Professor K.D. Hoover, Econ 210D Topic 5 Spring Econ 210D Intermediate Macroeconomics Spring 2015 Professor Kevin D. Hoover Topic 5 The Labor Market

Professor K.D. Hoover, Econ 210D Topic 5 Spring Labor Demand Firm’s demand labor. The labor demand curve = inverse relationship between labor demanded and the real wage rate ( w/p ). Aggregate labor demand curve sums labor horizontally and records sum against the average real wage.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Labor Supply People supply labor. Leisure is a good: supply of labor + demand for leisure = 168 hours per week. Opportunity Cost = of any choice is the value of the best alternative choice that it forecloses. Real wage ( w/p ) = opportunity cost of leisure = market price of leisure.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Types of Real Wage Product real wage: o p = price of the good produced for a firm; o p approximated in aggregate by the producer price index (PPI). Consumption real wage: o p = price of bundle of goods consumed by worker; o p approximated in aggregate by the consumer price index (CPI).

Professor K.D. Hoover, Econ 210D Topic 5 Spring Effect of Changes in Real Wage Rates on the Labor Supply and Labor Demand An increase in the real wage: ceteris paribus increases income; An increase in the real wage: ceteris paribus increases the opportunity cost of leisure.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Two Thought Experiments Set up: initially work 20 hours per $15 per hour, generating $300 per week income.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Experiment #1: pure income effect – 1 Wage rate remains constant at $15 per hour, but you receive $20 per week legacy independent of any action – hours of work or level of expenditure. Work more or less?

Professor K.D. Hoover, Econ 210D Topic 5 Spring Experiment #1: pure income effect – 2 normal good = good whose demand rises as income rises; inferior good = good whose demand falls as income rises; if leisure normal, then demand for leisure rises as income rises = supply of labor falls.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Experiment #2: pure substitution effect – 1 Wage rate rises to $16 per hour, but you face lump-sum tax – i.e., one you must pay independent of any action – hours of work or level of expenditure. If you continue to work 20 hours, then you continue to receive $300 per week. Work more or less?

Professor K.D. Hoover, Econ 210D Topic 5 Spring Experiment #2: pure substitution effect – 2 substitution effect = ceteris paribus demand reduced when price of good rises; leisure now more expensive ( w/p higher)  demand for leisure falls; supply of labor rises;

Professor K.D. Hoover, Econ 210D Topic 5 Spring Changes in Real Wage Rates and Labor Supply – Summing Up An increase in the real wage has two effects: Income effect: o reduces supply of labor, if leisure is a normal good; o increases the supply of labor, if leisure is an inferior good; Substitution effect: o increases the supply of labor.

Professor K.D. Hoover, Econ 210D Topic 5 Spring

Professor K.D. Hoover, Econ 210D Topic 5 Spring Participation Earlier question: how many hours? New question: work or don’t work? = participate in labor force or not?

Professor K.D. Hoover, Econ 210D Topic 5 Spring Opportunity Cost of Participation Factors determining opportunity cost: o value of idleness; o costs of working: clothes, transport, childcare; o loses from working: housework left undone; children unattended. Reservation wage = real wage just large enough to counteract the opportunity cost of working.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Participation Rate in the Data

Professor K.D. Hoover, Econ 210D Topic 5 Spring Three Thought Experiments Experiment #1: effect of a tax cut Experiment #2: effect of technological progress Experiment #3: effect of immigration on the labor market.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Are the Luddites Right?

Professor K.D. Hoover, Econ 210D Topic 5 Spring Two Fallacies Lump of labor fallacy = a fixed pool of workers has a fixed amount of work to do. o therefore, technical progress necessarily leads to fewer workers needed and unemployment. Fallacy of composition = what is true of the parts is true of the whole. o therefore, if workers are redundant at a particular firm, they are redundant to the whole economy.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Two Types of Unemployment Voluntary Unemployment = people who choose not to work, because the available real wage is below their reservation wage. Involuntary Unemployment = people who wish to work, and are qualified to work, at the existing real wage, but are not offered jobs.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Unemployment Rate Theoretical: Empirical:

Professor K.D. Hoover, Econ 210D Topic 5 Spring Why Do Real Wages Not Fall in the Face of Involuntary Unemployment? – 1 1. Mismatched Definitions: o Theoretical question:  Do you wish to work at the going wage for work you are qualified to do? o BLS questions:  Are you employed?  If no, are you actively seeking work?  Ignores wage rate and qualifications.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Why Do Real Wages Not Fall in the Face of Involuntary Unemployment? – 2 2. Transitional Unemployment: o In best of times, some people are between jobs. 3. Real-wage Floor: o Minimum wage laws; o Real efficiency-wage rates

Professor K.D. Hoover, Econ 210D Topic 5 Spring Third Type of Unemployment Frictional Unemployment = unemployment that for various reasons persists even at the peak of the business cycle.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Real Wages and Wage and Price Movements Real wages fall whenever wage inflation is less than price inflation. Price Stickiness = failure of wages to fall fast enough to clear the labor market.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Why are Wages Sticky? The Relative Efficiency-Wage Hypothesis o = worker productivity depends on their wage relative to workers in the same or other firms.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Insert Cartoon

Professor K.D. Hoover, Econ 210D Topic 5 Spring Real versus Relative Efficiency-Wage Hypotheses Real EWH: o explains unemployment at the peak of the business cycle; o does not induce nominal price stickiness: firms must adjust w for any change in p. Relative EWH: o explains cyclical unemployment; o induces nominal price stickiness; any rise in prices reduces real wages; o does not imply wages never fall: balance between gains in costs and losses in productivity.

Professor K.D. Hoover, Econ 210D Topic 5 Spring Fairness and Money Illusion At zero price inflation, 5% wage cut seen as unfair ; at 12% price inflation 7% wage rise seen as fair ; both = 5% real wage cut. Money illusion ? Are people too stupid to see the difference? Not necessarily: wage sends signal – boss chooses wage rate; does not choose inflation rate.

Professor K.D. Hoover, Econ 210D Topic 5 Spring A Difficult Fact Rational or not, wage stickiness real. Makes involuntary unemployment possible. A key to business cycles.

Professor K.D. Hoover, Econ 210D Topic 5 Spring END of Topic 5 Next Topic: 6. Aggregate Demand