1. Chapter 9 The Labor Market and Wage Rates

2. Labor Markets In Perspective
Labor Markets differ in an important way from the other markets we’ve considered so far in this book
Firms need resources to make goods and services
We can identify three general categories of resource markets
Markets for capital
Markets for land
Markets for labor
Labor is different from other things that are traded
Sellers of labor care about factors in the work place
Another feature of labor is the meaning of the price in this market
Wage rate
Lieberman & Hall; Introduction to Economics, 2005

3. Figure 1: Product and Factor Markets
Product Markets
Demand for Goods
and Services
Supply of Goods
and Services S D
Households
Firms S D
Supply of
Resources
Demand for
Resources
Factor Markets
Lieberman & Hall; Introduction to Economics, 2005

4. Defining a Labor Market
How broadly or narrowly we define a market depends on the specific questions we wish to answer
Broadly defined markets may look at markets that draw on labor from all over the world
Narrowly defined markets may look at markets that draw on labor on a very localized level
Lieberman & Hall; Introduction to Economics, 2005

5. Competitive Labor Markets
Market with many indistinguishable sellers of labor and many buyers
Involves no barriers to entry or exit
Perfectly competitive labor markets must satisfy three conditions
Great many buyers (firms) and sellers (households) of labor in market
All workers in market appear the same to firms
No barriers to entering or leaving labor market
Lieberman & Hall; Introduction to Economics, 2005

6. Competitive Labor Markets and The Equilibrium Wage
Wage rate determined like the price of other competitive markets:
Supply and demand
The labor demand curve in any labor market slopes downward because a rise in the wage rate
1) increases firms’ costs, causing them to decrease production and employ fewer workers
2) increases the relative cost of labor from that market, causing firms to substitute other inputs, such as capital or other types of labor
The labor supply curve in any labor market slopes upward because a rise in the wage rate
1) induces some of those not currently working to seek work
2) attracts some of those who are currently working in other labor markets
The forces of supply and demand will drive a competitive labor market to its equilibrium point—the point where the labor supply and labor demand curves intersect
Lieberman & Hall; Introduction to Economics, 2005

7. Figure 2: A Competitive Labor Market
Hourly
Wage LS
$12 LD
10,000
Number of
Workers
Lieberman & Hall; Introduction to Economics, 2005

8. Why Do Wages Differ? Significant inequality exists in wage rates
Among different occupations
Among and within occupations in U.S. labor market
Wage inequality is persistent
Both highest and lowest paid occupations have been so for decades
Lieberman & Hall; Introduction to Economics, 2005

9. An Imaginary World
To understand why wages differ in the real world, let’s start by imagining an unreal world
Except for differences in wages, all jobs are equally attractive to all workers
All workers are equally able to do any job
All labor markets are perfectly competitive
In such a world, we would expect every worker to earn an identical wage in long-run
Lieberman & Hall; Introduction to Economics, 2005

10. An Imaginary World
Figure 3 shows two different labor markets that initially have different wage rates
In our imaginary world, could this diagram describe long-run equilibrium in these markets? No
As these shifts occur, market wage rate of elementary school teachers will rise and that of systems analysts will fall
Lieberman & Hall; Introduction to Economics, 2005

11. Figure 3: Disappearing Wage Differentials
(b)
Hourly
Wage
Hourly
Wage B
$30 A'
$25 25 B' 20 A LD LD
Number of Elementary School Teachers
Number of Computer Systems Analysts
Lieberman & Hall; Introduction to Economics, 2005

12. An Imaginary World When will the entry and exit stop?
When there is no reason for an elementary school teacher to want to be a systems analyst
When both labor markets are paying same wage rate
Long-run adjustments will occur even if no one actually switches jobs
Changes will continue until—at points A’ and B’—the long-run wage rate is equal in both markets
Take any one of these assumptions away, and equal-wage result disappears
Tells us where to look for sources of wage inequality in real world
A violation of one or more of our assumptions
Lieberman & Hall; Introduction to Economics, 2005

13. Compensating Differentials
In our imaginary world, all jobs were equally attractive to all workers
In real world, jobs differ in hundreds of ways that matter to workers
When one job is intrinsically more or less attractive than another
Can expect wages to differ by a compensating wage differential
Difference in wage rates that makes two jobs equally attractive to workers
Lieberman & Hall; Introduction to Economics, 2005

14. Nonmonetary Job Characteristics
When evaluating a career, whether you are aware of it or not, you are evaluating hundreds of nonmonetary job characteristics, including
Risk of death or injury
Cleanliness of work environment
Prestige you can expect in your community
Amount of physical exertion required
Degree of intellectual stimulation
Potential of advancement
Lieberman & Hall; Introduction to Economics, 2005

15. Nonmonetary Job Characteristics
You will also think about geographic location of job and characteristics of the community in which you would live and work
Weather
Crime rates
Pollution levels
Transportation system
Cultural amenities
Nonmonetary characteristics of different jobs give rise to compensating wage differentials
Jobs considered intrinsically less attractive will tend to pay higher wages, other things being equal
Lieberman & Hall; Introduction to Economics, 2005

16. Nonmonetary Job Characteristics
What about unusually attractive jobs?
These jobs will generally pay negative compensating differentials
Different people have different tastes for working and living conditions
Cannot use our own preferences to declare a job as less attractive or more attractive
Or to decide which jobs should pay a positive or negative compensating differential
Rather, when labor markets are perfectly competitive
Entry and exit of workers automatically determines compensating wage differential in each labor market
Lieberman & Hall; Introduction to Economics, 2005

17. Nonmonetary Job Characteristics
Compensating wage differentials are one reason most economists are skeptical about idea of comparable worth
Holds that a government agency should determine skills required to perform different jobs and mandate wage differences needed between them
Economists generally prefer policies to increase competition and eliminate discrimination
So that the market itself can determine comparable worth
Lieberman & Hall; Introduction to Economics, 2005

18. Cost of Living Differences
Differences in living costs can cause compensating wage differentials
Areas where living costs are higher than average will tend to have higher than average wages
To compensate for the higher cost of living
Lieberman & Hall; Introduction to Economics, 2005

19. Differences in Human Capital Requirements
All else equal, jobs that require more education and training will be less attractive
In order to attract workers, these jobs must offer higher pay than other jobs that are similar in other ways, but require less training
Differences in human capital requirements can give rise to compensating wage differentials
Jobs that require more costly training will tend to pay higher wages, other things equal
Compensating differentials explain much of the wage differential between jobs requiring college degrees and requiring only a high school diploma
The idea of compensating wage differentials dates back to Adam Smith
First observed that unpleasant jobs seem to pay more than other jobs that require similar skills and qualifications
Lieberman & Hall; Introduction to Economics, 2005

20. Differences In Ability
Not everyone has the intelligence needed to perform well at any job
Scientific discoveries and technological advances have increased not only skill requirements of many jobs
But also abilities needed to acquire those skills
In general, those with greater ability to do a job well—based on their talent, intelligence, motivation, or perseverance—will be more valuable to firms
Firms will be willing to pay them a higher wage rate
Beyond any compensating differential for their human capital investment
Lieberman & Hall; Introduction to Economics, 2005

21. The Economics of Superstars
Why was owner of Texas Rangers willing to pay $25 million per year to have Alex Rodriguez play for his team?
Immediate answer
Because Rodriguez is so good
When we try to explain extremely high wage rates of these superstars based on their exceptional abilities alone, we confront a puzzle
The very top writers, rock stars, comedians, talk-show hosts, and movie directors all earn wage premiums that seem vastly out of proportion to their additional abilities
Why?
Explanation in all these cases is based on ability
And also by exaggerated rewards market bestows on those deemed the best or one of the best in a field
Lieberman & Hall; Introduction to Economics, 2005

22. The Economics of Superstars
If most people rank recent mystery novels in the same order, then the best will sell millions of copies, second best will sell hundreds of thousands, and third best might sell only thousands
Even though all three novels might be very close in quality
A publisher will earn ten times more revenue selling the best novel (compared to the second best), and ten times more revenue selling the second best (compared to the third best), and so on
Same thing happens in markets for athletes, rock concerts, action movies, and news broadcasters
But phenomenon is not limited to media markets or media stars
Lieberman & Hall; Introduction to Economics, 2005

23. Barriers to Entry
In some labor markets, barriers keep out would-be entrants
Resulting in higher wages in those markets
Since barriers to entry help maintain high wages for those protected by the barriers—those who already have jobs in the protected market
Should not be surprised to find that in almost all cases, it is those already employed who are responsible for erecting barriers
Lieberman & Hall; Introduction to Economics, 2005

24. Occupational Licensing
In many labor markets, occupational licensing laws keep out potential entrants
American Medical Association (AMA) is perhaps the strongest example of occupational licensing as a barrier to entry
Professional organization to which almost half of American physicians belong
Much of AMA’s activity has been designed to decrease supply of doctors
AMA has also increased demand for physicians’ services by preventing nonphysicians from competing
In late 1980’s, rising health care costs led to increased public scrutiny of AMA, and its anticompetitive practices came under heavy attack
Economists see AMA primarily as an instrument to maintain high incomes for doctors
Lieberman & Hall; Introduction to Economics, 2005

25. Figure 4: The Market for Physicians
Salaries
2. AMA restrictions on the supply of physicians move the market here. C
3. Other policies to increase demand for physicians move the market here, at final wage rate W3. W3 W2 B A W1
1. Without AMA activities to increase salaries, equilibrium is here, at wage rate W1.
Number of Physicians
Lieberman & Hall; Introduction to Economics, 2005

26. Union Wage Setting
A labor union represents collective interests of its members
Major objective of a union is to raise its members’ pay
Higher union wage is contrary to interests of employer—so why does employer agree?
Because union has power to strike
In a competitive labor market, a union—by raising the wage firms must pay—decreases total employment in the union sector
This, in turn, causes wages in non-union sector to drop
Result is a wage differential between union and non-union wages
Lieberman & Hall; Introduction to Economics, 2005

27. Figure 5(a): Union Wage Differentials
2. A union wage of for long-haul truckers of W2 creates an excess supply of workers. LS A' W2 W1 A
1. With no labor union, both long- and short-haul truckers earn the same wage rate, W1. LD
250,000
350,000
300,000
Number of Long-haul Truckers
Lieberman & Hall; Introduction to Economics, 2005

28. Figure 5(b): Union Wage Differentials
3. Unemployed long-haul truckers move to the nonunion short-haul market, and the labor supply curve shifts rightward . . .
Wage B W1 B' W3
4. pushing the short-haul wage rate down to W3. LD
200,000
Number of Short-haul Truckers
225,000
Lieberman & Hall; Introduction to Economics, 2005

29. Union Wage Setting
Unions still maintain a significant, though declining, presence in many industries
Such as automobiles, steel, coal, construction, mining, and trucking
Certainly responsible for at least some of the higher wages earned in those industries
Full effect of unions on labor markets is much more complex
Many of the features of modern work that we take for granted today originated in union struggles with management
Such as paid vacations and overtime pay
Unions can raise workers morale and reduce labor turnover
Through grievance procedures and other forms of communications with management
Lieberman & Hall; Introduction to Economics, 2005

30. Discrimination and Wages
Discrimination occurs when members of a group of people have different opportunities because of characteristics that have nothing to do with their abilities
First step in understanding economics of discrimination is to distinguish two words that are often confused
Prejudice
Emotional dislike for members of a certain group
Discrimination
Restricted opportunities offered to such a group
Lieberman & Hall; Introduction to Economics, 2005

31. Employer Prejudice
When you think of job discrimination, your first image might be a manager who refuses to hire members of some group because of pure prejudice
Such as African-Americans or women
May surprise you to learn that economists generally consider employer prejudice one of the least important sources of labor market discrimination
When prejudice originates with employers, market forces work to discourage discrimination and reduce or eliminate any wage gap between favored and unfavored group
Lieberman & Hall; Introduction to Economics, 2005

32. Employee and Customer Prejudice
What if workers—rather than employers—are prejudiced?
In a competitive output market, non-discriminating firm will be forced out of business
Cannot count on the market to solve the problem
Same argument applies if the prejudice originates with firm’s customers
When prejudice originates with firm’s employees or its customers
Market forces may encourage, rather than discourage, discrimination
Can lead to a permanent wage gap between favored and unfavored groups
Lieberman & Hall; Introduction to Economics, 2005

33. Figure 6: Employer Discrimination and Wage Rates
Sector A
(Discriminating)
Sector B
(Nondiscriminating)
Wage
Wage E' W3 F W1 W1 E W2 F' LD LD
Number of Workers
Number of Workers
Lieberman & Hall; Introduction to Economics, 2005

34. Statistical Discrimination
Suppose you are in charge of hiring 10 new employees at your firm
Young married women in your industry are twice as likely to quit their jobs within two years than men and those that quit are very costly to your firm
20 people apply for 10 positions—half men and half women
Whom will you hire?
If your sole goal is to maximize the firm’s profit
You will hire men
Even if there isn’t a trace of prejudice in you, in the firm’s employees, or in its customers, profit maximization may still dictate hiring the men
Lieberman & Hall; Introduction to Economics, 2005

35. Statistical Discrimination
When individuals are excluded from an activity based on the statistical probability of behavior in their group
Rather than their personal characteristics
Some observers have suggested that statistical discrimination is often a cover for prejudice
According to critics of the statistical discrimination theory, the negative behavior of a favored group is rarely considered by employers
Lieberman & Hall; Introduction to Economics, 2005

36. Dealing With Discrimination
Discrimination due to pure employer prejudice is unlikely to have much of an impact on labor markets
For other types of discrimination market incentives work in the opposite way, leading to a permanent and stubborn problem
Such as statistical discrimination or discrimination due to worker or consumer prejudice
In these cases, many economists and other policy makers believe that government action is needed
Some favor affirmative action programs
Others favor stricter enforcement of existing antidiscrimination laws and stiffer penalties when discriminatory hiring occurs
Both approaches to policy force all firms to bear costs of nondiscriminatory hiring
Lieberman & Hall; Introduction to Economics, 2005

37. Discrimination and Wage Differentials
Consider the black-white differential for men
Several studies suggest that if we limit comparisons to whites and blacks with same educational background, geographic location, and, in some cases, same ability (measured by a variety of different tests), 50% or more of the earnings difference disappears
In addition to job-market discrimination, there is pre-market discrimination
Occurs before an individual enters labor market
Such as unequal treatment in education and housing
For women, as well as blacks and other minorities, differences in skills and experience can be the result of lower wages
Since women know they will earn less than men and will have more trouble advancing on the job
They have less incentive to invest in human capital and to stay in labor force
Lieberman & Hall; Introduction to Economics, 2005

38. Discrimination and Wage Differentials
In the end, we do not know nearly as much about the impact of discrimination on wages as we would like to know
But research is proceeding at a rapid pace
As we’ve seen, data must always be interpreted with care
In measuring impact of job market discrimination on earnings
Wage gap between two groups gives an overestimate
Since it fails to account for differences in skills and experience
However, comparing only workers with similar skills and experience leads to an underestimate
Since some of the differences are themselves caused by discrimination—both in the job market and outside of it
Lieberman & Hall; Introduction to Economics, 2005

39. Figure 7: Vicious Cycle of Discrimination
Current Job Discrimination
Lower Wage
Lower Human Capital Investment
Unemployment
Lower Skill Level
Less Job Experience
Pre-market Discrimination
Lieberman & Hall; Introduction to Economics, 2005

40. Using The Theory: The Minimum Wage
Minimum wage law…makes it illegal to hire a worker for less than a specified wage
In any labor market covered by the law
Most people think about the minimum wage as a means to increase living standards for the lowest paid workers, and their analysis stops there
But minimum wage creates a wage differential among the least-skilled workers, depending on the industry in which they work
By raising wages rates in covered industries, and lowering them in uncovered industries
Lieberman & Hall; Introduction to Economics, 2005

41. Figure 8(a/b): The Minimum Wage
Unskilled Labor Covered by Law
Unskilled Labor Not Covered by Law
Hourly
Wage
Hourly
Wage
A minimum wage raises pay, but decreases jobs in the covered sector.
Some who can't find work go to the uncovered sector, lowering wages there. LS A'
$5.15 B
4.00
$4.00 B' A LD
3.00 LD N2 N1 N3
Number of Workers
Number of Workers
Lieberman & Hall; Introduction to Economics, 2005

42. Figure 8(c): The Minimum Wage
Skilled Labor
Hourly
Wage LS
$24.00 C'
20.00 C
As capital is substituted for unskilled labor, demand for skilled workers goes up, raising the skilled wage rate.
Number of Workers
Lieberman & Hall; Introduction to Economics, 2005

43. Using The Theory: The Minimum Wage
Only one group of workers in which everyone benefits: skilled workers
Should come as no surprise that for many decades the most vocal advocates of raising the minimum wage have been labor unions
Membership is disproportionately made up of skilled workers
What do economists think about the minimum wage?
Most regard it as an inefficient policy for helping poor working families
Lieberman & Hall; Introduction to Economics, 2005

44. Using The Theory: The Minimum Wage
You might think that economists would overwhelmingly oppose any increase in minimum wage
But that is not the case
Those who favored an increase in minimum wage tended to believe the effect on unemployment was much smaller than those who opposed an increase
Others may believe that higher unemployment is more likely to influence policy in a direction they favor
The minimum wage, like most issues of public policy, is not as simple as it appears
Lieberman & Hall; Introduction to Economics, 2005