1. The Labor Market
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

2. The Labor Market
The model of supply and demand can be used to study the determination of wages & employment in the labor market.
Topics in this chapter include:
The determination of wages in a perfectly competitive market
An explanation of why wages differ from one occupation to another
The effects of labor market imperfections
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

3. A Perfectly Competitive Input Market
A perfectly competitive firm:
Takes the prices of its inputs as given (price taker in the input market);
Is one of so many hiring firms in the market;
Can hire as many workers as it wants as long as it pays the market wage rate.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

4. Diminishing Returns and the Optimal Quantity of Labor
The firm uses the marginal principle to decide how many workers to hire.
Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.
The firm will pick the quantity of labor at which the marginal benefit of labor equals the marginal cost of labor.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

5. The Marginal Cost of Labor
The marginal cost of labor is simply the hourly wage in the market, or the extra cost associated with one more hour of labor.
The marginal cost curve is also the labor-supply curve faced by the firm.
When the wage is $8 an hour, the firm can hire 3, 5 or any number of workers at that wage.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

6. The Marginal Benefit of Labor
The marginal benefit of labor equals the monetary value of the output produced with an additional hour of labor.
The marginal benefit of labor is called marginal revenue product (MRP), or the extra revenue generated by one additional worker.
MRP = price of output × marginal product
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

7. The Firm Faces Diminishing Returns in the Short Run
In the short run, the firm is subject to diminishing marginal returns from labor. The change in output from one additional worker decreases as the number of workers increases.
PRINCIPLE of Diminishing Returns Suppose that output is produced with two or more inputs and that we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

8. Marginal Benefit and Diminishing Returns
Because the firm faces diminishing returns in the short run, the marginal product of labor decreases with additional workers hired.
In other words, there is a negative relationship between the number of workers hired and marginal revenue product.
The MRP curve (or marginal benefit) is also the firm’s short-run demand curve for labor.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

9. The Marginal Benefit (Demand) and the Marginal Cost (Supply) of Labor
The Marginal Principle for Labor Decision
Number of workers
Balls per hour
Marginal product
Price Per Ball
Marginal Benefit = MRP
Profit (Total Approach
Marginal Cost = Wage 1 26
$0.5
$13
$5,090 $8 2 50 24
$12
$5,760 3 72 22
$11
$6,165 4 92 20
$10
$6,300 5
108 16 6
120 12 $6
$5,740 7
128 8 $4
$5,000
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10. How Many Workers Will the Firm Hire?
At an hourly wage of $8, how many workers should the firm hire? Why? n
Marginal revenue product equals marginal cost when the firm hires five workers. 11 m 8
Marginal cost when Wage=$8
Marginal Benefit or marginal cost ($) t 6
Marginal Revenue Product or marginal benefit curve 3 5 6
Number of workers
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11. How Many Workers Will the Firm Hire?
At $8 an hour, the firm hires 5 workers. If the wage goes up to $11 an hour, how many workers should the firm hire? Why?
Marginal revenue product equals marginal cost when the firm hires three workers. n 11
Marginal cost when Wage=$11 m 8
Marginal cost when Wage=$8
Marginal Benefit or marginal cost ($) t 6
Marginal Revenue Product or marginal benefit curve 3 5 6
Number of workers
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12. Shifts in the Demand for Labor Curve
To draw the labor demand curve, we hold fixed the price of the output and the productivity of workers.
An increase in the price of the output or in productivity will shift the labor demand curve to the right.
At each wage, the firm will hire more workers.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

13. The SR Market Demand for Labor
The short-run market demand curve for labor is the sum of the labor demands of all the firms that use a particular type of labor.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

14. Labor Demand in the Long Run
The long-run labor demand curve shows the relationship between the wage and the quantity of labor demanded over the long run, when the number of firms and the size of their production facilities can change.
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15. Labor Demand in the Long Run
Although there are no diminishing returns in the long run, the long-run labor demand curve is still negatively sloped for two reasons:
The output effect: higher wages mean higher production costs, higher prices, lower quantity demanded, lower output sold; therefore, less need for inputs
The input-substitution effect: higher wages will cause the firm to substitute other inputs for labor; the firm will use more machinery and fewer workers
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

16. Short-run Versus Long-run Labor Demand
The demand for labor is less elastic (steeper) in the short-run than in the long run (flatter), because in the short run the firm has less flexibility to substitute other inputs for labor or modify its production facilities.
A decrease in wages, for example, results in a larger number of workers hired in the long run, after firms have a chance to make their facilities more labor-intensive.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

17. The Supply of Labor
The labor supply curve shows the amount of labor hours that will be supplied at each wage, for a specific occupation, in a specific geographical area.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

18. The Individual Decision: How Many Hours?
The decision to work is based on the principle of opportunity cost.
PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.
The decision to work is a decision to sacrifice leisure, and vice versa. In other words, the opportunity cost of leisure is the income sacrificed for each hour of leisure, or the hourly wage.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

19. The Demand for Leisure
An increase in the wage—the price of labor—has the following effects on the demand for leisure:
Substitution effect: as the wage increases, a worker will substitute income for leisure time
Income effect: an increase in the wage increases the worker’s real income and the demand for leisure time
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20. The Demand for Leisure
The substitution and income effects of a higher wage move in opposite directions:
The substitution effect increases the desired leisure time
The income effect decreases the desired leisure time
Therefore, we can’t predict if a higher wage will increase or decrease the preference for leisure, and consequently the supply of labor.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

21. The Demand for Leisure
There are three possible responses to a higher wage:
A decrease in hours worked while income remains the same
No change in hours worked, while income increases and leisure remains the same
An increase in hours worked, while income increases and leisure decreases
Studies show that in most labor markets, increases in hours worked nearly offset decreases.
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22. The Market Supply Curve
The market supply curve for labor shows the relationship between the wage and the quantity of labor supplied.
The positive slope of the labor supply curve is consistent with the law of supply. The higher the wage, the larger the quantity of labor supplied.
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23. Reasons for the Positive Slope of the Labor Supply Curve
An increase in the wage affects the quantity of labor supplied in three ways:
An increase in hours worked per worker
Occupational choice: a higher wage will attract workers to that occupation
Migration: people will move to the city where wages in a given occupation are higher
The first effect is uncertain, but the second and third effects carry sufficient weight to make the supply curve positively sloped.
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24. Market Equilibrium
Equilibrium in the labor market exists when there is no pressure for the wage to change. Changes in demand and supply will affect market equilibrium.
Market Supply curve
Hourly Wage ($) e 20 b c 13
Market demand curve
Hours of nursing per day
8,000
16,000
24,000
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25. Market Equilibrium
Equilibrium in the labor market exists when there is no pressure for the wage to change. Changes in demand and supply will affect market equilibrium.
In this example, an increase in demand increases the wage and the quantity of nursing services.
Market Supply curve f
Hourly Wage ($) 22 e 20
New demand curve
Market demand curve
Hours of nursing per day
16,000
19,000
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26. Explaining Differences in Wage and Income
When the supply of workers is small relative to the demand for those workers, the wage will be high.
Hourly
Wage ($)
Supply with few workers f
Market
Supply curve
Supply could be small for four reasons:
Few people have the required skills
There are high training costs involved
Undesirable job features
Artificial barriers to entry 30 e 20
Market demand curve
8,000
16,000
Hours of nursing per day
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27. Gender Discrimination
Studies about the gender gap have found that:
Women in many occupations have less education, less work experience, thus are less productive and are paid less.
Access denied to many occupations has caused women to flood certain other occupations. To close the gender gap, women would have to change occupations.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

28. Race Discrimination Studies about the gender gap have found that:
In 1995, black males earned 73% as much as their white counterparts.
Hispanic males earned 62% as much as white males. Hispanic females eared 73% as much as white females.
Discrimination decreases the wages of black men by about 13%.
Part of the earnings gap is due to productivity differences and part is due to racial discrimination, but in the 1990s, most disparities were due to differences in skills, not discrimination.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

29. Why Do College Graduates Earn Higher Wages?
In 2001, the typical graduate earned 76% more than the typical high-school graduate. Here are two reasons why:
The learning effect: college students learn the skills required for certain occupations for which there is a smaller supply of workers
The signaling effect: a person who completes a college degree sends a signal to the employers that some of the skills required to complete a degree are the same skills required at work (time management, ability to learn, etc.)
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30. Public Policy and Labor Markets: Effects of the Minimum Wage
The minimum wage decreases the quantity of labor employed and yields good news and bad news for workers and employers:
Good news: some workers keep their jobs and earn a higher wage.
Bad news: some workers lose their jobs, and production costs rise, increasing the price of goods and services. 51
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31. Public Policy and Labor Markets: Occupational Licensing
Government-sanctioned licensing boards require a person to:
Complete an educational program.
Pass an examination.
Have a certain amount of work experience.
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32. Public Policy and Labor Markets: Occupational Licensing
Occupational licensing has been criticized on three grounds:
Weak link between performance and licensing requirements
Alternative means of protection from incompetent workers
Restrictions that increase the cost of entry result in a decrease in the supply of workers, and an increase the wages paid
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33. Labor Unions
A labor union is an organized group of workers who generally pursue the following objectives:
To increase job security
To improve working conditions
To increase wages and fringe benefits
There are two types of labor unions:
Craft unions
Industrial unions
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34. Unionization Rates in the United States
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35. Important Pieces of Labor Legislation
1935
The Wagner Act guaranteed workers the right to join unions and required each firm to bargain with a union formed by a majority of its workers. The National Labor Relations Act was established to enforce the provisions of the Wagner Act.
1947
The Taft-Harley Act gave government the power to stop strikes that “imperiled the national health or safety” and gave the states the right to pass “right-to-work” laws. Right-to-work laws outlaw union membership as a precondition of employment.
1959
The Landrum-Griffin Act was a response to allegations of corruption and misconduct by union officials. This act guaranteed union members the right to fair elections, made it easier to monitor union finances, and made the theft of union funds a federal offense.
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36. Labor Unions and Wages
Three approaches to increase the wages of union workers:
Organize workers and negotiate a higher wage—restricting membership
Promote the products produced by union workers; labor demand is derived demand
Increase the amount of labor required to produce a given quantity of output—a practice known as “featherbedding”
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37. Imperfect Information in the Labor Market
There is asymmetric information in the labor market because employers cannot distinguish between skillful and unskillful workers, or between hard workers and lazy workers.
If the employer cannot distinguish between different types of workers, it will pay a single wage, realizing that it will probably hire workers of each type.
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38. Efficiency Wages
To attract some high-skill workers, the employer must pay a wage that exceeds the opportunity cost of high-skill workers.
As the firm attracts more skilled workers, the average productivity of the workforce rises.
It follows that by paying efficiency wages to increase the average productivity of its workforce, a firm could increase its profit.
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