1. Chapter 11: The Labor Market
Econ 101: Microeconomics
Chapter 11:
The Labor Market

2. Product vs. Factor Markets
To date, our focus has been on the supply and demand for end-products, also known as product markets
Markets in which firms sell goods and services to households or other firms
Products made from the economy’s resources
Another important set of markets are the factor markets
Markets in which resources are sold to firms
Resources include capital, land, labor, and natural resources
Resources are sometimes called factors of production
Hall & Leiberman; Economics: Principles And Applications, 2004

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
Hall & Leiberman; Economics: Principles And Applications, 2004

4. 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
Hall & Leiberman; Economics: Principles And Applications, 2004

5. Hall & Leiberman; Economics: Principles And Applications, 2004
Derived Demand
The demand for labor is a derived demand―it arises from, and will vary with—the demand for the firm’s output
The phrase “will vary with” is important
The demand for labor by a firm will change whenever demand for the firm’s product changes
Hall & Leiberman; Economics: Principles And Applications, 2004

6. Resource Demand: A General Rule
Marginal approach to profit
Firm should take any action that adds more to its revenue than it adds to its cost
When we view firm as a buyer in a resource or factor market, we use same principle of marginal decision making
This time action under consideration is “increase employment of the resource by another unit”
Rule becomes
Increase employment of any resource whenever doing so adds more to revenue than it adds to cost
To avoid confusion between decisions about resources and decisions about output, we don’t use terms “marginal revenue” and “marginal cost” when discussing factor markets
To track changes on the revenue side, use term “marginal revenue product”
Hall & Leiberman; Economics: Principles And Applications, 2004

7. Marginal Revenue Product (MRP)
The change in firm’s total revenue divided by change in its employment of a resource
MRP is the change in the firm’s revenue when it employs one more unit of the resource
Hall & Leiberman; Economics: Principles And Applications, 2004

8. Marginal Factor Cost (MFC)
To track changes on the cost side, we use the term marginal factor cost
The MFC tells us the rise in cost per unit increase in the resource.
When Δ Quantity of Resource = 1, MFC is increase in cost from employing one more unit of resource
Hall & Leiberman; Economics: Principles And Applications, 2004

9. Marginal Approach to Profit
To maximize profit firm should increase its employment of any resource whenever MRP > MFC
But not when MRP < MFC
Profit-maximizing quantity of any resource is quantity at which MRP = MFC
If MRP > MFC, employing more of resource increases revenue more than cost
Profit will rise
When MRP < MFC, using more of resource adds more to cost than to revenue
Profit falls
When firm exploits every opportunity to increase profit it will arrive at the point at which MRP = MFC
Hall & Leiberman; Economics: Principles And Applications, 2004

10. The Firm’s Employment Decision When Only Labor Is Variable
The Firm’s MRP in a Competitive Product Market
When output is sold in a competitive product market
MRP for any change in employment will equal price of output (P) times marginal product of labor (MPL)
MRP = P x MPL
The Firm’s MFC in a Competitive Labor Market
When labor is hired in a competitive labor market, MFC for any change in employment will equal market wage rate (W)
MFC = W
Hall & Leiberman; Economics: Principles And Applications, 2004

11. The Profit-Maximizing Employment Level
Marginal approach to profit
A firm should take any action that adds more to its revenue than to its cost
Hire another worker when MRP > W, but not when MRP < W
To maximize profit, the firm should hire the number of workers such that MRP = W
Where the MRP curve intersects the wage line
Hall & Leiberman; Economics: Principles And Applications, 2004

12. Figure 2: The Profit-Maximizing Employment Level
Number of Workers
Dollars
$200 1 3 4 5 6 7 8
150 50
100
1. Hiring another worker adds more to revenue . . .
3. until profits are maximized at five workers. 60
MFC = Wage
2. than it adds to cost . . .
MRP
Hall & Leiberman; Economics: Principles And Applications, 2004

13. The Two Approaches to Profit Maximization
Two different approaches for the firm to follow to maximize profit
MR and MC approach to find profit-maximizing output
MRP and MFC approach to find profit-maximizing employment
Can these two approaches lead to different decisions?
No, because these two “different” approaches are actually the same method viewed in two different ways
Remember that hiring another worker increases the firm’s output and therefore changes both its revenue and its cost
Whenever MRP > MFC for a change in employment, MR > MC for associated rise in output
Whenever MRP < MFC for a change in employment, MR < MC for associated rise in output
If MRP = MFC for a change in employment, MR = MC for associated change in output
Hall & Leiberman; Economics: Principles And Applications, 2004

14. The Firm’s Labor Demand Curve
When labor is the only variable input, downward-sloping portion of MRP curve is firm’s labor demand curve
Tells us how much labor firm will want to employ at each wage rate
Hall & Leiberman; Economics: Principles And Applications, 2004

15. Figure 3: The Firm’s Labor Demand Curve
Number of Workers
Dollars
Firm's Labor Demand Curve A W1 W1 B W2 W2
MRP n1 n2
Hall & Leiberman; Economics: Principles And Applications, 2004

16. The Firm’s Employment Decision When Several Inputs are Variable
Whether the firm can vary just labor, or several inputs simultaneously
Optimal level of employment will satisfy the MRP = W rule
Firm’s labor demand curve will slope downward
Decrease in wage rate will cause an increase in employment
Hall & Leiberman; Economics: Principles And Applications, 2004

17. Figure 4: The Employment Decision with Several Variable Inputs
Number of Workers
Dollars A W1 W1 B C W2 W2
Firm' Labor Demand Curve
MRP
MRP n1 n2 n3
Hall & Leiberman; Economics: Principles And Applications, 2004

18. The Market Demand For Labor
Market Labor Demand Curve
Indicates total number of workers all firms in a labor market want to employ at each wage rate
Found by horizontally summing across all firms’ individual labor demand curves
Hall & Leiberman; Economics: Principles And Applications, 2004

19. Figure 5/b/c: The Market Demand For Labor
Number of Workers
Hourly Wage
Firm A
Firm B
Firm C
$12 10 ld ld
At any wage rate (such as $10) . . . ld
and by Firms B, C, and all other firms as well . . .
if we add the number of workers demanded by Firm A . . . 80
100 40 50 30 90
Hall & Leiberman; Economics: Principles And Applications, 2004

20. Figure 5d: The Market Demand For Labor
Hourly Wage
Number of Workers
Labor Market
we get the market quantity of labor demanded at that wage rate.
$12 10 LD
N2 = ….
N1 = …
Hall & Leiberman; Economics: Principles And Applications, 2004

21. Figure 6: A Shift in the Labor Demand Curve
Number of Workers
Hourly Wage B A n2
$10
Typical Firm
Labor Market N1 N2
Hall & Leiberman; Economics: Principles And Applications, 2004

22. Shifts in the Market Labor Demand Curve
A change in any variable that affects quantity of labor demanded—except for the wage rate—causes labor demand curve to shift
Specific variables that shift the labor demand curve include a change in
Demand for the firm’s product
Technology
Prince of another input
Number of firms
Hall & Leiberman; Economics: Principles And Applications, 2004

23. A Change in Demand for the Firm’s Output
Effect of a change in output price on labor demand depends on whether many firms in the labor market also share the same product market
When they do
A rise in output price will shift market labor demand curve rightward
A fall in output price will shift market labor demand curve leftward
Hall & Leiberman; Economics: Principles And Applications, 2004

24. Hall & Leiberman; Economics: Principles And Applications, 2004
A Change in Technology
Complementary Input
An input whose utilization increases marginal product of another input
Substitute Input
An input whose utilization decreases marginal product of another input
Hall & Leiberman; Economics: Principles And Applications, 2004

25. Hall & Leiberman; Economics: Principles And Applications, 2004
A Change in Technology
When many firms in a labor market acquire a new technology, the market labor demand curve will shift
Rightward if technology is complementary with labor
Leftward if technology is substitutable for labor
Hall & Leiberman; Economics: Principles And Applications, 2004

26. Figure 7: Introducing a New Input
Number of Workers
Hourly Wage
More of a Substitutable Input
More of a Complementary Input
Hall & Leiberman; Economics: Principles And Applications, 2004

27. A Change in the Price of Another Input
When price of some other input decreases, market labor demand curve may shift
Rightward if the input is complementary with labor
Leftward if the input is substitutable for labor
Hall & Leiberman; Economics: Principles And Applications, 2004

28. Individual Labor Supply
Individuals as wage takers
No single labor seller can affect the market wage
In a competitive labor market
Each seller is a wage taker
He or she takes market wage rate as given
Hall & Leiberman; Economics: Principles And Applications, 2004

29. The Income-Leisure Trade-off
Wage rate determines exact nature of the income-leisure trade-off
Higher the income »» higher the expense of leisure time
Hall & Leiberman; Economics: Principles And Applications, 2004

30. The Labor Supply Decision
Individuals who are able to choose their own hours may
Choose optimal combination of income and leisure
Individuals who are not able to choose their own hours
Only make the choice of whether to offer their labor in a particular market or not
Hall & Leiberman; Economics: Principles And Applications, 2004

31. Hall & Leiberman; Economics: Principles And Applications, 2004
Reservation Wages
Lowest wage rate at which an individual would supply labor to a particular labor market
When wage rate in a market exceeds an individual’s reservation wage for that market
Individual will decide to work there
Hall & Leiberman; Economics: Principles And Applications, 2004

32. Hall & Leiberman; Economics: Principles And Applications, 2004
Market Labor Supply
Curve indicating the number of people who want jobs in a labor market at each wage rate
The higher the wage rate, the greater the quantity of labor supplied
Hall & Leiberman; Economics: Principles And Applications, 2004

33. Figure 8: The Market Labor Supply Curve
Number of Workers
Hourly
Wage
(a) D
$12 C 10
$10
1,000
1,200
1,000
1,800
Hall & Leiberman; Economics: Principles And Applications, 2004

34. Shifts in the Market Labor Supply Curve
A market labor supply curve will shift when
Something other than a change in wage rate causes a change in number of people who want to work in a particular market
Factors causing a labor supply curve to shift include
Change in market wage rate in other labor markets
Changes in cost of acquiring human capital
Number of qualified people
Changes in tastes
Hall & Leiberman; Economics: Principles And Applications, 2004

35. A Change in the Market Wage Rate in Other Labor Markets
As long as some individuals can choose to supply their labor in two different markets
A rise in wage rate in one market will cause a leftward shift in labor supply curve in other market
Hall & Leiberman; Economics: Principles And Applications, 2004

36. Changes in the Cost of Acquiring Human Capital
An increase in the cost of acquiring human capital will shift the labor supply curve leftward
A decrease in the cost of acquiring human capital will shift the labor supply curve rightward
Hall & Leiberman; Economics: Principles And Applications, 2004

37. Number of Qualified People
Population growth causes labor supply curves in both national and local labor market to shift rightward over time
Labor supply curves can also shift due to migration within a country
If new people entering a field exceeds number of retirees in that field
Increase in supply results
Hall & Leiberman; Economics: Principles And Applications, 2004

38. Hall & Leiberman; Economics: Principles And Applications, 2004
Changes in Tastes
Different types of jobs attract different people with different tastes
Danger and excitement vs. safety and routine
Women entering the workforce
Social contribution to community
Hall & Leiberman; Economics: Principles And Applications, 2004

39. Short-Run vs. Long-Run Labor Supply
Labor supply response to a wage-rate change comes from those who already have skills and geographic location needed to work in a market
Long-run
Labor supply response to a wage-rate change comes from those who will acquire skills and move into geographic location needed to work in a market
Hall & Leiberman; Economics: Principles And Applications, 2004

40. Short-Run vs. Long-Run Labor Supply
Long-run labor supply curve indicates how many (qualified) people will want to work in a labor market
After full adjustment to a change in the wage rate
Long-run labor supply response is more wage elastic than short-run labor supply response
Hall & Leiberman; Economics: Principles And Applications, 2004

41. Figure 9: The Long-Run Labor Supply Curve
2. When the wage rate rises to $40, employment rises to 60,000 in the short run.
Number of Workers
Hourly
Wage .
1. Initially, the wage is $25 and 30,000 people supply labor.
$40
3. In the long run, the wage rate of $40 attracts new entrants and employment rises to 90,000. B C A 25
4.The long-run labor supply curve connects points A and C.
30,000
60,000
90,000
Hall & Leiberman; Economics: Principles And Applications, 2004

42. Labor Market Equilibrium
Supply and demand will drive a competitive labor market to its equilibrium point
Point where the labor supply and labor demand curves intersect
Hall & Leiberman; Economics: Principles And Applications, 2004

43. Figure 10: Labor Market Equilibrium
Number of Paralegals
Hourly
Wage
Dollars
Labor Market
Typical Firm
3. hires up to where its MRP curve crosses the $20 wage line. LS
$24 20
$20 W 16 LD
2. Each law firm, taking the market wage of $20 as a given, ld
2,000
3,000
4,500 10
1. The market labor supply and labor demand curves determine the equilibrium wage rate and equilibrium employment.
Hall & Leiberman; Economics: Principles And Applications, 2004

44. What Happens When Things Change?
Events that can cause labor demand curve and labor supply curve to shift include
Change in labor demand
Change in labor supply
Labor shortages and surpluses
Hall & Leiberman; Economics: Principles And Applications, 2004

45. A Change in Labor Demand
In short-run, shift in labor demand moves along a short-run labor supply curve
In long-run, resulting increase in wage rate will cause short-run labor supply curve to shift also
Hall & Leiberman; Economics: Principles And Applications, 2004

46. Figure 11: A Change in Labor Demand
Number
of Workers
Hourly
Wage
Number of Workers
Labor Market
Typical Firm
Dollars B b
$40
$40 W C c 30 30 W A a 20 20 W
5,000
12,000 50 80
120
8,000
Hall & Leiberman; Economics: Principles And Applications, 2004

47. Hall & Leiberman; Economics: Principles And Applications, 2004
Change in Labor Supply
Shifts in labor supply typically happen slowly
When a long-run change in labor supply is the cause of changes in the labor market
No separate short-run change in equilibrium to investigate
Hall & Leiberman; Economics: Principles And Applications, 2004

48. Figure 12: The Market For Finance Professors (1995-2002)
Number of New Finance Professors
Annual Wage B
$102,400
66,900 A N1 N2
Hall & Leiberman; Economics: Principles And Applications, 2004

49. Labor Shortages and Surpluses
Quantity of labor demanded exceeds quantity supplied at prevailing wage rate
Labor Surplus
Quantity of labor supplied exceeds quantity demanded at prevailing wage rate
Hall & Leiberman; Economics: Principles And Applications, 2004

50. Labor Shortages and Surpluses
Shortages and surpluses in a labor market are not natural consequence of shifts in supply and demand curves
Labor shortage will occur only when wage rate fails to rise to its equilibrium value
Labor surplus will occur only when wage rate fails to fall to its equilibrium value
Hall & Leiberman; Economics: Principles And Applications, 2004

51. Using the Theory: Understanding the Market for College-Educated Labor
Students have many motives for attending college
One of the most important motives is to invest in their own human capital
Going to college will enable you to earn a higher income than you would otherwise be able to earn
Economists track the college wage premium
Percentage by which average college graduate’s income exceeds average high school graduate’s income
Wage premium was relatively stable in 1960s and 1970s, at around 40 to 50%
But premium began to rise sharply in 1980s and continued its rise through 1990s
By 2001 college wage premium reached 76% for men and 97% for women
Hall & Leiberman; Economics: Principles And Applications, 2004

52. Using the Theory: Understanding the Market for College-Educated Labor
Why did labor supply shift rightward each year?
An increase in proportion of young people attending college
Population itself increased
Why did labor demand curve shift rightward each year?
Partly due to normal growth in economy
Technological change
Increase skill requirements for many types of work
Hall & Leiberman; Economics: Principles And Applications, 2004

53. Figure 13: The Market for College-Educated Labor
In 1978, the average wage rate (in 2001 dollars) for college-educated labor was $31,732.
Between 1978 and 2000, the labor supply curve shifted rightward . . .
Millions
of Workers
Median
Annual
Wage
2001
dollars
but the rightward shift in the labor demand curve was even greater.
$40,479 B
31,732 A
As a result, the average wage in 2001 rose to $40,479. 14 31
Hall & Leiberman; Economics: Principles And Applications, 2004

54. Using the Theory: Understanding the Market for College-Educated Labor
An increase in yearly wage rate has resulted over last two decades
Because demand curve for college graduates shifted rightward faster than supply curve
What will happen in the future?
Competing trends
Acceleration in rightward shift of labor supply curve for college graduates
Will work to decrease college wage premium
Acceleration in rightward shift of labor demand curve for college graduates
Due to further changes in technology
Hall & Leiberman; Economics: Principles And Applications, 2004

55. Using the Theory: Understanding the Market for College-Educated Labor
Most labor market economists predict
For college-educated labor
Labor demand curve will shift rightward more rapidly than labor supply curve over next several years
Wage rate for college graduates is expected to rise
For high school graduates
Shifts in labor supply curve are expected to outpace shifts in demand curve
Wage premium for college students is expected to increase
Hall & Leiberman; Economics: Principles And Applications, 2004