1. R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN FIFTH EDITION © 2015 Pearson Education, Inc.

2. 2 Chapter Outline and Learning Objectives 17.1The Demand for Labor 17.2The Supply of Labor 17.3Equilibrium in the Labor Market 17.4Explaining Differences in Wages 17.5Personnel Economics 17.6The Markets for Capital and Natural Resources CHAPTER 17 CHAPTER The Markets for Labor and Other Factors of Production

3. 3 © 2015 Pearson Education, Inc. How Different Is Labor? Labor markets are important to understand, because most people gain most of their income from their labor. Labor market decisions are among the most important that people make. In labor markets, firms are buyers, and workers are sellers. Does this make much of a difference? Do workers behave just like other sellers? Can we explain why different workers are paid different amounts? In this chapter, we will explore these questions, and more.

4. LEARNING OBJECTIVE 4 © 2015 Pearson Education, Inc. The Demand for Labor 17.1 Explain how firms choose the profit-maximizing quantity of labor to employ.

5. 5 © 2015 Pearson Education, Inc. Apple’s Demand for Workers Suppose Apple wants to hire some workers to make iPhones. It does this not because it has a preference for hiring workers, but because it seeks to maximize profit by hiring the right number of workers. Apple’s demand for workers is a derived demand: like the demand for other factors of production, it depends on the demand for the good the factor produces. Apple’s demand for workers depends on: 1.How many additional iPhones Apple can produce if it hires an extra worker 2.The additional revenue Apple receives from selling the additional iPhones

6. 6 © 2015 Pearson Education, Inc. Effect of Increase in the Number of Workers Assume that Apple is a price-taker, in the market for labor (plausible) and in the market for smart phones (less plausible). Then as Apple increases the number of workers: 1.Apple sells more iPhones. 2.Apple receives more revenue ($200 per phone). 3.Apple’s wage bill goes up. 4.Profit goes up or down, depending on whether 2. or 3. is greater. The marginal revenue product of labor and the demand for labor (table) Figure 17.1 Number of Workers Output of iPhones per Week LQ 00 16 211 315 418 520 621 Marginal Product of Labor (iPhones per week) MP ̶ 6 5 4 3 2 1 Product Price Marginal Revenue Product of Labor (dollars per week) PMRP = P × MP $200 ̶ 200$1,200 2001,000 200800 200600 200400 200 Wage (dollars per week) W $600 600 Additional Profit from Hiring One More Worker (dollars per week) MRP – W ̶ $600 400 200 0 –200 –400

7. 7 © 2015 Pearson Education, Inc. Marginal Product of Labor The additional output a firm produces as a result of hiring one more worker is known as the marginal product of labor. Ultimately, the firm cares about the money it will receive, so it calculates the change in its revenue from hiring an additional worker: marginal revenue product of labor (MRP). Apple is selling each additional iPhone for the same price; so MRP = P x MP The marginal revenue product of labor and the demand for labor (table) Figure 17.1 Number of Workers Output of iPhones per Week Marginal Product of Labor (iPhones per week) Product Price Marginal Revenue Product of Labor (dollars per week) Wage (dollars per week) Additional Profit from Hiring One More Worker (dollars per week) LQMPPMRP = P × MP WMRP – W 00 ̶ $200 ̶ $600 ̶ 166200$1,200600$600 21152001,000600400 3154200800600200 4183200600 0 5202200400600–200 6211200 600–400

8. 8 © 2015 Pearson Education, Inc. The Optimal Number of Workers The summary table suggests that hiring 4 workers will maximize profits; and so it does. This echoes the MC = MR rule for output: the wage is the marginal cost of hiring workers, and MRP is the marginal revenue. The marginal revenue product of labor and the demand for labor (table) Figure 17.1 Number of Workers Output of iPhones per Week Marginal Product of Labor (iPhones per week) Product Price Marginal Revenue Product of Labor (dollars per week) Wage (dollars per week) Additional Profit from Hiring One More Worker (dollars per week) LQMPPMRP = P × MP WMRP – W 00 ̶ $200 ̶ $600 ̶ 166200$1,200600$600 21152001,000600400 3154200800600200 4183200600 0 5202200400600–200 6211200 600–400 When …The firm … MRP > W,should hire more workers to increase profits. MRP < W,should hire fewer workers to increase profits. MRP = W,is hiring the optimal number of workers and is maximizing profits. The relationship between the marginal revenue product of labor and the wage Table 17.1

9. 9 © 2015 Pearson Education, Inc. Finding the Optimal Number of Workers Graphically We can graph the MRP. It is the firm’s demand curve for labor. The profit-maximizing number of workers comes at the quantity of labor where the wage hits the MRP curve. If the wage changed, so would the profit-maximizing number of workers to hire. The marginal revenue product of labor and the demand for labor (graph and partial table) Figure 17.1 Number of Workers Marginal Revenue Product of Labor (dollars per week) Additional Profit from Hiring One More Worker (dollars per week) LMRP = P × MP MRP – W 0 ̶̶ 1$1,200$600 21,000400 3800200 46000 5400–200 6200–400

10. 10 © 2015 Pearson Education, Inc. The Market Demand Curve for Labor At each wage, we can determine the number of workers firms want to hire; summing across firms gives the market quantity of labor demanded at that wage. Doing this for each wage in turn will reveal the market labor demand curve. In forming this curve, we must keep all other variables (price of output, abilities of workers, etc.) constant; changes in these would cause the entire labor demand curve to move. We will examine these changes over the next two slides, thinking about each effect in isolation.

11. 11 © 2015 Pearson Education, Inc. Factors That Shift the Demand Curve for Labor 1.Increases in human capital Human capital is the accumulated training and skills that workers possess. Better workers produce more, increasing their MRP and increasing demand for workers. 2.Changes in technology Improvements in technology allow workers to be more productive, shifting the labor demand curve to the right. 3.Changes in the price of the product A higher price increases MRP, shifting labor demand to the right; a lower price decreases MRP, shifting labor demand to the left.

12. 12 © 2015 Pearson Education, Inc. More Factors That Shift the Demand Curve for Labor 4.Changes in the quantity of other inputs Workers can typically produce more if they have more machinery and other inputs available to them. Increases in the quantity of these inputs tend to increase the productivity of workers, increasing the demand for labor. 5.Changes in the number of firms in the market Increasing the number of firms increases the demand for labor; decreasing the number of firms decreases the demand for labor.

13. LEARNING OBJECTIVE 13 © 2015 Pearson Education, Inc. The Supply of Labor 17.2 Explain how people choose the quantity of labor to supply.

14. 14 © 2015 Pearson Education, Inc. An Individual’s Labor Supply Curve Individuals have a limited amount of time. Labor economists assume they divide that time between labor (working) and leisure (not working). As the wage rate increases, leisure becomes expensive relative to consumption, so individuals consume less leisure—that is, they work more. This is related to the substitution effect from chapter 3. The labor supply curveFigure 17.2

15. 15 © 2015 Pearson Education, Inc. A Backward-Bending Labor Supply Curve If the wage gets very high, increases in the wage may cause an individual to work less instead of more. Example: If a musician can make $5,000 per concert, she may perform 50 concerts per year. But if she can make $50,000 per concert, she may choose to perform fewer concerts—say, 20. In this case, the income effect of the wage rate change is stronger than the substitution effect. A backward-bending labor supply curve Figure 17.3

16. 16 © 2015 Pearson Education, Inc. The Market Supply Curve of Labor While individual labor supply curves might bend backward, we will assume that market supply curves of labor do not. Why? We are examining single labor markets, like the market for fast food workers. As the wage paid to fast food workers rises, more people want to work in fast food, compared with the alternatives (not working, or working in a comparable industry).

17. 17 © 2015 Pearson Education, Inc. Factors That Shift the Market Supply Curve of Labor 1.Changes in population Increases or decreases in the number of available workers (due to changes in birth/death rates, or immigration/emigration) will increase or decrease the supply of labor. 2.Changing demographics Aging populations change the number of people available for work. Similarly, the role of women in the labor force has changed significantly over the last century: 21% of women were in the labor force in the U.S. in 1900; today, the figure is 60%. 3.Changing alternatives The availability and attractiveness of jobs in other competitive labor markets change the labor supply in whatever labor market we are currently considering. Similarly, the availability of unemployment benefits might decrease the labor supply.

18. LEARNING OBJECTIVE 18 © 2015 Pearson Education, Inc. Equilibrium in the Labor Market 17.3 Explain how equilibrium wages are determined in labor markets.

19. 19 © 2015 Pearson Education, Inc. Equilibrium in the Labor Market As in other markets, equilibrium in the labor market occurs where the demand curve for labor and the supply curve of labor intersect. Bear in mind that this is usually a particular labor market, like the market for economics tutors or the market for fast food workers. Equilibrium in the labor marketFigure 17.4

20. 20 © 2015 Pearson Education, Inc. An Increase in Labor’s Productivity Suppose that workers become more productive. Firms find that hiring workers is more profitable at any given wage; so they increase their labor demand. The result is more employment in this labor market, and a higher wage. The effect of an increase in labor demand Figure 17.5

21. 21 © 2015 Pearson Education, Inc. Making the Connection Why Do College Graduates Earn More? It is common knowledge that college graduates earn more than non- graduates. But why? It may be because college teaches useful job market skills, but there are other possible reasons too. One possibility is that college completion serves as a signal. Employers have a hard time finding out who will be a diligent and hard- working employee. College is easier to complete for people who are naturally diligent and hard-working, so if you complete college, employers infer that you have these qualities.

22. 22 © 2015 Pearson Education, Inc. An Increase in Population Suppose that currently, there are not very many people qualified to be software engineers relative to the demand; so the wage will be very high. With the wage being so high, many people will train to be software engineers, increasing the supply of labor in this market. Over time, the wage of software engineers will decrease, and employment will increase. The effect of an increase in the labor supply Figure 17.6

23. 23 © 2015 Pearson Education, Inc. Making the Connection Veterinarians Fall Victim to Demand and Supply A decrease in the number of dogs and cats in the United States has caused a decrease in the demand for veterinary services, and hence veterinarians. However the supply of veterinarians has continued to rise; vet schools produce 2,500 graduates per year. Average incomes have consequently fallen. The situation is even worse for new vets, who averaged earning $46,000 in 2013.

24. LEARNING OBJECTIVE 24 © 2015 Pearson Education, Inc. Explaining Differences in Wages 17.4 Use demand and supply analysis to explain how compensating differentials, discrimination, and labor unions cause wages to differ.

25. 25 © 2015 Pearson Education, Inc. Why Do Baseball Players Earn More Than Professors? Major League Baseball players earn over $3m per year, while college professors earn a little over $80,000 per year on average. Is this explained by differences in the relative demand, or in the relative supply in these markets? Many fewer people have the skills required to play MLB than have the skills required to be college professors. The wage differential is better explained by differences in supply. Baseball players are paid more than college professors Figure 17.7

26. 26 © 2015 Pearson Education, Inc. Should Baseball Players Earn More Than Professors? Is such a large wage differential justified? Economists (even economics college professors!) say “yes”. The marginal revenue product of a college professor is relatively low: hiring an additional professor allows just a few more students to be taught. But a highly skilled baseball player will increase attendance, TV viewership, and merchandise sales by a value of millions of dollars compared with a “replacement” player—a very high MRP indeed. Baseball players are paid more than college professors Figure 17.7

27. 27 © 2015 Pearson Education, Inc. Making the Connection Technology and the Earnings of “Superstars” In most areas of sports and entertainment, the highest-paid performers—the “superstars”—now have much higher incomes relative to other members of their professions than was true a few decades ago. Are they better performers now? In one sense, yes: improvements in technology allow the exploits of superstars to be enjoyed by more people that ever before. Thus the benefit provided by these superstars is higher; and the marginal revenue product (MRP) of a superstar compared with a mere “star” is magnified.

28. 28 © 2015 Pearson Education, Inc. Compensating Differentials If a job is unpleasant or dangerous, employers will generally have to pay workers more. This is a compensating differential: a higher wage that compensates workers for unpleasant aspects of a job. Example: Dynamite factory vs. semiconductor factory Assuming that workers are rational and aware of the risks, compensating differentials fully compensate them for the additional risks they take on. So occupational health and safety regulations would not make workers better off; in fact, they might be worse off, since forcing firms to decrease risks to workers will also result in them offering a lower wage.

29. 29 © 2015 Pearson Education, Inc. On the Other Hand… But do workers truly understand the risky nature of their activities? Psychologists argue that people often suffer from cognitive dissonance, viewing themselves as intelligent and rational, and rejecting evidence that contradicts this image: 1.I work in a dynamite factory. 2.I am not stupid. 3.Therefore I must be being adequately compensated for working in this dynamite factory. If people truly act like this, they will consistently underestimate the hazards of their jobs, making bad decisions. Safety and health regulations can protect them from these bad decisions.

30. 30 © 2015 Pearson Education, Inc. Discrimination It is well known that men earn more than women, on average. Also, whites earn more than blacks, who in turn earn more than Hispanics. Are these wage differentials due to economic discrimination? Economic discrimination: Paying a person a lower wage or excluding a person from an occupation on the basis of an irrelevant characteristic like race or gender. Such discrimination would be illegal, violating the Equal Pay Act (1963) and/or the Civil Rights Act (1964). Labor economists estimate that most, but not all, of these differentials can be explained by labor market characteristics. Why do white males earn more than other groups? Table 17.2 Group Annual Earnings White males $56,247 White females 42,171 Black males 39,816 Black females 35,090 Hispanic males 32,516 Hispanic females 29,508

31. 31 © 2015 Pearson Education, Inc. What Explains the Wage Differentials? 1.Differences in education White non-Hispanics are more likely to complete high school than blacks (88% vs. 84%), and to complete college (32% vs. 19%) (figures for men). There are educational quality differences also. This may still reflect some discrimination in access to education. 2.Differences in experience Women spend more time out of the labor force than do men, due to parenting. Such “career interruptions” mean that women often have less job experience than men of the same age. 3.Differing preferences for jobs Women and men tend to select different jobs for themselves. This may be due to discrimination; but it may also be due to preferences, as women select jobs in which career interruptions (say, for childbirth) are less likely to be punished.

32. 32 © 2015 Pearson Education, Inc. Measuring Discrimination In order to determine whether or not discrimination exists, labor economists need to account for the differences illustrated on the previous slide. Other personal characteristics, like intelligence, talent, and work ethic also affect wages. All such characteristics must be taken into account when determining whether or not discrimination exists. This requires relatively advanced statistical analysis; such analyses tend to reveal that discrimination has a small but non-zero effect on wages.

33. 33 © 2015 Pearson Education, Inc. Making the Connection Does Greg Have an Easier Time Finding a Job Than Jamaal? Marianne Bertrand of the University of Chicago and Sendhil Mullainathan of MIT responded to help-wanted ads by sending identical résumés, with the exception that half of the resumes were assigned an African-American-sounding name, and half were assigned a white-sounding name. Their findings showed that, in fact, employers were 50 percent more likely to interview workers with white-sounding names than workers with African- American–sounding names. According to the authors, “differential treatment by race… appears to still be prominent in the U.S. labor market.”

34. 34 © 2015 Pearson Education, Inc. Does It Pay to Discriminate? Suppose there are two airlines, “A” and “B”, each of which pay $1,100 per week to their pilots—the price determined by supply and demand. Now suppose “A” airlines decides to discriminate against women, refusing to hire any female pilots. The supply of available pilots decreases, and “A” airlines is forced to pay its pilots more. Discrimination and wagesFigure 17.8a

35. 35 © 2015 Pearson Education, Inc. Discrimination Leads to Higher Costs Meanwhile, “B” airlines receives a sudden large increase in job applications from now out-of-work female pilots. The wage that “B” airlines can pay to pilots is lower. “B” airlines will make more profit than “A” airlines, since its costs are lower. Employers who discriminate pay an economic penalty; we would expect “A” airlines to eventually go out of business. Discrimination and wagesFigure 17.8b

36. 36 © 2015 Pearson Education, Inc. If This is True, Why Do We Still Have Discrimination? Discrimination originating from employers ought to eventually be eliminated by market forces. What might prevent it from being eliminated entirely? 1.Worker discrimination If white workers, for example, refuse to work with black workers, then black workers can never “get a foot in the door”. 2.Customer discrimination Some customers might have discriminatory preferences; catering to those preferences increases rather than decreases profit. 3.Negative feedback loops If, say, a female lawyer would have a hard time finding a job due to discrimination, then few women would study law; but this would reinforce the men-only nature of the profession.

37. 37 © 2015 Pearson Education, Inc. Labor Unions Labor unions are organizations of employees that have a legal right to bargain with employers about wages and working conditions. Considering average wages, union workers earn more than non- union workers. But unionized jobs may be different from non- unionized jobs. To control for this, labor economists look at industries in which there are unionized and non-unionized labor. Such studies generally find that unions increase workers’ wages by about 10%. Union workers earn more than nonunion workers Table 17.3 Average Weekly Earnings Union workers$943 Nonunion workers742

38. 38 © 2015 Pearson Education, Inc. Overall Effect of Unions The existence of unions may be positive even for non-union workers, as non-unionized firms and industries have to raise wages for workers with unionized firms and industries. Perhaps because relatively few workers in the United States are unionized, labor economists tend not to find much evidence of this effect here. The United States is less unionized than most other high-income countries Figure 17.9

39. LEARNING OBJECTIVE 39 © 2015 Pearson Education, Inc. Personnel Economics 17.5 Discuss the role personnel economics can play in helping firms deal with human resources issues.

40. 40 © 2015 Pearson Education, Inc. How Should Workers Be Compensated? The application of economic analysis to human resource issues at firms is known as personnel economics. An important area of study within personnel economics is how employees ought to be compensated. While many employees are paid straight-time pay, some (like car salesmen) are typically paid commission or piece-rate pay. Suppose there are two car dealerships: one pays a fixed salary, while the other pays commissions. Better salesmen have an incentive to migrate to the commission-based dealership. Paying car salespeople by salary or by commission Figure 17.10

41. 41 © 2015 Pearson Education, Inc. Making the Connection Raising Pay, Productivity, and Profits at Safelite In the mid-1990s, Safelite Autoglass shifted from paying its autoglass installers hourly wages to paying them on the basis of how many windows they installed. Under this new system: Window installations increased 44% Average worker pay rose 9.9% Costs per window installed fell from $44.43 to $35.24 Safelite also kept track of who installed each window, making individual employees responsible for errors discovered later. Error rates fell dramatically, as workers tried harder, and poor workers left the company.

42. 42 © 2015 Pearson Education, Inc. Why Not Pay Everyone a Piece-Rate? The foregoing examples suggest that piece-rate pay is superior to salary. Why do many firms continue to pay salaries? Difficulty measuring worker output Often it is difficult to attribute output to any particular worker, or monitoring output is too costly to be worthwhile. Concerns about quality Workers will maximize whatever is counted and ignore what is not. Worker dislike of risk Piece-rate systems are inherently risky and unpredictable for workers. Some workers will prefer a salary-based system, even if it means lower average pay, in order to avoid risk.

43. LEARNING OBJECTIVE 43 © 2015 Pearson Education, Inc. The Markets for Capital and Natural Resources 17.6 Show how equilibrium prices are determined in the markets for capital and natural resources.

44. 44 © 2015 Pearson Education, Inc. Equilibrium in the Market for Capital Just like we can measure the marginal revenue product of labor, we can measure the marginal revenue product of capital: the change in a firm’s revenue resulting from employing one more unit of capital, like a machine or a piece of equipment. Diminishing returns will lead to the demand curve for capital being downward-sloping. We expect the equilibrium rental price of capital to be equal to its marginal revenue product, at least in the long run. Equilibrium in the market for capital Figure 17.11

45. 45 © 2015 Pearson Education, Inc. The Market for Natural Resources Similarly, we can think about the marginal revenue product of natural resources as the change in a firm’s revenue due to employing one more unit of natural resources. Again, diminishing returns will lead to a downward-sloping demand curve. But is the supply curve upward sloping? Take oil, for example. In principle, there is a fixed supply of oil. However the “supply of oil” describes how much oil is available over some fixed time period; and this amount can adjust in response to the price. Equilibrium in the market for natural resources Figure 17.12a

46. 46 © 2015 Pearson Education, Inc. Economic Rent Not all natural resources work this way. For example, there is a (mostly) fixed supply of land, especially considering only the short run. The equilibrium price received for a factor of production that is in fixed supply is known as the economic rent (or pure rent) of the factor. Equilibrium in the market for natural resources Figure 17.12b

47. 47 © 2015 Pearson Education, Inc. Monopsony Previously we examined the case of monopoly: a market with a single seller of a good or service. A market with a single buyer of a factor of production is known as a monopsony. We usually think of monopsony in remote labor markets. Examples: A 19 th -century West Virginia mining town A small Hawaiian island with a pineapple plantation Just like monopolists will use their market power to increase the price, monopsonists will use their market power to decrease the price: employing fewer workers at a lower wage. Labor unions might be able to offset this monopsony power; for example, in professional sports player markets, player unions negotiate with firms for a particular percentage of revenues to be distributed to players.

48. 48 © 2015 Pearson Education, Inc. The Marginal Productivity Theory of Income Distribution How will the income within society be divided? According to the theories in this chapter, factors of production command their marginal revenue product as a price. Therefore each person will receive income according to the marginal revenue products of the factors of production that individual owns. This idea is known as the marginal productivity theory of income distribution, and it implies that the key to receiving more income is to control access to more, and more valuable, factors of production— including your own labor, of course.

49. 49 © 2015 Pearson Education, Inc. Common Misconceptions to Avoid Marginal product of labor and marginal revenue product of labor sound similar; don’t confuse the two. While individual labor supply curves might bend backward, market labor supply curves do not. Just like ordinary prices, wages are derived from the relative supply and demand of workers. They say more about the scarcity of factors of production, rather than their absolute merit. Although whites and men tend to earn more, wage differentials are not necessarily evidence of discrimination; there are many other factors affecting wages. Profit forces will generally eliminate discrimination in labor markets when the discrimination originates from the employers, but not necessarily when it originates from other sources.