Chapter 5 Labor Market Equilibrium

2 Competitive Markets (firms and workers can freely enter and exit ) Equilibrium outcome will be efficient  Monopsonies E * ↓, w * ↓ relative to competitive markets Monopolies: Applications: Taxes Subsidies Immigration

3 Equilibrium in a Single Competitive Labor Market Equilibrium: Each firm hires up to the point where No unemployment Anyone who wants to work at w * can Individuals not working are looking for w_w * Firms not finding employees are offering w_w * Realistically, equilibrium will not last because of shocks in modern industrialized nations

4 Competitive Equilibrium Across Labor Markets Labor markets may be differentiated by: Region (north, south, etc) Industry (2 different production industries) Assume: Markets in two regions (north, south) Workers in the two regions have similar skills and can substitute for one another Initially, w s < w n

5 Competitive Equilibrium Across Labor Markets, cont. If workers have full mobility, southern workers will ___________ ____________ where they can earn a higher wage If firms have full mobility, northern firms will _______________ where they can pay a lower wage (not shown) In the end,

6 Competitive Equilibrium Across Labor Markets  Efficiency Efficiency: Also maximizes national income If w s < w n, VMP s _ VMP n since profit-maximizing firms hire up to the point where As workers migrate north, MP n_ and MP s _ until the two are equated, and In the end, ___________________, and profits are maximized

7 Empirical Evidence Do wages equate over time? In the US, there is a strong ____________ correlation between wages and annual growth of wages Roughly 30% of the wage gap between states disappeared over a 30-year period (states with lowest wages had highest growth rate) Similar evidence in Japan, a less mobile country Across countries: “Conditional convergence” Does not apply to the wage gap between the rich and poor countries because countries with lower human capital levels do not grow as rapidly

8 NAFTA: Mexico and the US Mobility of firms should: __crease demand for Mexican workers __crease demand for US workers with similar skills Eventually _______ wages across the two countries Some workers will clearly benefit and some will be harmed, but the total income of the two countries should increase as North America moves to a more __________ outcome

9 Policy Application: Payroll Tax Payroll tax Employers pay a tax on total wage bill Employers who first paid w 1 will now be willing to pay only _____ to E 1 workers _____ward shift of labor demand curve New wage paid to workers: Firms pay _____, because they pay tax t to the government ______ workers hired (E 2 _ E 1 ) Tax burden Firms: Employees:

10 Policy Application: Employee Tax Tax on workers E 1 workers first earned w 1, Workers now demand ______ ______ward shift of labor supply curve New wage is ____ Workers earn _____, because they pay tax t to government _____ workers hired (E 2 _ E 1 ) Tax burden Firms: Employees:

11 Tax policy application: Summary Note that the outcome is the same regardless of who is taxed Employee Tax: w_, so ______ bears the cost by having to ________________ Full amount of tax not recovered for ________ (tax is greater than the wage increase) Payroll Tax: w_, so _______bear the cost by ____________ Full amount of tax is not covered for ___________ by the wage decrease (tax is greater than the wage decrease)

12 Tax with no burden on the firm Assume firm is taxed Assume perfectly inelastic supply With tax, firm is only willing to pay ______ Number of workers ________ _____________ Firm passes entire incidence of the tax onto workers Therefore, a more ________ supply curve passes more tax burden onto employees Recall that labor supply curve for men is inelastic

13 Empirical Example Note: Evidence suggests firms pass approximately 90% of tax burden onto employees Suppose annual income = $30,000 Employee tax = 7.65%  $2295 annually Employer tax = 7.65%  $2295 annually 90% of tax shifted to worker:.9·2295 = $2066 Total employee tax = $ = $4361 annually If $4361 were invested annually at 3%, worker would accumulate $263,675 by age 65 If worker lives to age 80, would need SS benefits of $21,000 annually Average worker only receives $7,200

14 Policy Application: Government subsidy paid to employers Subsidy lowers the cost of hiring workers Firms are willing to pay ______ (s recouped in the form of the subsidy, so in essence, the firm is only paying original wage, w 1 ) New wage paid to worker: __ Cost of employment for the firm: _______ Benefits of subsidy Firm: Worker:

15 Empirical Example Assume: Elasticity of demand = -0.5 Elasticity of supply = 0.3 A 10% subsidy (reduction in hiring costs) would: Increase wage by 4% Increase employment by 2% Gains of a government subsidy may be limited Firms may be unaware of programs Firms may place a stigma on hiring targeted workers and do not hire them even to benefit from employer subsidy programs

16 Noncompetitive Labor Markets: Monopsony So far, competitive firms took p and w as given regardless of E* Recall that perfectly competitive firms face a horizontal demand curve given by the market price Analogously, an individual firm faces a horizontal labor supply curve, given w It can hire as many workers as it long as it pays wage = w Monopsony: Must pay higher wages to attract more workers (p taken as given) Note that all markets have upward-sloping supply curves, but monopsonies are firms that face upward-sloping supply curves Ex: one-company town

17 Perfectly discriminating monopsonist Monopsonist can hire different workers at different wages w 15 for worker 15, w 20 for worker 20, etc. Supply curve = ____ Wage paid for each worker is his ______ ____________ Demand curve = ______ Price is taken as given Firm hires up to the point where _____ ____ (E *,w * ), or where _____ = ______ Same __ as a competitive market, but __ is the wage for the last worker, and all others were paid w _ w *

18 Non-discriminating Monopsonist Monopsonist pays all workers the same wage, regardless of their reservation wages Supply ≠ MC, but MC __creases as E increases S _ MC If the 9th worker costs $7, total labor bill = $63 If 10th worker demands $7.50, total labor bill = $75 MC of the 10th worker is $12, but wage was $7.50 Analogous to D > MR for a monopolist

19 Non-discriminating Monopsonist, cont. Firms hire up to the point where ___ = ____ (E M,w M ) Monopsonist determines wage from _______ curve, not MC E curve Similar to how monopolists choose P from the demand curve, not MR E M _ E C and w M _ w C

20 Monopsony and Minimum Wage Set w min > w M, and firm can hire E * employees MC = w min up to E* employees, then returns to MC curve above supply curve Firm wants to hire where ______ = _____, which is E * employees (point A) at min wage, w min Outcome: w min _ w M and E * _ E M - no unemployment Better outcome: set w min = __ so E = __ and w = __ Minimum wage law outcomes may be explained by fast food restaurants acting as monopolists to teenagers

21 Competitive firms facing upward- sloping supply curves Even if employees are mobile, the costs associated with moving to take advantage of a new higher paying job can be huge Competitive firms must offer large wages to attract someone to move As the number of employees increases, monitoring workers to discourage shirking becomes expensive Employers may want to pay higher wages to make the cost to an employee of shirking more expensive

22 Professional Athletes Free agency If a player can go where he wants, he will present his current team with an outside offer Current team evaluates VMP, and if VMP exceeds offer, If not, No free agency New team can offer current team a trade – pay salary + bonus to total their value for the player Current team evaluates VMP and agrees to trade if If VMP exceeds offer,

23 Professional Athletes, cont. Allocation of resources (players) Player may not be paid according to worth, but he ends up with the team that values him the most (VMP) in either case Different income distribution __________ benefits from no free agency, but ________ benefits as a free agent Empirical evidence: supports migration and income distribution predictions

24 Noncompetitive Labor Markets: Monopoly Monopoly: Recall: Monopsonist did not control p, but could choose w

25 Monopoly, cont. When output increases, monopolist must ______ price on that unit and all previous units MR _ P, where P is represented by ______ since the firm chooses P* from demand curve after Q* is chosen (MR=MC) Competitive outcome: ______ P C _ P M and Q C _ Q M

26 Monopoly, cont. Since P≠MR, revenue generated by last worker hired is not equal to MP E ·P = VMP E Instead, marginal revenue product = MRP E = MPR E _ VMP E because MR < P π-max: w = ___, not w = VMP E M _ E C, where E C is found be equating wage to value of marginal product

27 Empirical Evidence Monopolists and oligopolists (few firms produce all of the output for an entire market) pay higher wages than competitive firms (approximately 10% more) Monopolists can pass high production costs onto consumers, so with little incentive to keep costs down, monopolists must pay high wages for the most desirable workers