1. Lecture 5 Labor Market Equilibrium Workers prefer to work when the wage is high, and firms prefer to hire when the wage is low. Labor market equilibrium “balance out” the conflicting desires of workers and firms and determines the wage and employment observed in the labor market.

2. 1. Equilibrium in a Single Competitive Labor Market The supply curve gives the total number of employee- hours that agents in the economy allocate to the market at any given wage level; the demand curve gives the total number of employee-hours that firms in the market demand at that wage. Equilibrium occurs when supply equals demand, generating the competitive wage w * and employment E *. The supply curve gives the total number of employee- hours that agents in the economy allocate to the market at any given wage level; the demand curve gives the total number of employee-hours that firms in the market demand at that wage. Equilibrium occurs when supply equals demand, generating the competitive wage w * and employment E *. Equilibrium in a Competitive Labor Market Employment Dollars E* W* D S Note: There is no unemployment in a competitive labor market. Persons who are not working are also not looking for work at the going wage.

3. 2. Competitive Equilibrium Across Labor Markets The economy typically consists of many labor markets, even for workers who have similar skills. As long as either workers or firms are free to enter and exit labor markets, a competitive economy will be characterized by a single wage. Dollars Employment DNDN S’ N W* Dollars Employment DSDS S’ S W* SNSN WNWN S WSWS Competitive Equilibrium in Two Labor Markets Linked by Migration

4. Note: The “single wage” property of competitive equilibrium has important implications for economic performance. That is, workers of given skills have the same value of marginal product of labor in all markets. The allocation of workers to firms which equates the value of marginal product across markets is also the allocation which maximizes national income. This type of allocation is called an efficient allocation. Note: The “single wage” property of competitive equilibrium has important implications for economic performance. That is, workers of given skills have the same value of marginal product of labor in all markets. The allocation of workers to firms which equates the value of marginal product across markets is also the allocation which maximizes national income. This type of allocation is called an efficient allocation.

5. 3. Policy Application: Payroll Taxes Payroll taxes on employers are heavily used in the social insurance area. With our simple labor model, we can show that the party making the social insurance payment is not necessarily the one that bears the burden of the tax. Payroll taxes on employers are heavily used in the social insurance area. With our simple labor model, we can show that the party making the social insurance payment is not necessarily the one that bears the burden of the tax. Tax Employment S0S0 D0D0 D1D1 Real Wage E0E0 E1E1 E2E2 W1W1 W0W0 W 1 +X W 0 +λ Tax is a fixed dollar amount X. D 0 →D 1 with vertical distance of X. pt. A: excess supply→ real wage↓ Employees bear part of the burden of the payroll tax in the form of lower wage rates and lower employment levels. Note: In general, the extent to which the labor supply curve is sensitive to wages determines the proportion of the employer payroll tax that gets shifted to employee’s wages.

6. 4. The Cobweb Model Our analysis of labor market equilibrium assumes that markets adjust instantaneously to shifts in either supply or demand curves, so that wages and employment change swiftly from the old equilibrium levels to the new equilibrium level. Many labor markets, however, do not adjust so quickly to shifts in the underlying supply and demand curves. Our analysis of labor market equilibrium assumes that markets adjust instantaneously to shifts in either supply or demand curves, so that wages and employment change swiftly from the old equilibrium levels to the new equilibrium level. Many labor markets, however, do not adjust so quickly to shifts in the underlying supply and demand curves. Example: the Engineering Market Example: the Engineering Market Note: The adjustment of college enrollments to changes in the returns to education is not always smooth or rapid, particularly in fields that are highly technical. Note: The adjustment of college enrollments to changes in the returns to education is not always smooth or rapid, particularly in fields that are highly technical. → The inability to respond immediately to changed market conditions can cause boom-and-bust cycles in the market for highly technical workers.

7. Wage Number of Engineers D’ S D N0N0 N2N2 N3N3 N1N1 W2W2 W0W0 WeWe W3W3 W1W1 Demand increase to D’; temporary supply is N 0. → W increase to W 1 → W 1 wage induce increase in supply to N 1 → excess supply → W reduce to W 2 → W 2 wage reduce supply to N 2 → W increase to W 3 → at W 3, supply increase to N 3 → excess supply → W reduces, etc.

8. Overtime the swings become smaller and eventually equilibrium is reached. → cobweb model. Note: There are two key assumptions in the cobweb model: 1. It takes time to produce new engineers, so that the supply of engineers can be thought of as being perfectly inelastic in the short run. 2. Students are very myopic when they are considering whether to become engineers.

9. 5. Policy Application: The Impact of Minimum Wages The standard economic model of the impact of minimum wages on employment is illustrated in the following figure: The standard economic model of the impact of minimum wages on employment is illustrated in the following figure: Dollars E* W* D S E S W E The Impact of the Minimum Wage on Employment Note: A minimum wage creates unemployment both because some previously employed workers lose their jobs, and because some workers who did not find it worthwhile to work at the competitive wage find it worthwhile to work at the higher minimum wage. Employment

10. The Covered and Uncovered Sectors Dollars E C W* DCDC SCSC W Employment E (a) Covered Sector The Impact of Minimum Wages on the Covered and Uncovered Sectors Dollars E U W* DUDU SUSU Employment (b) UNcovered Sector S’ U S” U E’ U E” U

11. Note: In the absence of a minimum wage, the migration of workers across sectors equates the wage in the two sectors. The migration of workers when the wage in one of the markets is set at the minimum wage equates the expected wage across sectors. I.e., the free migration of workers across sectors ensure that the expected wage in the covered sector equals the for-sure wage in the uncovered sector. Note: In the absence of a minimum wage, the migration of workers across sectors equates the wage in the two sectors. The migration of workers when the wage in one of the markets is set at the minimum wage equates the expected wage across sectors. I.e., the free migration of workers across sectors ensure that the expected wage in the covered sector equals the for-sure wage in the uncovered sector.

12. 6. Noncompetitive Labor Markets (1) Monopsony Because the firm is the only demander of labor in this market, it can influence the wage rate. Monopsnoists face an upward-sloping supply curve. This is because the supply curve confronting them is the market supply curve. Because the firm is the only demander of labor in this market, it can influence the wage rate. Monopsnoists face an upward-sloping supply curve. This is because the supply curve confronting them is the market supply curve. Note: To expand its work force, a monopsonist must increase its wage rate, i.e., the marginal cost of hiring labor excess the wage.

13. To maximize profits, we know that any firm should hire labor until the points at which marginal revenue product equals marginal cost. MRP = MC L W L MRP S MC L EmEm EcEc WmWm WCWC Wages are below marginal revenue product for a monopsonist. W m < W C and E m < E C

14. (2) Monopoly A monopoly trying to maximize profits and facing a competitive labor market will hire workers until its marginal revenue product equals the wage rate: A monopoly trying to maximize profits and facing a competitive labor market will hire workers until its marginal revenue product equals the wage rate: MRP = (MP L )(MR) = W MRP = (MP L )(MR) = W → (MR/P)(MP L ) = (W/P) → (MR/P)(MP L ) = (W/P) <1 <1 The demand-for-labor curve for a firm that has monopoly power in the output market will lie below and to the left of the demand-for-labor curve for an otherwise identical firm that takes product prices as given. The demand-for-labor curve for a firm that has monopoly power in the output market will lie below and to the left of the demand-for-labor curve for an otherwise identical firm that takes product prices as given.

15. Note: The wage rates that monopolies pay are not necessarily different from competitive levels even though employment levels are. An employer with a product market monopoly may still be a very small part of the market for a particular kind of employee, and thus be a price taker in the labor market even though a price maker in the product market. Employment Dollars The Labor Demand of a Monopolist VMP E MRP E W A EmEm E*