Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 6 Wage Determination and the Allocation of Labor

Theory of a Perfectly Competitive Labor Market

6-3 Perfectly Competitive Labor Market oPerfectly competitive labor markets have the following characteristics: Large number of firms trying to hire an identical type of labor Numerous qualified people independently offering their services Neither firms nor workers have control over the market wage Perfect, costless information and labor mobility

6-4 Market Labor Supply Quantity of Labor Hours Wage rate Though individuals have backward-bending labor supply curves, market supply curves are usually positively sloped over normal wage ranges. High relative wages attract workers away from household production, leisure, or their previous jobs. The height of the market supply curve measures the opportunity cost of using the marginal labor hour in this employment. S The shorter the time period, the less elastic is the labor supply curve.

6-5 Wage and Employment Determination Quantity of Labor Hours Wage rate The equilibrium wage rate W 0 and level of employment Q 0 occur at the intersection of labor supply and demand. An excess demand of Q 2 - Q 1 would occur at a wage rate of W ed. An excess supply of Q 2 - Q 1 would occur at a wage rate of W es. S D Q0Q0 W0W0 W ed Q2Q2 Q1Q1 W es

6-6 Labor Supply Determinants Labor Supply will change if there are changes in the following factors: oOther wage rates oNonwage income oPreferences for work versus leisure oNonwage aspects of job oNumber of qualified suppliers

6-7 Labor Supply Determinants oOther wage rates If wages in other occupations rise (fall), then labor supply will fall (rise). oNonwage income If nonwage income rises (falls), then labor supply will fall (rise). oPreferences for work versus leisure If preferences for work increase (decrease), then labor supply will increase (decrease).

6-8 Labor Supply Determinants oNonwage aspects of job If the nonwage aspects of a job improve (worsen), then labor supply will increase (decrease). oNumber of qualified suppliers An increase (decrease) in the number of qualified workers will increase (decrease) labor supply.

6-9 Labor Demand Determinants Labor Demand will change if there are changes in: oProduct demand oProductivity oPrices of other resources Gross substitutes Gross complements oNumber of employers

6-10 Labor Demand Determinants oProduct demand Changes in product demand that increase (decrease) the product price, will increase (decrease) labor demand. oProductivity An increase (decrease) in productivity will increase (decrease) labor demand, assuming that it does not cause an offset in the product price.

6-11 Labor Demand Determinants oPrices of other resources For gross substitutes, an increase (decrease) in the price of a substitute input will increase (decrease) labor demand. For gross complements, an increase (decrease) in the price of a complement input will decrease (increase) labor demand.

6-12 Labor Demand Determinants oPrices of other resources For pure complements, an increase (decrease) in the price of a complement input will decrease (increase) labor demand. oNumber of employers An increase (decrease) in the number of employers will increase (decrease) labor demand.

6-13 Changes in Labor Demand Quantity of Labor Hours Wage rate Assume that the productivity of workers rises due to computer innovations. This will raise the marginal product and thus shift the labor demand curve to the right (D 0 to D 1 ). The equilibrium wage rate will rise to W 1 and equilibrium quantity will rise to Q 1. S D0D0 Q0Q0 W0W0 D1D1 Q1Q1 W1W1

6-14 Changes in Labor Supply Quantity of Labor Hours Wage rate Assume that the number of working-age immigrants increases substantially. This will shift the labor supply curve to the right (S 0 to S 1 ). The equilibrium wage rate will fall to W 1 and equilibrium quantity will rise to Q 1. S0S0 D0D0 Q0Q0 W0W0 S1S1 Q1Q1 W1W1

6-15 Labor Market Demand & Supply Elasticities oWage Elasticity of Labor Demand Inelastic: very little change in the number of jobs if wages change Elastic: a large change in the number of jobs if wages change oWage Elasticity of Labor Supply Inelastic: very little change in the number of job seekers if wages change Elastic: a large change in the number of job seekers if wages change

6-16 Digression: Labor Supply Elasticity Determinants Key: Are individuals willing & able to enter and exit an occupation if wages either increase or decrease? Elastic Supply: workers are willing & able to enter if wages increase and leave if wages decrease Inelastic Supply: workers are unwilling & unable to enter if wages increase and leave if wages decrease

6-17 Digression: Labor Supply Elasticity Determinants oLabor Supply will be more/less elastic if: Relative wages are low/high Relative training/skills are low/high Training/skills can/can’t be transferred from other occupations Nonwage benefits of the job aren’t/are important Typical jobs require relatively few/many hours per week (Income vs. Substitution Effect)

6-18 Digression: Labor Demand Elasticity Determinants Key: Are employers willing & able to increase or decrease the number of persons hired in an occupation if wages either decrease or increase? Elastic Demand: firms are willing & able to decrease employment if wages increase and increase employment if wages decrease Inelastic Demand: firms are willing & able to decrease employment if wages increase and increase employment if wages decrease

6-19 Digression: Labor Demand Elasticity Determinants oLabor demand will be more/less elastic if Customers do/don’t care about product price Labor costs are a large/small part of total costs Substitutes for labor do/don’t exist Supplies of labor substitutes are ample/scarce

6-20 Equilibrium Changes and the Labor Demand Elasticity oIf labor supply increases and labor demand is inelastic Wages will decrease a lot Employment will increase a little Total wages to workers will decrease oIf labor supply increases and labor demand is elastic Wages will decrease a little Employment will increase a lot Total wages to workers will increase

6-21 Equilibrium Changes and the Labor Demand Elasticity

6-22 Equilibrium Changes and the Labor Demand Elasticity oIf labor demand increases and labor supply is inelastic Wages will increase a lot Employment will increase a little oIf labor demand increases and labor supply is elastic Wages will increase a little Employment will increase a lot oRising labor demand increases total wages and falling labor demand decreases total wages

6-23 Equilibrium Changes and the Labor Supply Elasticity

6-24 Wage and Employment for Firms with Competitive Product & Labor Markets Quantity of Labor Hours Wage rate Assume wages are the only cost a firm hiring in a perfectly competitive labor market is a “wage taker.” Its labor supply curve, S L =MLC=P L, is perfectly elastic at W 0. A firm will hire another worker if the additional revenue the worker generates, marginal revenue product (MRP), is greater than the cost of hiring an additional worker, marginal labor cost (MLC). S L =MLC=P L D L =MRP=VMP Q0Q0 W0W0 The firm maximizes its profits by hiring Q 0 units of labor (MRP=MLC).

6-25 Allocative Efficiency oAn efficient allocation of labor is obtained when society gets the largest possible amount of output from a given amount of labor. oEfficient allocation requires the VMP of labor for each product be equal to the price of labor. oPerfect competition in the product and labor markets creates allocative efficiency.

6-26 Questions for Thought 1. What effect will each of the following have on the market demand for a specific type of labor: (a) An increase in product demand that increases the product price. (b) A decline in the productivity of this type of labor. (c) An increase in the price of a gross substitute of labor. (e) The demise of several firms that hire this type of labor. (f) A decline in the market wage for this type of labor. (d) An increase in the price of a gross complement of labor.

Wage and Employment Determination: Market Power in the Product Market

6-28 Wage and Employment for Firms with Non- Competitive Product Markets Quantity of Labor Hours Wage rate Assume wages are the only cost Because a monopolist faces a downward sloping demand curve, increased hiring of labor and the resulting larger output force the firm to lower its price. Because it must lower its price on all units, its marginal revenue (MR) is less than the price. S L =MLC=P L D C =VMP (MP*P) QCQC W0W0 The firm’s MRP curve (MP * MR) lies below the VMP curve (MP * P), and thus firm hires Q M rather than Q C. D M =MRP (MP*MR) a b c QMQM An efficiency loss of abc results.

Complete the following table for a firm operating in labor market A and product market AA. Questions for Thought LaborWageTLCMLCMRPVMP 1$10$16 2$10$14$15 3$10$12$14 4$10 $12 5$10$8$10 6 $6$8 (a) What can we conclude about the degree of competition in the labor market and product market? (b) What is the profit maximizing level of employment?

Market Power in the Labor Market: the Case of Monopsony

6-31 Monopsony oA monopsony is a labor market where a single firm is the sole hirer of a particular type of labor. A monopsonist has control over the wage rate workers are paid by hiring more or less labor.

6-32 $ 2 $ 6 $12 $20 $30 $42 $ TLC (3) $ 7 $ 9 $ 8 $ 3 (VMP) MRP (5) $ 6 $ 5 $ 4 $ 10 A monopsonist faces an upward sloping labor curve. It has to pay a higher wage to get more workers. The total labor cost (TLC) to the firm is calculated as the number of units of labor times the wage rate (assuming no other costs when hiring). The firm maximizes profits by hiring MRP = MLC at 3 units. The marginal labor cost (MLC) is the additional cost of hiring the last worker. Monopsony MLC (4) --- $ 2 $ 4 $ 6 $ 8 $10 $12 $14 Wage (2) Units of Labor (L) (1) $1.00 $2.00 $3.00 $4.00 $5.00 $6.00 $7.00 $8.00

6-33 Wage and Employment for a Monopsonist Quantity of Labor Hours Wage rate The firm’s MLC lies above the S L. To attract these workers, it need only pay W M. S L =P L QCQC The firm thus pays a lower wage (W M rather than W C ) and hires fewer units of labor (Q M instead of Q C ) than firms in a competitive labor market. D L =MRP=VMP An efficiency loss of abc results. MLC WCWC QMQM WMWM The monopsonist equates its MRP with its MLC at point a and hires Q M units of labor. b a c

6-34 Baseball Free Agency oBefore 1976, baseball players were bound to single teams = monopsony power. In 1976, players could become “free agents” after 6 years oTheory says that pre 1976 players should have been paid far less than MRP Studies confirm, with star pitchers only receiving 21% of their MRPs, bad pitchers receiving 54% and bad hitters receiving 37%.

6-35 After free-agency, market competition reduced monopsony power Wages soared to more closely match MRP

Wage Determination: Delayed Supply Responses

6-37 Cobweb Model The market for highly trained professionals such as nurses has delayed supply responses to changes in demand and wage rates. Q0Q0 W0W0 D0D0 Quantity of Labor Hours Wage rate S Because the quantity of labor supplied is temporarily fixed at Q 0, the wage rate rises to W 1 when demand changes from D 0 to D 1. At wage rate W 1, Q 1 nurses are attracted to the profession. With supply fixed at Q 1, the wage rate falls to W 2. With this wage rate, the quantity of nurses falls over time to Q 2. The cycle repeats until equilibrium is achieved at the intersection of S and D. D1D1 W1W1 W2W2 Q1Q1 Q2Q2

6-38 Evidence oSome evidence exists for cobweb adjustments in markets such as lawyers and engineers. oCritics argue that: Students make choices on the basis of the lifetime earnings stream rather than starting salaries. Students make a forecast of the long-run outcome of a change in demand or supply and make the right choice.