Introduction to Economics: Social Issues and Economic Thinking Wendy A. Stock PowerPoint Prepared by Z. Pan CHAPTER 9 WAGE DETERMINATION AND SUPERSTAR SALARIES Copyright © 2013 John Wiley & Sons, Inc. / Photo Credit: BARTON SILVERMAN/© The New York Times/Redux Pictures

 Explain how buyers in the labor market make hiring and salary decisions  Demonstrate the importance of the value of the marginal product of labor and the marginal cost of labor  Explain why there are pay differences across occupations  Explain why individual salary comparisons are not valid for determining how much society values different occupations Copyright © 2013 John Wiley & Sons, Inc. 2 AFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO:

 In 2001 Alex Rodriguez signed a 10-year contract for $252 million with the Texas Rangers team. In 2011  Tiger Woods ’s earnings were $75 million  Oprah Winfrey ’s earnings were $290 million  Average annual earnings for registered nurses, elementary school teachers, and fire fighters were $67,000, $56,000, and $47,000, respectively Copyright © 2013 John Wiley & Sons, Inc. 3 PAY DIFFERENCES ACROSS OCCUPATIONS

 In the labor market, the demand and supply of labor determines worker earnings and the quantity of labor hired.  Wages and other labor earnings are simply prices that are determined by the market interactions between buyers and sellers of labor. Copyright © 2013 John Wiley & Sons, Inc. 4 THE LABOR MARKET

 The buyers of labor are business firms  Restaurants, accounting firms, banks, school districts, hospitals, and all the other producers of goods and services in the economy.  For superstars: movie studios, sports teams, and those hiring superstars for marketing or endorsement purposes. Copyright © 2013 John Wiley & Sons, Inc. 5 THE BUYERS OF LABOR

The Marginal Cost of Labor is the increase in costs that businesses incur from hiring the worker. Including: wages, costs of advertising, screening and interviewing job candidates, training, related taxes and employee benefits. Copyright © 2013 John Wiley & Sons, Inc. 6 THE MARGINAL COST OF LABOR

The Marginal Benefit of hiring an additional worker depends on the output that you gain by hiring the worker. Described by production function:  A Production Function shows the amount of output that can be produced with different amounts of inputs.  Total Product is the total output produced at a given level of input use. Copyright © 2013 John Wiley & Sons, Inc. 7 THE MARGINAL BENEFIT OF HIRING LABOR

Copyright © 2013 John Wiley & Sons, Inc. 8 AN EXAMPLE OF PRODUCTION FUNCTION

The Marginal Product of Labor (MP L ) is the additional output gained from hiring an additional worker, ceteris paribus. Copyright © 2013 John Wiley & Sons, Inc. 9 MARGINAL PRODUCT OF LABOR

Copyright © 2013 John Wiley & Sons, Inc. 10 MARGINAL PRODUCT OF LABOR

Copyright © 2013 John Wiley & Sons, Inc. 11 MARGINAL PRODUCT OF LABOR

Law of Diminishing Marginal Product Holding other inputs constant, as additional units of an input are added to a production process, at some point increases in total production occur at a decreasing rate. Copyright © 2013 John Wiley & Sons, Inc. 12 LAW OF DIMINISHING MARGINAL PRODUCT

The Value of the Marginal Product of Labor (VMP L ) is the increase in total revenue earned when the firm hires an additional worker. VMP L is equal to the MP L multiplied by the price of the output being produced. VMP L = MP L x P output Copyright © 2013 John Wiley & Sons, Inc. 13 THE VALUE OF THE MARGINAL PRODUCT OF LABOR

Copyright © 2013 John Wiley & Sons, Inc. 14 THE VALUE OF THE MARGINAL PRODUCT OF LABOR

Copyright © 2013 John Wiley & Sons, Inc. 15 THE VALUE OF THE MARGINAL PRODUCT OF LABOR

 Anything that affects labor productivity  Motivation  Human Capital (The acquired skills and knowledge that makes workers more productive)  Access to capital equipment and technology  Price of output Copyright © 2013 John Wiley & Sons, Inc. 16 DETERMINANTS OF MP L AND VMP L

Optimal Number of Workers to Hire In determining the optimal number of workers to hire in order to maximize Java ’s profits, we compare the marginal benefits and marginal costs of hiring each additional worker. Copyright © 2013 John Wiley & Sons, Inc. 17 THE FIRM ’S PROFIT MAXIMIZING HIRING DECISION

Marginal benefits and marginal costs of hiring workers at Java Copyright © 2013 John Wiley & Sons, Inc. 18 THE FIRM ’S PROFIT MAXIMIZING HIRING DECISION

Java’s profits are maximized when hiring 4 th worker Copyright © 2013 John Wiley & Sons, Inc. 19 THE FIRM ’S PROFIT MAXIMIZING HIRING DECISION

 A firm will earn profit whenever it can pay a worker less than his or her value of marginal product of labor.  A firm will break even if it pays the worker a wage equal to his or her VMP L.  So the maximum wage a firm is willing and able to pay a worker = VMP L Copyright © 2013 John Wiley & Sons, Inc. 20 MAXIMUM WAGE TO PAY A GIVEN WORKER

Copyright © 2013 John Wiley & Sons, Inc. 21 FIRM ’S DEMAND CURVE FOR LABOR

Copyright © 2013 John Wiley & Sons, Inc. 22 SUMMARY OF THE PROFIT-MAXIMIZING HIRING DECISION

 The supply of labor comes from workers who sell their time and effort to employers.  The sellers of labor are individuals, like athletes Cristiano Ronaldo and Tiger Woods, actress Cameron Diaz, and you.  Individual sellers of labor face choices about how much to work, who to work for, and how much to invest in their human capital.  Economists assume that individuals make their labor supply decisions based on the goal of maximizing their utility. Copyright © 2013 John Wiley & Sons, Inc. 23 THE SELLERS OF LABOR

Copyright © 2013 John Wiley & Sons, Inc. 24 LABOR MARKET EQUILIBRIUM

Copyright © 2013 John Wiley & Sons, Inc. 25 SHIFTS IN THE DEMAND AND SUPPLY OF LABOR

 Lisa Leslie, Kobe Bryant both top players in their sport.  However, in 2009 Kobe Bryant earned $29 million from the Lakers, while Lisa Leslie earned only $100,000 from the Sparks (the maximum in the WNBA at that time).  Why? VMP L ’s are different! Copyright © 2013 John Wiley & Sons, Inc. 26 THE SUPERSTAR LABOR MARKET

Wage reflects marginal value, not total value of labor Copyright © 2013 John Wiley & Sons, Inc. 27 MARGINAL VALUE VS. TOTAL VALUE OF LABOR

QUESTIONS/DISCUSSIONS Copyright © 2013 John Wiley & Sons, Inc. 28 1)Professional U.S. soccer players earn much less than professional U.S. baseball players. Using economic reasoning, explain why. 2)From an economic perspective, are professional sports players worth their multimillion-dollar salaries? Explain why or why not.

Copyright © 2013 John Wiley & Sons, Inc. 29 KEY CONCEPTS Production function Total product Marginal product of labor Law of diminishing marginal product Value of the marginal product of labor Human capital Profit