1. Wage Determination Chapter 13 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives Labor productivity and real compensation Wage and employment determination Competitive and monopsony markets Unions and wage rates Causes of wage differentials “Pay-for-Performance” plans 13-2

3. Labor Wages and Earnings Wages refer to the price paid for labor –Labor may be workers such as blue-collar and white collar workers –Workers may also be professional people and owners of small businesses since they provide their own labor services in operating their business Wages may also be in the form of bonuses, royalities, commisions and salaries In this chapter, the term wages is used to mean the wage rate or price paid per unit of labor time 13-3

4. Labor Wages and Earnings There is an important distinction between nominal and real wages Nominal wages are the amount of money received per hour (or day, etc), however real wages are the purchasing power of the wage –For example, if nominal wages rise by 10% and there is a 5% inflation rate, then the real wage rose by only by 5% –In our discussions, it is assumed that the price level is constant (no inflation) and the term “wages” refers to “real wages”

5. Level of Wages Across Nations Hourly Wages of Production Workers Hourly Pay in U.S. Dollars, 2006 Source: U.S. Bureau of Labor Statistics, 2006 Germany Sweden Switzerland United Kingdom Australia Canada Italy France United States Japan Spain Korea Taiwan Mexico 0 5 10 15 20 25 30 35 13-5

6. Role of Productivity Productivity is very important in determining wages Historically, American wages have been high and have risen because of high productivity There are several reasons for the high productivity –Capital equipment per worker is high –Natural resources have been abundant relative to the labor force –Technological advances have been generally higher in the U.S. than in most other nations 13-6

7. Role of Productivity The quality of American labor has been high because of good education, health, and work attitudes Other reasons include good management, stable social and political environment, the large size of the domestic market, and increased specialization of global production enhanced by free-trade agreements

8. Real Wages Long run trend of average real wages in the U.S. –Variation across occupations Real Wage Rate (Dollars) Quantity of Labor D 1900 S 1900 D 1950 D 2000 D 2020 S 1950 S 2000 S 2020 13-8

9. Model of the Competitive Labor Market Characteristics of a competitive labor market include: –Numerous firms competing to hire a specific type of labor –Many qualified workers with identical skills available to supply this type of labor service –Both employer and employee are “wage takers” in that neither can control the market wage rate 13-9

10. Model of the Competitive Labor Market The market demand for labor is determined by summing horizontally the labor demand curves (MRP curves) of the individual firms

11. Model of the Competitive Labor Market The market supply of labor will be determined by the amount of labor offered at different wage rates; more will be supplied at higher wages because the wage must cover the opportunity costs of alternative uses of time spent either in other labor markets or in leisure activities The market equilibrium wage and quantity of labor employed will be where the labor demand and supply curves intersect This occurs at a $10 wage and 1,000 employed

12. Model of the Competitive Labor Market Individual firms will take this wage rate as given, and will hire workers up to the point at which the market wage rate is equal to the MRP of the last worker (according to the MRP=MRC rule) Note that the demand curve in Figure 13.3 is based on figures from Table 12.1 in the last chapter For each firm, the MRC is constant and equal to the wage because the firm is a “wage taker” and by itself has no influence on the wage in the competitive model

13. Model of the Competitive Labor Market

14. Wage Rate (Dollars) ($10) W C ($10) W C Labor MarketIndividual Firm Quantity of Labor QCQC (1000) 00 D=MRP (∑ mrp’s) d=mrp qCqC (5) s=MRC S e c b a Competitive Labor Market 13-14

15. Monopsony Model Monopsony is a market in which a single employer of labor has substantial power over hiring –There is only a single buyer of a particular type of labor –The labor immobile, either geographically or because of lack of skills –The firm is a “wage maker” because the wage rate it must pay varies directly with the number of workers it employs 13-15

16. Characteristics of the Monopsony Model The labor supply curve will be upward sloping; if the firm is large relative to the labor market, it will have to pay a higher wage rate to attract more labor As a result, the marginal resource cost (the cost of hiring labor) will exceed the wage rate because the higher wage paid to additional workers will have to be paid to all similar workers employed

17. Characteristics of the Monopsony Model Therefore, the MRC is the wage rate of an added worker plus the increments that will have to be paid to others already employed Equilibrium in the monopsonistic labor market will also occur at MRC=MRP However, now the MRC is above the wage so the wage will be lower than it would be if the market were competitive As a result, the monopsonistic firm will hire fewer workers than under competitive conditions

18. Characteristics of the Monopsony Model For example, one worker can be hired at a wage rate of $6. To hire the second, you would pay him/her $7 plus $1 to the first worker or you would have unhappy workers! –The MRC for the second worker is $8 To hire the third worker, you would pay them $8 plus $1 for each of the first two, making the MRC of the third worker $10 Key point: the MRC cost for the Monopsonist exceeds the wage rate and lies above the average labor supply curve S

19. Wage Rate (Dollars) Quantity of Labor 0 S MRP MRC c b a WcWc WmWm QmQm QcQc Examples of monopsony power Monopsony Model 13-19

20. Monopsony Model Conclusion: in a monopsonistic labor market there will be fewer workers hired and at a lower wage than would be the case if that same labor market were competitive, other things being equal –Nurses paid less in towns with fewer hospitals

21. Union labor models With unions, employers do not deal directly with the individual workers, but with their unions who try to raise wage rates in several ways Demand-Enhancement Model –Unions prefer to raise wages by increasing the demand for labor –Unions may try to increase the price of substitute resources, thus increasing the demand for union workers (supporting politically a higher minimum wage) –Unions can increase the demand for labor by supporting public actions that would result in the construction of mass-transit systems where unions would supply most of the workers

22. Demand Enhancement Model Union model –Increase product demand –Alter price of other inputs, such as minimum-wage Wage Rate (Dollars) Quantity of Labor WuWu QcQc QuQu WcWc D1D1 D2D2 S Increase In Demand 13-22

23. Exclusive or Craft Union Model The members of Craft Unions possess a particular skill such as brick masons, carpenters, or plumbers The craft unions are able to raise wage rates by restricting the supply of workers –Large membership fees; compulsory retirement –Long apprenticeships; shorter work week –Forcing employers to hire only union workers 13-23

24. Inclusive or industrial unions Industrial unions include companies such as automobile workers and steelworkers They seek both skilled and unskilled workers so they have the power to impose a higher wage than the employer would otherwise pay The bargained wage becomes the MRC for the employer between point “a” and “b ”

25. Inclusive or industrial unions In fig. 13.7, the competitive equilibrium wage is Wc and the level of employment is Qc An industrial union might demand a higher wage rate of Wu That wage rate Wu would create a perfectly elastic labor supply over the range ae If firms wanted to hire any workers in this range, they would have to pay the union-imposed wage rate If they decide against this, they would face a strike If firms decide to pay the higher rate, they will cut back on employment from Qc to Qu

26. Inclusive or industrial unions Note from point e on the labor supply curve that Qe workers desire employment at wage Wu But as indicated by point b on labor demand curve D, only Qu workers are employed As a consequence, a surplus of labor of Qe-Qu results In a competitive market, the effect of surplus of unemployed workers would be lower wages. However, with a union, individual workers can not work for less and employers can not pay less than that

27. Union Models Are unions successful? Wages 15% higher on average Consequences: –Higher unemployment –Restricted ability to demand higher wages because of the effect of increasing unemployment within the unions 13-27

28. Minimum Wage The minimum wage controversy concerns the effectiveness of minimum wage legislation as an antipoverty device The Federal minimum wage has ranged between 30 and 50 percent of the average wage paid to manufacturing workers in 2007 13-28

29. Minimum Wage The case against minimum wage contains two major criticisms –The minimum wage forces employers to pay a higher than equilibrium wage, so they will hire fewer workers as the wage pushes them higher on their MRP curve –The minimum wage is not an effective tool to fight poverty. Some minimum wage workers are teens or from affluent families who do not need protection from poverty

30. Minimum Wage The case for minimum wage indicates that minimum-wage laws occur in markets that are not competitive and always changing In a monopolistic market, the minimum wage increases wages with minimal effects on employment Increasing minimum wage may increase productivity: managers will use workers more efficiently when they have higher wages; minimum wage may reduce labor turnover and thus training costs

31. Wage Differentials Wage differentials can be explained by using supply and demand for various occupations Given the same supply conditions, workers for whom there is a strong demand will receive higher wages Given the same demand conditions, workers where there is a reduced supply will receive higher wages

32. Labor Demand, Labor Supply and Wage Differentials

33. Wage Differentials Average Annual Wages, 2007 Surgeons Aircraft Pilots Petroleum Engineers Financial Managers Law Professors Chemical Engineers Dental Hygienists Registered Nurses Police Officers Electricians Travel Agents Barbers Retail Salespersons Recreation Workers Teacher Aides Fast Food Cooks $191,410 148,810 113,890 106,200 95,510 84,240 64,910 62,480 50,670 48,100 32,190 25,860 24,530 23,790 22,820 16,860 Source: Bureau of Labor Statistics, 2006 Occupation Annual Average Wages 13-33

34. Labor Supply and Demand Differences across occupations Explains wage differentials Marginal revenue productivity Noncompeting groups –Ability –Education and training Compensating differences 13-34

35. Labor Supply and Demand A workers contribution to the employer’s total revenue (MRP) will depend upon the worker’s productivity and the demand for the final product On the supply side, workers are not all the same, i.e., they are in noncompeting groups which differ by: –Ability level –Education and training

36. Education levels and individual earnings

37. Labor Supply and Demand Wage differentials may also exist because of nonmonetary aspects of a job –Physically hard –Fear of being laid off –Unsafe job –Poor advancement opportunities

38. Inability to go from a lower to higher paying job (Market Imperfection) Workers lack information about alternative job opportunities Workers may be reluctant to move to other geographic locations Artificial restraints on mobility (some municipalities require that you live within them if you are employed by them) Discrimination in certain labor markets may crowd women and minorities into certain labor markets and out of others –This is referred to as occupational segregation

39. Pay for Performance The principal-agent problem occurs when the interests of the worker and the firm are not identical –Workers will act to improve their own well-being, often at the expense of the firm –Loafing on the job, using company materials, just not working very hard 13-39

40. Principal-agent problem Incentive methods sometimes help to avoid the principal-agent problem With piece-rate payments, workers earn according to the quantity of output produced Commissions and royalties are payment schemes linked to the value of sales Bonuses, stock options, and profit sharing are other ways to motivate workers Efficiency wages also may provide an incentive through paying above average wages

41. Negative sides to the incentive approach A rapid production pace can compromise quality and endanger workers Commissions may cause salespeople to exaggerate claims Bonuses based on personal performance may be resented by fellow workers Less energetic works can take a free ride in profit sharing firms Firms paying “efficiency wages” may have fewer opportunities to hire new workers

42. Are CEOs Overpaid? U.S. CEO salaries relatively high Good decisions enhance productivity Limited supply, high MRP Incentive to raise productivity at all levels High salary bias by board members Unsettled issue 13-42

43. Key Terms wage rate nominal wage real wage purely competitive labor market monopsony exclusive unionism occupational licensing inclusive unionism bilateral monopoly minimum wage wage differentials marginal revenue productivity noncompeting groups human capital compensating differences incentive pay plan 13-43

44. Next Chapter Preview… Rent, Interest, and Profit 13-44