Quasi-Fixed Costs and Labor Demand

Quasi-Fixed Costs Costs that are not strictly proportional to the hours of work and allocated on a per worker basis Non-wage labor costs such as required insurance programs and employee benefits are important components of labor costs. Quasi-fixed costs affect demand for labor but also the nature of that demand, such as the choice between hiring new employees and increasing hours worked of existing employees. Q-F, such as costs of hiring and training, are strategic investment decisions that firms must make.

Non-wage Labor Costs Hiring and Training Costs –Formal versus informal training –Costs of Training Explicit costs Implicit or opportunity cost of the on-the-job trainer Implicit or opportunity cost of the on-the-job trainee –Since many of the costs are implicit they are difficult to measure. Studies cited in text say that 30% of an employees time in the first 3 months are for training. –Tradeoffs between high-wage/low-training and low- wage/high training strategies.

Employee benefits –Legally required benefits –Privately provided benefits –Non-wage benefits are about 30% of total compensation Quasi-fixed costs –Certain benefits are proportional to hours worked most quasi-labor costs are proportional to the number of workers. Workers’ comp. Are strictly proportional Social Security are for most employees Unemployment insurance is less so because it is charged up to a relatively low max. level of income Health insurance and defined benefit retirement plans are per worker

Employment/Hours Tradeoff So far, we have talked about labor as the number of hours worked and ignored the distinction between hiring a new worker and employing an existing worker for more hours. To determine what is the optimal mix of employees versus hours worked we can redefine of profit-maximization and cost-minimization rules. Two marginal products and two new marginal input expenses: –MP M - the marginal product of a new worker assuming that the average work hours remain the same. –ME M – the extra costs associated with hiring and employing a worker given the going average hours worked –MP H – the marginal product of increasing the average amount of hours worked assuming that the number of workers is constant –ME H – the extra costs associated with increasing the average hours worked of existing employees

Optional Mix of Workers and Hours Worked Profit-maximization implies hiring workers and employing them for a average number of hours that satisfy the following conditions: –MRP M = ME M, and –MRP H = ME H Cost-minimization implies hiring workers and employing them for a average number of hours that satisfy the following condition: –ME M /MP M = ME H /MP H

Figure 5.1 The Predicted Relationship between ME M /ME H and Overtime Hours

Now assume that overtime pay is doubled as some lawmakers have suggested as a way to increase employment – ME H ↑ on M and H mix→ Scale effect: ME H ↑ → MC q|H ↑ → Q↓ → H↓, M↓ Substitution effect: (W H /W M ) ↑ → Q constant → H↓, M↑ –But average labor costs would rise, even if no overtime is scheduled because they would have to hire more workers with the associated quasi- fixed costs. These costs must be higher than paying time and a half because otherwise the firms wouldn’t have paid overtime. This causes changes in the L and K mix –ME L ↑ → on L and K mix → Scale effect: ME L ↑ → MC q|L ↑ → Q↓ → L↓, K↓ Substitution effect: (W l /C) ↑ → Q constant → L↓, K↑ Will this increase employment? Perhaps, but there are offsets? –Shift to more capital intensive production –Substitutability might be low if overtime workers are skilled –Employers and employees might reduce straight-time hours to keep overall wage bills the same.

Part-time Employment and Mandated Benefits In the EROP, it was argued that manufacturing job losses were overstated because of domestic outsourcing and part- time employees who are counted as service employment. Temporary help services have growing rapidly accounting for one-fourth of all employment growth in the 1990’s. Those counted as employed part-time in the non-ag sector has doubled in the last 50 years from about 10% to 22%. –Supply-side reasons: increased participation rate of women, phased retirement and students working to finance educations. –The previous analysis of quasi-fixed costs suggest demand-side explanation as well. Britain’s 1975 legislation slowed substitution and sectoral studies in the US indicated that a low ratio of part-time wages to full-time wages results in a higher ratio of part-time employees to full time employees –What would happen if all workers were covered by mandatory health insurance?

Investments in Training and Hiring and the Demand for Labor Training and hiring decision involve costs and benefits and need to be included in understanding the demand for labor. Benefits of training and hiring are primarily higher productivity by increasing human capital, lowering turnover, and increasing motivation and/or effort. Costs of training and hiring include both explicit and implicit costs. –Examples of explicit costs are paying trainers, hiring head-hunters –Examples of implicit costs are lost productivity from on the job training either by the trainer or trainee.

Training and hiring decisions also bring an inter- temporal dimension to the employment decision. The costs of training are usually incurred in the present and their benefits are usually received in the future. The concept of present value. –Since costs and revenues in different time period can’t simply be added together because of the time value of money –Calculation of future value vs. present value –Using spreadsheets to analyze inter-temporal choices

Multi-period Employment Decisions To model inter-temporal employment decisions, the following simplifying assumptions are made: –Two time period – (this year and next year) –Benefit costs are ignored –All workers work for the entire period –Firm’s sell output and hire inputs in competitive markets –Training/hiring costs are incurred in the present and their benefits are received in the future –MP DT <MP * <MP AT OR MP O <MP * <MP 1 –Z are the training costs in real terms –Real wages are paid W DT =W o and W AT =W 1

Figure 5.2 Effects of Training on Marginal Product Schedules

Figure 5.3 Multiperiod Demand for Labor

Remember that we hire workers until the ME L =MRP L PVME L = W 0 + Z + W 1 /(1+r) PVMRP L = MP 0 +MP 1 /(1+r) So the profit-maximizing rule for hire labor in a multi- period model with training costs is: PVME L = PVMRP L or W 0 + Z + W 1 /(1+r)=MP 0 +MP 1 /(1+r) PV of Net Marginal Expenses of training = PVNME T = W 0 + Z - MP 0 (all cost are borne in the first period)

The assumption is that training creates a present expense that is not compensated completely by lower wages. This implies that the present value of net marginal expenses are positive. –PVNME T = (W 0 + Z) – MP 0 > 0 –(W 0 + Z) > MP 0 Profit-maximizing firms subject to competition in output markets cannot make losses. So, the PVNME T must be covered by paying labor less than their marginal product in the future. The present value of the net marginal gain is: –PVNMG T = MP 1 /(1+r) –W 1/ (1+r) = (MP 1 – W 1 ) / (1+r)>0 –MP 1 >W 1

Multi-period Labor Agreements Covering training costs requires that a firm pay less than a worker’s marginal product in the future. Will a worker accept a wage below their marginal product? –Yes, if, W 0 + W 1 /(1+r) > W * + W*/(1+r), where W * is the single period wage –But, when W 0 and W 1 are not the same the worker and the employer may have competing interests that require a formal or informal contract to come to agreement –One can describe various payment plans that tradeoff wages in the present for wages in the future but keep the PV of payments the same. –See table.

Formal versus informal contract: –Formal contracts: employer is more likely to be bound to future payments than the employee is to accept them. –Informal contracts: employees are worried that the employer may break the agreement about future payments. Limitations on multi-period wage offers: –High present wage and low future wage: employer worries that employees may leave. –Low present wage and higher future wage: employees are concerned that the employer may break the agreement. –Without binding contracts on both the employer and employee, the dominant solution, in the absence of credentials or mobility costs, is paying the same wage each period that is equal to the single period wage. –The inability to pay lower wages in the future discourages employers from incurring training costs.

Training and Multiperiod Wage Offers An employer can afford to offer a wage package greater than the single period wage scenario, if training/hiring creates net marginal gains and if the employer is able to capture some of that gain. General versus specific training General training – the employer appears to have little incentive because, in the absence of credentials or mobility costs or the possibility of brokering information, they may not be able to capture a sufficient amount of the net marginal gains. If they attempt to pay a future wage below the employee’s new higher marginal wage, the employee may quit and go elsewhere

Figure 5.4 A Two-Period Wage Stream Associated with Specific Training

Specific Training Because the training is specific to the firm, the employee’s increased productivity is only relevant to the firm. Therefore, employers can recuperate by lower future wages the cost of training and also possibly a surplus in future periods. Two questions arise: –How much training should occur? –How should wages be structured after training?

Wages should be structured to take into account: –Quit rates and costs of mobility As mobility costs decrease the present wage and the future wage would converge to the single period wage. As mobility costs increase the present wage and the future wage would diverge from the single period wage. –Protecting investments – mutual benefit to employees and employers to share the costs of specific training Employees want to increase their wages but reduce the possibility they are fired. –Lower present and future wages encourage firms to train workers. –However, employees do not want to pay all the costs of training, even though they could capture all the future surplus from training, because employers would have no investment in training to protect and the possibility of being let go would increase. Employers must decrease wages to pay for training but also reduce the possibility that employees quit. –Higher present and future wages encourage employees to undertake training and to stay with the firm. –However, if employers bear all the costs the lower future wage they would pay would encourage quitting and the loss of their surplus from the investment in training

Theoretical Implications Layoffs Labor productivity and the business cycle Cases where employers will pay for general training –Mobility costs –Brokering information

Figure 5.5 Productivity and Wage Growth, First Two Years on Job, by Occupation and Initial Hours of Employer Training Source: John Bishop, “The Incidence of and Payoff to Employer Training,” Cornell University Center for Advanced Human Resource Studies Working Paper 94-17, July 1994, Table 1.

Figure 5.6 The Effect of a Decline in Demand on Employment with General and Specific Training

Hiring Investments Credentials Internal labor markets Recouping hiring investments