2. The Labor Market
There isn’t just one labor market because everyone is not qualified to do every job.
Some jobs pay more, some jobs pay less.
As with any market, the various labor markets are governed by the supply of labor and the demand for labor. And the market will determine the price of labor – that is, the wage.
You might wish to review who are the buyers and who are the sellers in a labor market.
It is not intuitive to students that the job applicant is a seller of labor and that the prospective employer is the buyer.

3. Learning Objectives
Know what factors shape labor supply and demand.
Know how market wage rates are established.
Know how wage floors alter labor market outcomes.
We will use these objectives to review the chapter.

4. Labor Supply
Labor supply: the willingness and ability to work specific amounts of time at alternative wage rates in a given time period.
As with any supply of anything, people, in general, will be willing to work more hours if the pay is higher and fewer hours if the pay is lower, ceteris paribus.
In addition to being paid for work, there is also an intrinsic satisfaction one gets from working.
It might be instructive to reiterate market motivations.
Law of demand applies to employers; law of supply applies to employees.

5. Labor Supply
There is value in not working, too. It is called enjoying leisure time.
Economists divide your time into work hours and leisure hours. The two together add up to 24 hours a day.
The opportunity cost of working more hours is the value you place on the leisure hours you give up to work those extra hours.
Another thing not intuitive to students is the labor-leisure trade-off.
Economists identify anything not working as leisure – not the typical concept of leisure.

6. Labor Supply
If you have 24 hours of leisure, taking a job requires you to give up some of those hours.
The opportunity cost of doing so is very low.
As you increase work hours, you must give up leisure hours that are more valuable to you.
As work hours increase, the opportunity cost rises rapidly as leisure hours become more scarce.
You will require a higher wage to compensate for this increasing opportunity cost. This is the basis for overtime pay.
An excellent exercise is to have your students write down their use of time for all the things they do.
Once they figure out how they use a typical day’s 24 hours, impose 2 hours of work in a part-time job. What do they give up?
Increase it to 4 hours, 6 hours, 8 hours. They will see that the opportunity cost of the added hours will increase as they have to give up more and more important tasks.

7. Labor Supply
Therefore, we will supply more labor hours only if offered a higher wage.
The labor supply curve slopes upward.
From a marginal utility (MU) point of view, the first few dollars you earn have a very high MU, but as you work more hours and earn more money, the MU of income may decline.
This reinforces the need for a higher wage to get us to work more hours.
The MU declines because the first few hours working yield dollars that are vitally needed.
As work hours increase, the next dollars earned are a bit less vital. Continue adding work hours, and the MU of the added income continues to decline.
Declining MU of added work, combined with increasing opportunity cost of added work, leads to the need for overtime pay and other inducements to secure added work hours.

8. Labor Supply
At some wage, even more wages may not induce us to work more hours.
In fact, increased wages may induce us to work fewer hours, not more:
Say, each week you earn $10 an hour working 60 hours, or a total of $600. This amount is enough to fund your lifestyle.
Now you are offered a raise to $15 an hour. It is possible you would cut back to 40 hours and earn $600. You increase your leisure time by 20 hours.
This leads into the backward-bending labor supply curve.

9. Labor Supply There are two effects in operation here:
Substitution effect of higher wages: an increased wage rate encourages people to work more hours (substitute labor for leisure).
Income effect of higher wages: an increased wage rate allows a person to reduce hours worked without losing income.
At low wages, the substitution effect dominates; at high incomes, the income effect dominates.
This can be easily demonstrated on the board.

10. Labor Supply The resulting labor supply curve bends backward.
The wage rate where the income effect begins to dominate is where the curve begins to bend backward.
The graph is easily described.

11. Market Supply
The market supply of labor is the collective individual labor supply.
The market supply curve will shift if any determinant changes:
Tastes (for leisure, income, and work).
Income and wealth.
Expectations (of a change in income or consumption requirement).
Prices (of consumer goods).
Taxes.
Just as in a product market, the market supply is the sum of the individual workers’ supply curves.
The bend back will be different for each worker according to that person’s value system.

12. Elasticity of Labor Supply
Consider day laborers or any low-skill job.
How many people are currently qualified to do the work?
Of those, how many are currently available to be hired?
How long is the “pipeline” – that is, the time required to become qualified to do the job?
It is easy to qualify for a low-skill job. Breathing and the willingness to do the work are just about all that is required.
Also, there are usually many more people qualified to do the work than there are jobs available. There is a surplus of qualified workers.
The pipeline to qualify is short, almost zero.

13. Elasticity of Labor Supply
For low-skill jobs, the supply of labor is large and the time to qualify is short.
A very small % increase in the wage rate would generate a large % increase in applicants.
For low-skill jobs, labor supply is highly elastic.
The labor supply curve for this type of market is nearly horizontal.

14. Elasticity of Labor Supply
Consider surgery nurses or any high-skill job.
How many people are currently qualified to do the job?
Of those, how many are currently available to be hired?
How long is the “pipeline” – that is, the time required to become qualified to do the job?
Just the opposite applies here.
The pipeline is long, from entering training until achieving whatever certification is needed.
Once qualified, most workers are already employed in the field. A few might be temporarily out of the market.
Increase demand in this market, and an employer will have to offer a much higher wage to (a) induce those not currently working to reenter the workforce and (b) lure workers from other employers.

15. Elasticity of Labor Supply
For high-skill jobs, the supply of labor is small and the time to qualify is long.
A large % increase in the wage rate would generate a small % increase in applicants.
For high-skill jobs, labor supply is highly inelastic.
The labor supply curve for this market is nearly vertical.

16. Labor Demand
Labor demand: the quantities of labor employers are willing and able to hire at alternative wage rates in a given time period.
Labor demand is not independent. Firms don’t hire just to have people around.
Labor demand is a derived demand – that is, it is derived from the demand for the goods and services being made.
Firms will be willing to hire more workers at low wage rates and fewer workers as wage rates rise.
Firms don’t hire just to have workers hanging around.
Firms increase their hiring when product demand increases. So the worker demand is totally dependent on product demand.
It works backward, too. Decrease product demand and the firm lays off workers.
Finally, the law of demand (last bullet) is in effect.

17. Labor Demand
Labor is a factor input to the process used to generate a salable product.
The value to the firm of an added worker is related to the added sales revenue –marginal revenue (MR) – received when the added output is sold.
The added output a new hire can produce is called marginal physical product (MPP).
Adding a worker increases the ability to produce salable goods.
The ultimate value of that added worker is the revenue received when the added products are sold.

18. Labor Demand
Change in total revenue
Marginal revenue (MR) =
Change in output
Marginal physical product (MPP) =
Change in quantity of labor
Put these two ratios together to get the dollar value of a worker’s contribution to the firm’s output: marginal revenue product (MRP).
The added revenue, therefore, is the change in total revenue per added worker. That’s MRP.
MRP = MR x MPP.

19. Labor Demand
Assume the firm can sell all its output at the market price, so MR = p.
The value of a worker, MRP, is equal to the product of price (p) and marginal physical product (MPP).
Here we are operating in a range where the firm is essentially in perfect competition. The added output is sold at a price p.
Therefore MR=p and MRP = MPP x p.
Change in total revenue
Marginal revenue product =
Change in quantity of labor
MRP = MPP X p

20. Labor Demand
Marginal revenue product (MRP) sets the upper limit to the wage an employer will pay.
MRP is subject to the law of diminishing returns.
As more workers are hired, MPP begins to diminish because capital is fixed in the short run.
As MPP diminishes, so does MRP.
Recall that MRP = MPP X p
MRP is the firm’s demand curve and slopes downward.
Since MPP is subject to diminishing returns, it slopes downward as quantity of output increases.
Therefore, MRP slopes downward and MRP becomes the demand curve for the firm.

21. The Hiring Decision Compare benefit to cost.
The benefit is MRP; the cost is the wage rate.
If MRP > wage (point B), add workers and profit rises.
If MRP < wage (point D), lay off workers and profit rises.
The ideal number of workers exists where MRP = wage (point C), where profit is maximized.
This is a simple application of benefit-cost analysis.
Or you may look at it as a variant of the profit maximization rules.

22. Changing Wages
Lower the wage rate and the firm will hire more workers, and vice versa.
If the wage falls from $4 to $2, one more worker will be hired (point D).
If the wage rises from $4 to $6, one worker will be laid off (point G).
Straightforward.

23. Changing Productivity
Start at point C.
Increase productivity and MRP shifts right (and vice versa).
The firm could hire one more worker (point E) or increase wages (point F).
There might be a problem with a productivity increase (MPP increases).
If product demand does not increase, should the firm hire more workers just because MRP>wage?
Wouldn’t more productive workers produce more goods?
The more logical move is to increase wages. Why? If there is an industrywide increase in productivity, firms will begin to search for the better workers. If your firm does not increase the better workers’ wages, other firms will hire them away from you.

24. Labor Market Equilibrium
The intersection of labor market demand and labor market supply sets the equilibrium wage.
At this rate, the quantity of labor supplied equals the quantity of labor demanded.
Above this rate, there is a surplus of labor.
Below this rate, there is a shortage of labor.
This is a simple use of the market model.

25. Minimum Wage
A government-imposed minimum wage is set at WM, above the market wage of We.
A surplus is created.
Some workers (0 to qd) benefit with higher pay; some lose their jobs (qd to qe); some start looking but can’t find jobs (qe to qs).
The minimum wage is a price floor. All consequences of a price floor apply.

26. Minimum Wage A minimum wage
Reduces the quantity of labor demanded.
Increases the quantity of labor supplied.
Creates a market surplus.
A minimum wage increase makes all three results worse.
The minimum wage applies mainly to the low-skill end of the labor market, so supply is highly elastic. Firms cut jobs at a greater rate than the minimum wage increase.
These are the consequences of a minimum wage.

27. Choosing among Inputs
When deciding whether to hire more labor or to add more capital, a firm will compare the cost efficiency of each.
Cost efficiency: the amount of output associated with an additional dollar spent on an input; the MPP of an input divided by its price (or cost).
The most cost-efficient input is the one that produces the most added output per dollar.
The question here is what mix of resources should be used to make the product.
If labor costs are high and capital costs are low (relative to productivity), the company will shift from a labor- to a capital-intensive process.
Vice versa applies.

28. Choosing among Inputs Compare MPP/P for labor to MPP/P for capital.
If labor is more cost-efficient, add workers and the process becomes more labor-intensive.
In countries where labor is cheap and capital is expensive, work is labor-intensive.
If capital is more efficient, add capital and the process becomes more capital-intensive.
In countries where labor is expensive and capital is cheap, work is capital-intensive.
This is a simple variant of the consumer equilibrium concept.