1. The Market for Labor Module KRUGMAN'S MICROECONOMICS for AP* 35 71
Margaret Ray and David Anderson

2. What you will learn in this Module:
The way in which a worker’s decision about time preference gives rise to labor supply.
How to find equilibrium in the perfectly competitive labor market.
How equilibrium in the labor market is determined if either the product, or the factor, market is not perfectly competitive.
The purpose of this module is to first explain a worker’s decision to supply labor as an alternative to consuming leisure. A labor supply curve is built, and when combined with the labor demand curve, we can model the competitive market for labor. The module also discusses the implications in the market if the assumptions of perfectly competitive markets do not hold.

3. The Supply of labor Work versus leisure Wages and labor supply
Households demand many things (gasoline, milk, Nintendo gaming systems) from firms that supply them. These exchanges take place in product markets. We have discussed product markets throughout the course. Now we must switch our perspective to factor markets, and focus on the labor market.
Households supply labor to the firms that need (demand) it. The price for this transaction is the going wage.
Our first task is to determine what makes a person supply hours of their labor to employers.
-Work versus leisure
Economists view a person’s choice to work as a cost-benefit decision.
Benefit of one hour of work: a wage that can be used to consume goods and services that provide utility.
Cost of one hour of work: the utility that could be gained from leisure. The price of leisure is the wage a person gives up.
 So the decision is simple:
You will work the next hour if you expect your wage to provide you with more marginal utility than the leisure activities you give up.
You will not work the next hour if you expect your wage to provide you with less marginal utility than the leisure activities you give up.
Equilibrium occurs when:
The marginal utility of the next hour of work is equal to the marginal utility of the next hour of leisure.
-Wages and labor supply
 Depending upon the type of work, there is a wage below which a person will not work any hours. This is called the reservation wage. A person must receive more than his/her reservation wage before that person supplies any hours to the labor market. Usually, as the wage rises, the person decides that working more hours (so they can consume more goods and services) will increase their utility and so they leisure fewer hours. This results in an upward sloping labor supply curve.

4. The Supply of labor Substitution effect Income effect Hourly wage
Hours of work (week)
IE>SE, downward sloping
SE>IE, upward sloping
Labor supply
Hourly wage
Substitution effect
Income effect
But the higher wage gives this person more income at all levels of work, so maybe this person will choose to work fewer hours and leisure more hours.
When wages rise, there are two things affecting a person’s decision to work more, or fewer hours.
Substitution effect (SE): a higher wage increases the opportunity cost, or price, of leisure. If leisure comes at a higher price, the person will substitute fewer hours of leisure for more hours of work.
Income effect (IE): a higher wage increases a person’s income, no matter how many hours of work they choose. At higher levels of income, a person will consume more hours of leisure activities (leisure is a normal good), and this reduces hours of work.
So as the wage rises, the substitution effect says “work more” while the income effect says “work less”. If the individual’s labor supply curve is upward sloping, it must be the case that the substitution effect is stronger than the income effect.
If the income effect is stronger, particularly at very high wages, the labor supply curve is downward sloping, or “backward bending”.
The graph shows a backward bending labor supply curve at very high wages. We usually assume that for most people the labor supply curve does slope upward.

5. Shifts of the Labor Supply Curve
Changes in preferences and social norms
Changes in population
Changes in opportunities
Changes in wealth
If we add up all of the hours each individual supplies at each wage, we will get the market labor supply curve. There are some factors, unrelated to the wage that can shift the market supply curve outward or inward.
1. Changes in Preferences and Social Norms
After WWII in the U.S. the participation of women in the workplace greatly increased. This shifted the supply of labor to the right.
2. Changes in Population
With immigration and birth rates that exceed death rates, a nation’s population and labor force gradually increases in size. This will slowly shift the labor supply curve to the right.
3. Changes in Opportunities
We have seen opportunities in some labor markets grow, while opportunities in others have diminished.
As demand for health care has increased, jobs in health services (nursing, pharmaceuticals, e.g.) have become more highly demanded. When more students graduate from college with nursing degrees, collectively they shift the supply of labor to the right in the nursing labor market.
The opposite has happened in the manufacturing industries. Because manufactured goods in the U.S. have been faced with difficult international competition, factories have shut down and older workers have been offered early retirement. Gradually this has resulted in a decreased supply of manufacturing labor.
4. Changes in Wealth
Wealth is the value of a person’s assets, not the current wage that they earn.
Examples: value of a home or real estate, mutual funds, stocks or bonds, or pensions.
If the stock market is weak and the housing market has depressed the value of homes and real estate, the level of wealth declines. This would shift the supply of labor to the right because individuals cannot consume as much leisure anymore and must work more.

6. Equilibrium in the Labor Market
Up to this point we have assumed that both the product and labor markets are perfectly competitive
There are differences when either the product market or labor market is not perfectly competitive
Market Labor Demand
Market Labor Supply
Wage W*
When we combine the labor demand curves for many competitive firms and the labor supply curves for many individuals we can model the entire labor market with simple supply and demand.
Labor demand for the market is downward sloping as firms will, all else equal, wish to employ fewer units of labor at higher wages.
Labor supply for the market is upward sloping as individuals will, all else equal, wish to offer more units of labor at higher wages.
Equilibrium is (of course) at the only wage where the quantity of labor supplied is equal to the quantity of labor demanded.
The wage W* is equal to the value of the marginal product of the last unit of labor hired.
Quantity of Labor (workers) E*

7. Table Marginal Revenue Product of Labor with Imperfect Competition in the Product Market Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

8. Imperfect Competition in the Product MarketW*
Recall that MR < P with imperfect competition. That means the value of the marginal product = MP x MR.
With imperfect competition the value of the marginal product is called marginal revenue product (MRP).
MRP = MP x MR
Wage
MRPL
VMPL
Remind the students of a fundamental difference between perfect competition and imperfect competition: the ability to set the price of the product.
When firms have price-setting ability, we saw that price must be lowered to increase the quantity sold. This creates a situation where the price of the last unit sold is greater than the marginal revenue from selling it.
Perfect competition: P=MR due to price-taking behavior.
Imperfect competition: P>MR due to price-setting behavior.
How does this impact the decision to hire inputs like labor?
Recall that hiring under perfectly competitive conditions, takes place up to the point where the marginal dollars of benefit collected from his/her production is equal to the marginal dollars of cost incurred from his/her employment. VMPL = P*MPL = W.
The same is true under imperfect competition except the marginal dollars of benefit received is not a function of price (P), but marginal revenue (MR). The marginal revenue product MRPL = MR*MPL.
Hiring decision is now: hire where MRPL = W
Since MR<P, it must be the case that MRPL < VMPL. In a graph, both are downward sloping but the MRPL will lie below the VMPL. This means the demand for labor with imperfect competition lies below the demand for labor with perfect competition.
Assuming a constant wage, we can see in the graph below that fewer units of labor will be employed if firms in the product market have pricing power (Em) than if they are price takers (Ec). Em Ec
Quantity of Labor (workers)

9. Table Marginal Factor Cost of Labor with Imperfect Competition in the Labor Market Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

10. Imperfect Competition in the Labor Market
A monoposony is a single buyer of a factor of production.
With imperfect competition in a factor market, MFC > W
MFCL
Labor Supply
$12
$10
Wage
When we assumed a perfectly competitive labor market, we assumed that many small firms could employ as much labor as they wish at the prevailing wage; they were wage takers.
The additional cost of hiring the next unit of labor, or marginal factor cost of labor (MFCL) was constant and equal to the wage.
This implied that the supply of labor was a horizontal line at the market wage.
What if the assumption of many small wage-taking firms is not true? Suppose there is one very large firm in the market. When this firm, a monopsony, hires labor more and more labor, it must offer higher and higher wages to attract them. This is because the labor supply curve is upward sloping.
The wage must be increased for all units of labor. This tells us that the MFCL rises as more workers are employed, and we can see that the MFCL > W 3
Quantity of Labor (workers)

11. Figure Equilibrium in the Labor Market with Imperfect Competition Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

12. Equilibrium with Imperfect Competition
Monopsony power allows firms to pay a wage below MRP
MFCL
Labor Supply W*
MRPL
Wage
MRP
So when both the product market and the labor market are imperfectly competitive, how many units of labor will the firm employ?
Same decision as before: hire up to the point where the additional dollars of revenue earned is equal to the additional dollars of labor cost incurred.
Hire E* units of labor where: MRPL = MFCL
What is the equilibrium wage? Consult the labor supply curve at the employment level E*. See the graph below.
One thing we can see from the graph below is that the workers are being paid a wage W* that is less than the MRP dollars their efforts bring to the firm. This should not be surprising. We are describing a firm that may be the sole employer in the labor market. This monopsony power allows them to pay lower wages than they would if the labor market were perfectly competitive. E*
Quantity of Labor (workers)

13. Summary – Supply and Demand
Supply – income and substitution effects
Shifts: preference, population, opportunities, and wealth.
Equilibrium determines wage.
In perfect competition, firm is wage taker.
If we add up all of the hours each individual supplies at each wage, we will get the market labor supply curve. There are some factors, unrelated to the wage that can shift the market supply curve outward or inward.
1. Changes in Preferences and Social Norms
After WWII in the U.S. the participation of women in the workplace greatly increased. This shifted the supply of labor to the right.
2. Changes in Population
With immigration and birth rates that exceed death rates, a nation’s population and labor force gradually increases in size. This will slowly shift the labor supply curve to the right.
3. Changes in Opportunities
We have seen opportunities in some labor markets grow, while opportunities in others have diminished.
As demand for health care has increased, jobs in health services (nursing, pharmaceuticals, e.g.) have become more highly demanded. When more students graduate from college with nursing degrees, collectively they shift the supply of labor to the right in the nursing labor market.
The opposite has happened in the manufacturing industries. Because manufactured goods in the U.S. have been faced with difficult international competition, factories have shut down and older workers have been offered early retirement. Gradually this has resulted in a decreased supply of manufacturing labor.
4. Changes in Wealth
Wealth is the value of a person’s assets, not the current wage that they earn.
Examples: value of a home or real estate, mutual funds, stocks or bonds, or pensions.
If the stock market is weak and the housing market has depressed the value of homes and real estate, the level of wealth declines. This would shift the supply of labor to the right because individuals cannot consume as much leisure anymore and must work more.

14. Summary – Imperfect Competition
Monopoly – Marginal revenue product
Hire based on MRP = MFC
At same wage, fewer workers than PC
Monopsony – Marginal factor cost.
Hire based on MFC = MRP
Fewer workers than pure competition at lower wages.
If we add up all of the hours each individual supplies at each wage, we will get the market labor supply curve. There are some factors, unrelated to the wage that can shift the market supply curve outward or inward.
1. Changes in Preferences and Social Norms
After WWII in the U.S. the participation of women in the workplace greatly increased. This shifted the supply of labor to the right.
2. Changes in Population
With immigration and birth rates that exceed death rates, a nation’s population and labor force gradually increases in size. This will slowly shift the labor supply curve to the right.
3. Changes in Opportunities
We have seen opportunities in some labor markets grow, while opportunities in others have diminished.
As demand for health care has increased, jobs in health services (nursing, pharmaceuticals, e.g.) have become more highly demanded. When more students graduate from college with nursing degrees, collectively they shift the supply of labor to the right in the nursing labor market.
The opposite has happened in the manufacturing industries. Because manufactured goods in the U.S. have been faced with difficult international competition, factories have shut down and older workers have been offered early retirement. Gradually this has resulted in a decreased supply of manufacturing labor.
4. Changes in Wealth
Wealth is the value of a person’s assets, not the current wage that they earn.
Examples: value of a home or real estate, mutual funds, stocks or bonds, or pensions.
If the stock market is weak and the housing market has depressed the value of homes and real estate, the level of wealth declines. This would shift the supply of labor to the right because individuals cannot consume as much leisure anymore and must work more.