1 Chapters , , 18.1, 18.2: Input & Labor Markets, Wages & Rent

2 Input Demand Curve of a Competitive Firm Input demand shows the total quantity of the input that will be demanded at various prices Input demand will depend on the marginal value product (MVP), which is the extra revenue a competitive firm receives by selling the additional output generated when employment of an input is increased by 1 unit –For a competitive firm, MVP = MP L * P (this is b/c output price is constant for a competitive firm) –It makes sense for a firm to hire to the point where MVP = w, w = MP L *P and therefore w/MP L = P

3 Competitive Firms Demand for Labor: All Inputs Variable When all inputs are variable, an input’s MVP curve shifts with changes in the employment of other inputs –A lower wage rate causes the firm to substitute toward labor and away from capital Input demand is a “derived demand” reflecting the fact that industry demand for an input ultimately derives from consumers’ demand for the final product produced by that input Labor Capital E2E2 E E1E1 New expansion path IQ 2 IQ 1 Z1Z1 Z’ A1A1 A A’ Output Substitution Effect Output Effect q1q1 q2q2 0 P3P3 E E1E1 E2E2 Dollars per unit MC MC’

4 Competitive Industry Demand for Labor A C B d (P = $100) d’ (P = $80) $300 = w $200 = w’ The firm Wage Labor A’ C’ B’ ∑ d (P = $100) ∑ d’ (P = $80) $300 = w $200 = w’ The market Wage Labor 2,0002,7003,0000 D

5 Elasticity of an Industry’s Demand Curve for an Input Elasticity of input demand is the sensitivity of input demand to changes in input cost = (%  input demand)/(%  input cost) Four major determinants of the elasticity of an industry’s demand for an input 1.Elasticity of the final product 2.The substitutability of one input for another in production 3.The supply of other inputs 4.Time period

6 Supply of Inputs w2w2 w1w1 Wage Labor (in all industries) L 1 (100,000,000) 0 w2w2 w1w1 Wage Labor (in software programming industry) L 1 (5,000) 0L 2 (15,000) S S

7 Equilibrium in Input Markets s d Laborl (500) 0 Wage $300 = w DADA Labor L A (500) 0 Wage $350 = w’ A S D LaborL (10,000) 0 Wage $300 = w The firm The industry $250 = w 1 L 0 (6,000) L 1 (12,000) The Equilibrium Wage and Employment Level for a Competitive Industry Aerospace industry $400 = w A SS A SS’ A Input Price Equalization Across Industries L’ A (700) s DTDT Labor L T (800) 0 Wage $300 = w T Telecommunications industry $350 = w’ T SS T SS’ T L’ T (1,000)

8 Income Leisure Choice of the Worker Weekly Income A Y2Y2 $800 = Y 1 B E G F $20 1 hr. U1U1 U3U3 U2U2

9 Supply of Hours of Work $25 1 hr. $25 1 hr. $20 1 hr. Weekly Income A’ H A 0 L3L3 L1L1 L2L2 H’Z U2U2 U1U1 E’ E E1E1 S I TE Leisure

10 A Backward Bending Labor Supply Curve? L2L2 L3L3 L1L1 $30 1 hr. $25 $20 A A’ A’’ Weekly income 0 Z Leisure E’’ E’ E Hourly wage $30 $25 $20 E’’ E’ E Labor ZL 1 ZL 3 ZL 2

11 Why Do Wages Differ? If wage rates differ across occupations and there is free entry and exit from/into occupations, shouldn’t we see individuals leave the low wage occupation (shifting supply to the left) and enter the high wage occupation (shifting supply to the right), equalizing wages across occupations. So why do wages differ across individuals and occupations? 1.Compensating wage differentials 2.Differences in human capital 3.Differences in ability

12 Minimum Wages Wage $5.15 $ L2L2 L1L1 L3L3 Unskilled Labor Wage $5.15 $ L2L2 L1L1 L3L3 Unskilled Labor S D S D

13 Burden of Social Security Tax Social security is financed by a payroll tax composed of two equal-rate levies, one collected from employers and one collected from employees (about 7.6% on each for the first $80K of income), so who really pays for this tax? D D’ = D - T $2 S $10 = w $8 = w’ Total revenue 0 L1L1 Labor Wage D D’ = D - T $2 S $10.00 = w $8.50 = w’ 0 L1L1 Labor Wage $10.50 = w’’