The Labor Market

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

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

Product and Factor Markets

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

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

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

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

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

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

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”

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

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

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

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

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

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

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

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

The Firm’s Labor Demand Curve 1 Number of Workers Dollars 2 W Firm’s Labor Demand Curve A W 1 B W 2

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

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

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

The Market Demand For Labor

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

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

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

A Change in Technology Complementary Input Substitute Input An input whose utilization increases marginal product of another input Substitute Input An input whose utilization decreases marginal product of another input

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

Introducing a New Input Number of Workers Hourly Wage l d 1 More of a More Complementary of a Input Substitutable Input l d 2 l d 3

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

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

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

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

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

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

Figure 8: The Market Labor Supply Curve

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

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

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

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

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

Short-Run vs. Long-Run Labor Supply 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

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

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

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

Labor Market Equilibrium

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

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

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

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

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

Labor Shortages and Surpluses Quantity of labor demanded exceeds quantity supplied at prevailing wage rate Labor Surplus Quantity of labor supplied exceeds quantity demanded at prevailing wage rate

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

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

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

The Market for College-Educated Labor

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

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