Chapter 5 Quasi-Fixed Labor Costs and Their Effects on Demand

Nonwage Labor Costs hiring and training costs employee benefits These costs make up 20 to 30% of payroll. (See Table 5.2 on page 135)

These nonwage labor costs are important in determining the number of employees hired and the number of hours they work. WHY?

Hiring costs include: advertising positions screening potential employees processing successful applicants To fill a vacancy, Employers spend 15 – 22 hours screening and interviewing less-skilled workers (“1982 survey” cited in Bishop (1993)

Training can be formal or informal

Three types of training costs: Explicit monetary costs - labor costs of individuals used as trainers and materials used in training process Implicit opportunity costs of trainee’s time - lost production while a worker is being trained Implicit and opportunity costs of capital and experienced employees used in training - lost production while a worker is being trained

These costs are incurred in early years of employment and yield returns throughout the term of employment.

One important aspect of training is who bears the cost of the training - - the firm or the worker?

Employee Benefits legally required social insurance contributions –unemployment insurance, workers’ compensation, Social Security, Medicare privately provided benefits –holiday pay, vacation and sick leave, pensions, health and life insurance

Because many of these nonwage costs are costs per worker instead of costs per hour worked, they are considered to be quasi-fixed costs. Once an employee is hired, these quasi-fixed costs don't change, regardless of hours worked.

Hiring and training costs are quasi-fixed because they are associated with each new employee hired and not with the number of hours he or she works.

Insurance premiums are also quasi-fixed.

How do quasi fixed costs affect these decisions: How many workers should the firm hire? How many hours should each employee work? If the firm needs to increase output, should it hire more workers or increase the number of hours worked by each employee?

Let's look at the firm's decision of how many workers to hire (M) and the average number of hours worked each week per employee (H).

Q = f (M,H) Assume MP M > 0 and MP H > 0 but both are diminishing.

Let’s call the marginal expense an employer faces when employing an additional worker ME M. ME M will be a function of both the quasi- fixed labor costs plus the worker’s wage and variable employee benefit costs

Let’s call the marginal expense an employer faces when it decides to increase the average workweek of its employees by one hour ME H. ME H will be equal to the hourly wage and variable employee benefits costs multiplied by the number of workers

To minimize costs, the firm should follow the equi-marginal principle: MP M /ME M = MP H /ME H

Much overtime worked is due to rush orders, deadlines, seasonal demand, etc. However, some of it is regularly scheduled overtime

Why does an employer regularly schedule overtime?

Suppose that a firm is currently maximizing profit and then quasi- fixed costs increase: MP M /ME M < MP H /ME H because ME M increased to restore the equi-marginal principle, the firm must either increase the left-hand side or decrease the right-hand side (or both) because of diminishing marginal product, the left hand side will increase if M is lowered and the right hand side will decrease if H is increased

Suppose government wishes to encourage employers to increase employment and stop using regular overtime. How can it do this? Increase the overtime premium this will increase ME H so that MP M /ME M > MP H /ME H employers will need to either decrease H or increase M (or both)

But, there may be reasons why this does not lead to an increase in employment: Employers may substitute capital for labor scale effects may occur as the price of output increases total labor hours may fall limiting the employment gain for any decline in overtime hours

Hiring And Training Costs Firms worry about not only current MRP L but also future MRP L Contracts with workers are usually long term

We’re going to assume a two- period time horizon firms incur hiring and training costs in the first period which cost Z per worker in real terms (dollar costs/product price) without training the worker's MP L is MP * during training he's not as productive so his MP L is MP 0 (which < MP *) after training, MP L is higher than without training (i.e., MP 1 > MP *) the wage the firm must pay is w 0 in the first period and w 1 in the second period

Figure 5.2 Effects of Training on Marginal Product Schedules

MP * - MP 0 is the implicit cost of the trainee’s time in training

Since a dollar in the future is worth less than a dollar today we must discount the future costs and productivity.

Present value of marginal productivity

Present value of the marginal expense of labor

The profit-maximizing condition is therefore: PVP = PVE

If Z=0 (no hiring and training costs), profit maximization requires that: this implies that the firm can maximize profit by setting MP 0 = w 0 and MP 1 = w 1 in this case, the end result of the two- period model is exactly the same as the one-period model (workers are paid their MP L )

However, Z > 0 implies that the firm has made some sort of initial investment in terms of hiring or training costs. Thus, the firm will want to recoup these costs in the future.

The Net Expense of Hiring a Worker in the Initial Period: this is likely to be positive because the amount that the firm spends on the worker in the initial period (w 0 + Z) is likely to be greater than the worker’s productivity in the initial period (MP 0 )

In order to recoup the net expense, the firm must run a net surplus in the next period Note that the net surplus must be discounted because it occurs in the second period.

The Net Surplus Is Defined As:

To maximize profits, net expense in the initial period must equal the surplus from the subsequent period:

Note that wages may not always be equal to MP If net expense > 0 then net surplus > 0 this implies W 1 < MP 1 if the firm's labor costs in the first period exceed MP then wages in the second period will be less than MP

What determines who pays for the costs of training? It depends on what type of training is received there are two types of training: general training and specific training

General training increases a worker's productivity to many employers equally.

Specific training increases the worker's productivity only at the specific firm.

Suppose the firm offers general training and incurs net costs NE 0 : the training increases productivity to MP 1 in the second period but, to maximize profit, the firm must keep w 1 < MP 1 to get a net surplus the worker’s MP=MP 1 to other firms so they would be willing to pay him a wage= MP 1 so the worker can earn w 1 < MP 1 if he stays with the firm or he can earn w 1 = MP 1 at other firms what will the worker likely do?

Will a firm offer general training? Who will have to pay?

Specific training: increases the worker's productivity only at the specific firm to MP 1 at all other firms, the worker is only worth MP * the firm has an incentive to pay the worker at least MP * (what other firms are willing to pay) but less than MP 1 (to recoup some of the costs of training)

Let’s do an example: Assume: the worker has a MP = MP* without training the worker can obtain w= w* = MP* at all firms without training during specific training the worker’s MP falls to MP 0 and then after training MP rises to MP 1 > MP*

Graphically: Period 0Period 1 w* = MP* MP 0 MP 1

How will the firm set wages? It must meet three conditions: to maximize profit, the firm must not incur wage and training expenses that exceed the value of the worker’s productivity to attract workers, the firm must offer a wage stream whose present value is at least as large as alternative firms to keep workers after training, the firm must pay a wage greater than w*

What will the wage structure look like? Period 0Period 1 w* = MP* MP 0 MP 1 w0w0 w1w1 Employees and firms share the costs of specific training

Oi used the idea of quasi-fixed costs to explain the following: occupational differences in the stability of employment and earnings the uneven incidence of unemployment the persistence of differential labor turnover rates discriminatory hiring and firing policies

Suppose that there is a decrease in product demand a scale effect causes a decrease in the demand for all variable inputs however, the decreases in demand will not be the same proportion for each input

With reduced demand for variable factors, there is an increase in the relative employment of fixed factors. This means that the firm now employs too much of the fixed factor and wishes to substitute this fixed factor for the variable factor.

Variable factors that can be more easily replaced by fixed factors will experience the greatest decrease in demand due to the drop in product demand.

The more the firm invests in its workers, and the more specific the training, the greater the degree of fixity of that worker.

A decline in the demand for the product is reflected in a decrease in the price of the product (P*) this will lead to a decrease in the demand for factors with low degrees of fixity this decrease occurs through a decline in the MRP L from the reduction in P (remember that MRP L = P * MP L ) The higher the degree of fixity, the smaller the decrease in the demand for the factor

Why are some workers more at risk for facing layoffs than others? Since firms want to gain a surplus in the second period, they will not want to lay off workers with high degrees of fixity this is true because the firm would have more to lose (i.e., training costs incurred in the first period) if these workers take a job at another firm

If training is general, then the degree of fixity is lower than if training is specific.

Workers with general training are paid a wage equal to MRP L MRP L W=MRP Gen MRP L w

Workers with specific training are paid a wage lower than MRP L MRP L W<MRP Sp MRP L w MRP Sp The 3rd worker produces $7 worth of output and is paid $4

For general training w=MP L. Thus, a decrease in demand results in decrease in the quantity of labor hired.

General Training MRP L W=MRP Gen MRP W

General Training MRP L W=MRP Gen MRP W MRP L ’ Decrease in demand

General Training MRP L W=MRP Gen MRP W MRP L ’ Decrease in demand Employment drops from 6 to 4

For specifically trained workers, the quasi-fixed costs create a gap between wage and MP L that cushions the workers from layoffs over the business cycle.

Firms hoard the workers with high degrees of fixity and have them do lower level jobs. So when the demand for labor shifts we get the following:

Specific Training MRP L W<MRP Sp MRP W MRP Sp

Specific Training MRP L W<MRP Sp MRP W MRP Sp Demand decreases MRP L ’

Specific Training MRP L W<MRP Sp MRP W MRP Sp Demand decreases MRP L ’ 3 workers are still employed because w < MRP sp

How Do Minimum Wage Laws Affect Training?

Minimum wage laws may prevent workers from receiving initial general training since the firm cannot have the workers pay for the training through a lower wage.

If minimum wage laws prevent employers from lowering the training-period wage much, employers will not be able to offer a second- period wage that is high enough to keep workers from looking elsewhere for a job. Employers will be reluctant to invest in specific training if they believe that the worker will leave after training

Hiring Investments

Firms wish to get the best possible work force at the lowest cost. They want workers who are high quality and fast learners. But, investigating the skill levels of workers can be expensive.

Firms rely on credentials or signals in the hiring process an example of this is a requirement that applicants have a college degree instead of a high school degree the use of the degree as a signal assumes that college degree holders are more productive workers than those without a college degree

Firms that require a college degree do not have spend anytime (or money) investigating any high school applicants other signals may include age and marital status

This is called statistical discrimination judging an individual by his group’s characteristics there are potential costs to using these signals -- the firm may miss out on some good workers (who don’t have the correct signal) or may get lemons (who do have the correct signal)

Why are older workers not given the same preference as prime age workers for better paying jobs? prejudice may be a cause however, this could result from a firm’s desire to avoid losses on hiring and training investments firms will not want to train applicants who are close to retirement age

Women tend to enter the labor force and leave the labor force more often than men. The average white woman ages 25 to 59 is 15 times more likely to go from having a job to being out of the labor force in any one month period than a comparable male worker. The average length of job tenure for males is twice that of women.

If tenure is shorter, then the firm will have a lower chance of recouping a worker’s training costs. employers have economic incentives to hire employees who will remain in the labor force when high hiring and training costs are involved

Individuals within a group vary considerably, so using individual characteristics to estimate tenure may be problematic and probably does a disservice to many members of that group.