maximizing level of employment:

Figure 5.6 The Predicted Relationship between MEM /MEH and Overtime Hours If MEM > MEH : This will lead to ↑ H and ↓ M because of the quasi-fixed costs incurred in hiring more M. Conversely, if MEM < MEH : This will lead to ↑ M (use more contingency workers with no benefits) and ↓ H.

Policy Analysis: The Overtime Pay Premium 5.2 Frictions on the Employer Side of the Market Policy Analysis: The Overtime Pay Premium The Fair Labor Standards Act requires that employees covered by the act (hourly paid, nonsupervisory workers) receive an overtime pay premium of at least 50 percent of their regular hourly wages for each hour worked in excess of 40 hours per week. Employers who regularly schedule overtime do so because it is cheaper than incurring the quasi-fixed costs of employing more workers. In fall 2004, the U.S. Department of Labor introduced several controversial revisions to federal overtime regulations that redefined which jobs are exempt from coverage.

Overtime and Spreading the Work 5.2 Frictions on the Employer Side of the Market Overtime and Spreading the Work The time-and-one-half requirement for overtime protects workers by “spreading the work” (creating more job openings) through reduced usage of overtime. If firms eliminate overtime and hire more workers at the same base wage rate, their labor costs will clearly rise, thus reducing the scale of output and increasing firms’ incentive to substitute K for L. Even if base wages are not changed, it is unlikely that all the reduced overtime hours will be replaced by hiring more workers.

5.2 Frictions on the Employer Side of the Market Overtime and Total Pay Many overtime hours are regularly scheduled with the possible mutual agreement between the employees and employers on a “package” of weekly hours and total compensation. Employers could respond to a legislated increase in coverage by reducing the straight-time salary such that with the new overtime payments considered, total compensation per worker remained unchanged. A study of the effects of overtime premiums in the U.S. found evidence that base wages adjust to mandated changes and that the legislated expansions in overtime coverage have had no measurable effect on overtime hours worked.

5.3 Training Investments Recall that employer-provided training is part of the quasi-fixed costs of hiring workers. The Training Decision by Employers Employers incur explicit and implicit training costs if the decision is to train a worker after hiring. During training, Coststraining > MRPL, therefore, training will be undertaken if the employer believes it can collect returns after training: (1) increased worker productivity (↑MRPL more than W), (2) reduced turn-over – employee stays longer with the firm.

5.3 Training Investments The Types of Training At the extreme, there are two types of training that employers can provide: general training and specific training. General Training – Teaches workers skills that can be used to enhance their productivity with many employers – skills are easily transferable – thus paying for general training can be a risky investment for an employer. Specific Training – Teaches workers skills that increase their productivity only with the employer providing the training – skills are firm-specific and not transferable – thus employers have stronger incentives to invest in specific training.

5.3 Training Investments Training and Post-Training Wage Increases The best way to provide incentives for on-the-job (OJT) is for employees and employers to share the costs and returns of the investment in training. If employees bear part of the training costs, post-training wage can be increased more than if employers bear all the training costs. Employers can recoup training costs by not raising the post-training wage too much – a point confirmed by empirical evidence – see Figure 5.7, p. 157. Increased post-training wage may protect employers’ investment by reducing the chances that the trained workers will quit.

Figure 5.7 Productivity and Wage Growth, First Two Years on Job, by Occupation and Initial Hours of Employer Training

5.3 Training Investments Layoffs Employer Training Investments and Recessionary Layoffs Employers will invest in OJT of its workers as long as: MRPL|after training > W |after training. If due to a recession, MRPL|after training is barely greater than W |after training, the employer will not layoff its trained employees, particularly, those workers with specific training and the longest job tenure. Employers cannot recoup training costs from laid-off workers/employees who obtained specific training. If MRPL|after training < W |after training and a recession is prolonged, employers may have no choice but to layoff workers because it is profitable to do so.

5.4 Hiring Investments The Use of Credentials Firms bear the hiring and training costs of workers, thus, it is in their interests to reduce costs through effective evaluations when making hiring-placement-promotion decisions. The Use of Credentials Firms rely on credentials or signals to determine workers’ trainability (fast learners vs. slow learners) and potential MPL. (a) Are college graduates (CG) more productive than high school graduates (HSG)? (b) If yes, there is no need to waste valuable resources in interviewing and testing all candidates (CG and HSG) to find out their respective MPLs. Firms use educational standard to screen applicants and such use of credentials to judge group characteristics can lead to statistical discrimination – with obvious costs.

5.4 Hiring Investments Internal Labor Markets Internal labor markets(ILM) exist or firms create them because they cannot ascertain workers’ personal attributes (dependability, motivation, honesty, and flexibility) based on interviews, employment tests, or even recommendations of former employers. Firms fill job vacancies with employees from within (ILM) because they know more about their current employees than those from outside – firms can make better decisions. Hiring within the ILM may not be economically efficient and cost effective, but it fosters workers’ attachment to the firms. Firms that invest heavily in specific training use ILM.

5.4 Hiring Investments How Can the Employer Recoup Its Hiring Investments? Firms/Employers can recoup their hiring investments by hiring only those employees whose productivity would be higher than the average productivity. Firms can recoup their hiring investments by paying a wage that is higher than the average wage but still less than the workers’ marginal productivity: MRPL| after training > W > Waverage Paying W > Waverage, high mobility costs, and the fact information obtained about a worker by a particular employer may not be relevant across employers, the employee is more likely to remain longer with its employer.