1. Chapter 4 – Labor Market Equilibrium
4-1 Equilibrium in a single competitive market
4-2 Competitive equilibrium across labor markets
4-3 PA: Payroll taxes and subs.
4-4 PA: Payroll taxes vs mandated benefits
4-8 The Cobweb Model
4-9 Non-competitive markets: Monopsony
4-10 Non-competitive markets: Monopoly
Give a brief overview of the presentation. Describe the major focus of the presentation and why it is important.
Introduce each of the major topics.
To provide a road map for the audience, you can repeat this Overview slide throughout the presentation, highlighting the particular topic you will discuss next.

2. Introduction Competitive: many sellers & buyers
Labor market equilibrium coordinates the desires of firms and workers, determining the wage and employment observed in the labor market.
Market types:
Competitive: many sellers & buyers
Monopsony: one buyer of labor
Monopoly: one seller of labor
These market structures generate unique labor market equilibria.

3. 4-1Equilibrium in a Single Competitive Labor Market
Competitive equilibrium occurs when supply equals demand, generating a competitive wage and employment level.
It is unlikely that the labor market is ever in an equilibrium, since supply and demand are dynamic.
The model suggests that the market is always moving toward equilibrium.

4. Efficiency
Pareto efficiency exists when all possible gains from trade have been exhausted.
When the state of the world is (Pareto) Efficient, to improve one person’s welfare necessarily requires decreasing another person’s welfare.
In policy applications, ask whether a change can make any one better off without harming anyone else. If the answer is yes, then the proposed change is said to be “Pareto-improving”.

5. Equilibrium in a Competitive Labor MarketS D0 w* P Q E*
Dollars
Employment
The labor market is in equilibrium when supply equals demand; E* workers are employed at a wage of w*.
In equilibrium, all persons who are looking for work at the going wage can find a job (no involuntary unemployment).
The triangle P gives the producer surplus; the triangle Q gives the worker surplus.
A competitive market maximizes the gains from trade, or the sum P + Q.

6. 4-2 Competitive Equilibrium Across Labor Markets
If workers were mobile and entry and exit of workers to the labor market was free, then there would be a single wage paid to all workers.
The allocation of workers to firms equating the wage to the value of marginal product is also the allocation that maximizes national income (this is known as allocative efficiency).
The “invisible hand” process: self-interested workers and firms accomplish a social goal that no one had in mind, i.e., allocative efficiency.

7. Competitive Equilibrium in Two Labor Markets Linked by MigrationSS
Dollars
Employment w* wS DS
(b) The Southern Labor Market SN wN DN
(a) The Northern Labor Market s A B C
Assumption: No/small mobility costs, Perfectly inelastic Ls (simplicity)
Suppose the northern region (wN) has higher wages than south(wS).
Southern workers want to move North, shifting the southern supply curve to the left and the northern supply curve to the right.
In the end, wages are equated across regions at w*.
Surplus created in North from inflow of workers exceeds the surplus destroyed in South (net surplus from migration is positive!)

8. Efficiency Revisited
The “single wage” property of a competitive equilibrium has important implications for economic efficiency:
Recall that in a competitive equilibrium the wage equals the value of marginal product of labor.
As firms and workers move to the region that provides the best opportunities, they eliminate regional wage differentials.
Therefore, workers of given skills have the same value of marginal product of labor in all markets.
The allocation of workers to firms that equates the value of marginal product across markets is also the sorting that leads to an efficient allocation of labor resources.

9. Wages and International Trade: NAFTA
NAFTA created a free trade zone in North America.
Free trade reduces the income differential between the United States and other countries in the zone, such as Mexico.
Total income of the countries in the trade zone is maximized as a result of equalized economic opportunities across the countries in the zone.

10. Wage Convergence Across States
Source: Olivier Jean Blanchard and Lawrence F. Katz, “Regional Evolutions,” Brookings Papers on Economic Activity 1 (1992): 1-61.

11. 4-3 Payroll Taxes and Subsidies
Payroll taxes assessed on employers increase total cost of employment and lead to a downward, parallel shift in the labor demand curve.
The new demand curve shows a wedge between the amount the firm must pay to hire a worker and the amount that workers actually receive.
Payroll taxes increase total costs of employment, so these taxes reduce employment in the economy.
Firms and workers share the cost of payroll taxes (tax incidence), since the cost of hiring a worker rises and the wage received by workers declines.
Payroll taxes result in deadweight losses.

12. The Impact of a Payroll Tax Assessed on FirmsB
Dollars
w1 + 1 w0 S D0 D1 w1
w0  1 E1 E0 A
A payroll tax of $1 assessed on employers shifts down the demand curve (from D0 to D1).
The payroll tax decreases the wage that workers receive from w0 to w1, and increases the cost of hiring a worker from w0 to w1 + 1 (wedge!).
Employment

13. The Impact of a Payroll Tax put on Firms with Inelastic Supply
A payroll tax assessed on the firm is shifted completely to workers when the labor supply curve is perfectly inelastic.
The wage is initially w0. The $1 payroll tax shifts the demand curve to D1, and the wage falls to w0 – 1.
Dollars w0 D0 S D1 E0 A B
Employment
w0 – 1

14. The Impact of a Payroll Tax Assessed on Workers
Dollars S1
A payroll tax assessed on workers shifts the supply curve to the left (from S0 to S1). The payroll tax has the same impact on the equilibrium wage and employment regardless of who it is assessed on. S0
w0 + 1 w1 w0
w1  1 D0 D1 E1 E0
Employment

15. Payroll Subsidies (Read)
An employment subsidy lowers the cost of hiring for firms.
This means payroll subsidies shift the demand curve for labor to the right (up).
Total employment will increase as the cost of hiring has fallen.

16. The Impact of an Employment Subsidy (Read)w1 S D1 D0 w0 E0 E1 B A
Employment
w0 + 1
w1 – 1
An employment subsidy of $1 per worker hired shifts up the labor demand curve, increasing employment. The wage that workers receive rises from w0 to w1. The wage that firms actually pay falls from w0 to w1 – 1.

17. 4.4 -The Impact of a Mandated Benefit
Dollars w0 S1 D0 D1 E1 E0 P Q
Employment S0 w1
w0  C E* w*
w* + B R
w* + C
(a) Cost of mandate exceeds worker’s valuation
(b) Cost of mandate equals worker’s valuation

18. In-class exercise:
4-1 Figure 4-9 discusses the changes to a labor market equilibrium when the government mandates an employee benefit for which the cost exceeds the worker’s valuation (panel a) and for which the cost equals the worker’s valuation (panel b).
(a) Provide a similar graph to those in Figure 4-9 when the cost of the benefit is less than the worker’s valuation, and discuss how the equilibrium level of employment and wages have changed. Is there deadweight loss associated with the mandated benefit?
(b) Why is the situation in which “a mandated benefit would cost less than the worker’s valuation” less important for public policy purposes than when “the cost of the mandated benefit exceeds the worker’s valuation?”

19. Homework: 4-6 Consider a country with two regions (i.e. like Italy)
An economy consists of two regions, the North and the South.
The short-run elasticity of labor demand in each region is –0.5.
Labor supply is perfectly inelastic within both regions.
The labor market is initially in an economy-wide equilibrium, with 600,000 people employed in the North and 400,000 in the South at a wage of $15 per hour.
Suddenly, 20,000 people immigrate from abroad and initially settle in the South.
They possess the same skills as the native residents and also supply their labor inelastically.

20. Homework (continued):
What will be the effect of this immigration on wages in each of the regions in the short run (before any migration between the North and the South occurs)?
Suppose 1,000 native-born persons per year migrate from the South to the North in response to every dollar differential in the hourly wage between the two regions. What will be the ratio of wages in the two regions after the first year native labor responds to the entry of the immigrants?
What will be the effect of this immigration on wages and employment in each of the regions in the long run (after native workers respond by moving across regions to take advantage of whatever wage differentials may exist)? Assume labor demand does not change in either region.

21. 4-5 The Cobweb Model Two assumptions of the cobweb model:
Time is needed to produce skilled workers (Sluggish adjustment).
Persons decide to become skilled workers by looking at conditions in the labor market at the time they enter school (No forward looking individuals!!).
A “cobweb” pattern forms around the equilibrium.
The cobweb pattern arises when people are misinformed.
The model assumes naïve workers who do not form rational expectations. Rational expectations are formed if workers correctly perceive the future and understand the economic forces at work.

22. The Cobweb Model in the Market for New Engineers
Dollars w1 E* E2 E1 w3 w* w2 w0 D D E0
Employment
The initial equilibrium wage in the engineering market is w0. The demand for engineers shifts to D, and the wage will eventually increase to w*.
Because new engineers are not produced instantaneously and because students might mis-judge future opportunities in the market, a cobweb is created as the market adjusts to the increase in demand.
Critique: Valid under strict assumptions

23. 4-10 Non-competitive Labor Market: Monopoly
Firms that have monopoly power can influence the price of the product (p) that they sell. (Output markets)
Important: Still consider the case where firm operates in a competitive labor market (Input market)
Monopolist faces a downward sloped market demand curve for its output and an even lower downward sloped marginal revenue curve.
Consequently, MR<P

24. Marginal Revenue and Price - Monopoly
Faces the entire market demand, hence has absolute market power: Can set the price of the output
Consequently, has to lower the price in order to be able to sell more.
Point A: p=$10 q=20 units TR=$200
Point B: p=$8 q=30 units TR=$240
MR= ΔTR/Δq = ( )/(30-20) =$4
Hence, at point B, p=$10 but MR=$4
The marginal revenue from selling an additional unit of output is less than the price of the product (MR<P).

25. The Output Decision of a Monopolist
A monopolist faces a downward-sloping demand curve for her output.
The marginal revenue from selling an additional unit of output is less than the price of the product (MR<P).
Profit maximization occurs at point A where the monopolist produces qM units of output (where MR=MC) and sells each unit of output at a price of pM dollars (max price that consumers are willing to pay at qM).
Monopolist produces less (qM< q*) but chargers more (pM> p*) than the competitive firm.

26. The Labor Demand Curve of a Monopolist
How does hiring decision of monopolist differ?
Recall the (competitive) condition for profit maximization:
VMPL=MCL
VMPL=MRq * MPL and MCL=w (competitive input markets)
Similarly, monopolist keeps hiring additional workers until the marginal revenue product of labor is equal to the wage rate:
MRq * MPL = w
Intuitively, as L increases, not only MPL decreases (law of diminishing returns) but MRq decreases as well due to the downward sloping demand curve & monopolist having to reduce the price in order to sell the additional output.

27. The Labor Demand Curve of a Monopolist
The marginal revenue product (MRP) gives the worker’s contribution to a monopolist’s revenues (or the worker’s marginal product times marginal revenue), and is less than the worker’s value of marginal product.
Profit maximization occurs at point A where the monopolist hires fewer workers (EM) than would be hired in a competitive market.

28. In-class Exercise:
4-8. A Polly’s Pet Store has a local monopoly on the grooming of dogs. The daily inverse demand curve for pet grooming is:
 P = 20 – 0.1Q
where P is the price of each grooming and Q is the number of groomings given each day.
This implies that Polly’s marginal revenue is:
MR = 20 – 0.2Q.
Each worker Polly hires can groom 20 dogs each day.
How many workers should the firm hire each hour to maximize profits?
What is Polly’s labor demand curve as a function of w, the daily wage that Polly takes as given?

29. 4-9 Noncompetitive Labor Markets: Monopsony
Monopsony market exists when a firm is the only buyer of labor.
i.e. coal mine, university/hospital in a small town
Monopsonists must increase wages to attract more workers.
Two types of monopsonist firms:
Perfectly discriminating
Nondiscriminating

30. Perfectly Discriminating Monopsonist
Discriminating monopsonists are able to hire different workers at different wages.
To maximize firm surplus (profits), a perfectly discriminating monopsonist “perfectly discriminates” by paying each worker his or her reservation wage.
i.e. Analogous to perfect price discriminating monopolist

31. The Hiring Decision of a Perfectly Discriminating Monopsonist
Dollars S
VMPE
Employment w*
w30
w10 30 10 E* A
A perfectly discriminating monopsonist faces an upward-sloping labor supply curve and can hire different workers at different wages.
Therefore the labor supply curve gives the marginal cost of hiring.
Profit maximization occurs at point A.
The monopsonist hires the same number of workers as a competitive market, but each worker is paid his or her reservation wage.

32. Nondisriminating Monopsonist
Must pay all workers the same wage, regardless of each worker’s reservation wage.
Must raise the wage of all workers when attempting to attract more workers.
Employs fewer workers than would be employed if the market were competitive.

33. Wages and MCL Monopsonist
A nondiscriminating monopsonist pays the same wage to all workers.
Point A: w=$5 L=1 worker TCL=$5
Point B: w=$6 L=2 workers TCL=$12
MCL= ΔTC/ΔL = ($12-$5)/(2-1) =$7
Hence, at point B, w=$6 but MCL=$7
The marginal cost of hiring exceeds the wage, and the marginal cost curve lies above the supply curve.

34. The Hiring Decision of a Nondiscriminating Monopsonist
The marginal cost of hiring exceeds the wage, and the marginal cost curve lies above the supply curve.
Profit maximization occurs at point A; the monopsonist hires EM workers and pays them all a wage of wM.
Monopsonist hires less workers (underemployment) and pays less than the competitive case.
Question: Could competitive firms possess Monopsony power?

35. The Impact of the Minimum Wage on a Nondiscriminating Monopsonist
MCE
Dollars S A
wmin w* wM
VMPE
Ewmin EM
Employment
The minimum wage may increase both wages and employment when imposed on a nondiscriminating monopsonist.
A minimum wage set at wmin increases employment to Ewmin.

36. Homework:
4-7. A firm faces perfectly elastic demand for its output at a price of $6 per unit of output. The firm, however, faces an upward-sloped labor supply curve of
 E = 20w – 120
where E is the number of workers hired each hour and w is the hourly wage rate. Thus, the firm faces an upward-sloped marginal cost of labor curve of
MCE = E
Each hour of labor produces five units of output.
How many workers should the firm hire each hour to maximize profits?
What wage will the firm pay?
What are the firm’s hourly profits?