1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 28 The Labor Market: Demand, Supply, and Outsourcing

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-2 Introduction Since the mid-1990s, a number of U.S. firms, including International Business Machines (IBM) Corporation, have been engaging in outsourcing by hiring workers in foreign countries. Why are IBM and many other U.S. firms hiring workers abroad instead of here in the United States? In this chapter, you will learn the answer to this question.

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-3 Learning Objectives Understand why a firm’s marginal revenue product curve is its demand labor curve Explain in what sense the demand for labor is a “derived” demand Identify the key factors influencing the elasticity of demand for inputs

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-4 Learning Objectives (cont'd) Describe how equilibrium wage rates are determined for perfectly competitive firms Explain what labor outsourcing is and how it is ultimately likely to affect U.S. workers’ earnings and employment prospects Contrast the demand for labor and wage determination by a product market monopolist with outcomes that would arise under perfect competition

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-5 Chapter Outline Labor Demand for a Perfectly Competitive Firm The Market Demand for Labor Wage Determination in a Perfectly Competitive Market Labor Outsourcing, Wages, and Employment Monopoly in the Product Market The Utilization of Other Factors of Production

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-6 Did You Know That... In Ukraine, when politicians want to have a large crowd at a political rally, they sometimes turn to a company called Easy Work, which pays college students to cheer for politicians? The demand for participants at political rallies by politicians can be studied in much the same manner as we studied the demand for output. A firm will hire employees up to the point at which the marginal benefit of hiring a worker will just equal the marginal cost.

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-7 Labor Demand for a Perfectly Competitive Firm We will start our analysis under the assumption that the market for input factors is perfectly competitive We will further assume that the output market is perfectly competitive This provides a benchmark against which to compare other labor markets or product markets that are not perfectly competitive

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-8 Labor Demand for a Perfectly Competitive Firm (cont'd) Assumptions –Each employer is one of a very large number of employers –Workers do not need special skills –Workers are free to move from one employer to another –The firm is a price taker in the labor market

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-9 Labor Demand for a Perfectly Competitive Firm (cont'd) Marginal Physical Product (MPP) of Labor –The change in output resulting from the addition of one more worker –The change in total output accounted for by hiring the worker, holding all other factors of production constant –Eventually declines because of the law of diminishing marginal product

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-10 Labor Demand for a Perfectly Competitive Firm (cont'd) Marginal Revenue Product (MRP) –The marginal physical product (MPP) times the marginal revenue (MR) –The additional revenue obtained from a one-unit change in labor input –The MRP represents the incremental worker’s contribution to the firm’s total revenues

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-11 Figure 28-1 Marginal Revenue Product, Panel (a)

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-12 Figure 28-1 Marginal Revenue Product, Panel (b)

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-13 Labor Demand for a Perfectly Competitive Firm (cont'd) Marginal Factor Cost (MFC) –The cost of using an additional unit of an input –For example, if a firm can hire all the workers it wants at the going wage rate, the MFC of labor is the wage rate. Marginal factor cost = change in total cost change in amount of resources used

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-14 Labor Demand for a Perfectly Competitive Firm (cont'd) In a perfectly competitive labor market –The market determines the wage –The individual employer is a wage taker –All workers are hired for the same wage –MFC = wage

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-15 Labor Demand for a Perfectly Competitive Firm (cont'd) General rule for hiring –The firm hires workers up to the point at which the additional cost associated with hiring the last worker is equal to the additional revenue generated by hiring that worker

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-16 Labor Demand for a Perfectly Competitive Firm (cont'd) The MRP Curve: Demand For Labor –The MRP curve is the demand curve for labor for the firm –This tells us how many workers will be hired at various possible wage rates –The firm will hire any worker who can contribute to revenues by more than they contribute to costs

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-17 Labor Demand for a Perfectly Competitive Firm (cont'd) Derived Demand –Input factor demand derived from demand for the final product being produced The factors of production are needed to manufacture a final good or to provide a final service

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-18 Figure 28-2 Demand for Labor, a Derived Demand

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-19 The Market Demand for Labor The downward-sloping portion of each firm’s MRP curve is also its demand curve for labor When we go to the entire market for labor, we will also find that the quantity of labor demanded varies inversely with wage rate changes

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-20 Figure 28-3 Derivation of the Market Demand Curve for Labor Wage rate of $20 Firms will hire 2,000 workers Wage rate of $10 Firms will hire 3,000 workers

21. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-21 The Market Demand for Labor (cont'd) Price elasticity of demand for labor similar to elasticity for goods Percentage change in quantity demanded divided by percentage change in price of labor –Inelastic < I –Unit-elastic = 1 –Elastic > 1

22. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-22 The Market Demand for Labor (cont’d) Determinants of Demand Elasticity for Inputs –The price elasticity of demand for a variable input will be greater: 1.The greater the price elasticity of demand for the final product 2.The easier it is to employ substitute inputs 3.The larger the proportion of total costs accounted for by the particular variable input 4.The longer the time period available for adjustment

23. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-23 International Example: Globalization of Tasks and the Elasticity of U.S. Labor Demand Economist Mine Senses has found evidence that a shift toward using foreign labor to perform more tasks has boosted labor demand elasticities in the United States by at least 20 percent on average. Thus, greater ease of substitution of foreign labor for labor in the United States has increased elasticities of U.S. labor demand.

24. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-24 Wage Determination in a Perfectly Competitive Labor Market Having developed the demand curve for labor in a particular industry, let’s turn to the labor supply curve By adding supply to our analysis, we can determine the equilibrium wage rate that workers earn in an industry, such as in Figure 28-4 We can think in terms of a supply curve for labor that slopes upward in a particular industry

25. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-25 Figure 28-4 The Equilibrium Wage Rate and the Titanium Battery Industry

26. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-26 Wage Determination in a Perfectly Competitive Labor Market (cont’d) Reasons for labor demand curve shifts 1.Change in demand for the final product 2.Change in labor productivity 3.Change in the price of related factors

27. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-27 Wage Determination in a Perfectly Competitive Labor Market (cont’d) A change in the demand for the final product that labor is producing will shift the market demand curve for labor in the same direction A change in labor productivity will shift the market labor demand curve in the same direction

28. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-28 Wage Determination in a Perfectly Competitive Labor Market (cont’d) A change in the price of a substitute input will cause demand for labor to change in the same direction A change in the price of a complimentary input will cause the demand for labor to change in the opposite direction

29. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-29 Wage Determination in a Perfectly Competitive Labor Market (cont’d) Labor supply curves may shift in a particular industry for a number of reasons: 1.Change in wages in other industries 2.Changes in working conditions 3.Job flexibility

30. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-30 International Example: An Increase in the Demand for Services of Icelandic Translators Two recent events increased the derived demand for Icelandic translation services: –In 2008 and 2009, Iceland’s banking crisis led European and U.S. customers of banks in that nation to seek financial and legal assistance, which in turn required translations of documents written in the Icelandic language. –In 2010, Iceland’s Eyjafjallajökull volcano began to erupt, raising the demand for media coverage and thus the demand for Icelandic translators.

31. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-31 Labor Outsourcing, Wages, and Employment Outsourcing –A firm’s employment of labor outside the country in which the firm is located

32. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-32 Labor Outsourcing, Wages, and Employment (cont'd) Outsourcing –Some U.S.-based companies outsource labor to other countries. –Some firms based around the globe outsource labor to the United States.

33. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-33 Figure 28-5 Outsourcing of U.S. Computer Technical-Support Services

34. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-34 Labor Outsourcing, Wages, and Employment (cont'd) Question –How are U.S. workers affected by outsourcing? Answers –If cheaper labor is available in other countries, this will dampen the demand for U.S. labor –But as the volume of global commerce rises, there may be more of a demand by foreign firms to hire U.S. workers as well

35. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-35 Labor Outsourcing, Wages, and Employment (cont'd) Labor outsourcing by U.S. firms tends to reduce U.S. wages and employment Whenever foreign firms engage in labor outsourcing to the United States, however, U.S. wages and employment increase

36. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-36 Figure 28-6 Outsourcing of Accounting Services by Canadian Firms

37. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-37 Labor Outsourcing, Wages, and Employment (cont'd) Summing up the economic implications of outsourcing –Even in the best of times, workers experience short-run ups and downs in wages and jobs. In the United States, after all, about 4 million jobs come and go every month.

38. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-38 Labor Outsourcing, Wages, and Employment (cont'd) Summing up the economic implications of outsourcing (cont’d) –Outsourcing is a two-way street –Labor outsourcing does not just involve U.S. firms purchasing the labor services of residents located abroad –This phenomenon also entails the purchase of labor services from U.S. workers who provide outsourcing services to companies located in other nations

39. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-39 Labor Outsourcing, Wages, and Employment (cont'd) Summing up the economic implications of outsourcing (cont’d) –Not all workers gain equally from the trade of outsourced labor services, and some people temporarily lose, in the form of either lower wages or reduced employment opportunities –Nevertheless, specialization and trade of labor services through outsourcing generate overall gains from trade for participating nations, such as India, Canada, and the United States

40. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-40 Why Not … prohibit U.S. firms from outsourcing? Barring U.S. companies from engaging in international labor outsourcing likely would have two negative consequences for the U.S. economy: –The equilibrium wages that U.S. firms would have to pay to obtain labor that they had previously outsourced would increase, which would boost their operating costs and thus the equilibrium prices for consumers. –Other nations’ governments probably would respond by prohibiting their own companies from outsourcing to U.S. workers, resulting in a decrease in the demand for U.S. labor.

41. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-41 Monopoly in the Product Market Now, let’s assume that the firm sells its product in an imperfectly competitive market (we assume the firm purchases inputs under perfect competition still) In other words, we are considering output market structures of monopoly, oligopoly, and monopolistic competition For the remainder of the chapter, we simply refer to a monopoly situation for ease of analysis

42. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-42 Monopoly in the Product Market (cont'd) Constructing the monopolist’s input demand curve –In reconstructing the demand schedule for an input, we must recognize that The marginal physical product falls because of the law of diminishing marginal product as more workers are added The price (and marginal revenue) received for the product sold also falls as more is produced and sold

43. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-43 Figure 28-7 A Monopolist’s Marginal Revenue Product, Panel (a)

44. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-44 Figure 28-7 A Monopolist’s Marginal Revenue Product, Panel (b)

45. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-45 Monopoly in the Product Market (cont'd) Question –Why does the monopolist hire fewer workers? Answer –The marginal benefit to the monopolist of hiring an additional worker is affected by the fact that the monopolist faces a reduction in the price charged on all units in order to be able to sell more of the product

46. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-46 The Utilization of Other Factors of Production (cont'd) Cost minimization –To minimize total costs for a particular rate of production, the firm will hire factors of production up to the point at which the marginal physical product per last dollar spent on each factor is equalized

47. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-47 The Utilization of Other Factors of Production (cont'd) Cost minimization MPP of labor Price of labor = MPP of capital Price of capital MPP of land Price of land =

48. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-48 Policy Example: Payroll Regulations Spur the Hiring of Independent Contractors Recently, U.S. firms have been hiring more independent contractors relative to the number of full-time employees. The key reason is that the federal government has gradually been requiring firms to provide more benefits—overtime pay, family leave, and health benefits—for full-time employees. The resulting higher effective wage rate for full- time employees has push down their MMP/wage rate ratio relative to the ratio for independent contractors.

49. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-49 The Utilization of Other Factors of Production (cont’d) Profit maximization revisited –MRP of labor = Price of labor (wage) –MRP of land = Price of land (rent) –MRP of capital = Price of capital (cost per unit of service)

50. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-50 You Are There: At Staples, the Demand for Robotic Inputs Is Increasing Warehouses operated by Staples, the office supply retailer, have used robots called the “Kiva bot” to transport items and work alongside human workers. Robotic technology has become more useful for smaller and smaller tasks that were previously performed only by humans. What will happen to the demand for human warehouse workers at Staples?

51. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-51 Issues & Applications: The Incentives to Outsource Labor Internationally What affects a firm’s decision regarding international labor outsourcing? –The workers’ constant-quality marginal physical product in different countries –The distance between a firm’s location and the outsourced labor that it hires: the greater the distance, the more miscommunications and other problems –Wages

52. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-52 Figure 28-8 Average Hourly Wages of Call- Center Agents in Selected Nations

53. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-53 Summary Discussion of Learning Objectives Why a firm’s marginal revenue product curve is its labor demand curve –In competitive markets, firms hire labor to the point at which the wage equals MRP The demand for labor as a “derived demand” –The demand for labor by perfectly competitive firms is derived from the demand for the final products they produce

54. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-54 Summary Discussion of Learning Objectives (cont'd) Key factors affecting the elasticity of demand for inputs –Price elasticity of demand for the final product –Ease of substitution of other inputs –Proportion of total costs –Time period

55. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-55 Summary Discussion of Learning Objectives (cont'd) How equilibrium wage rates at perfectly competitive firms are determined –The wage at which the quantity of labor supplied by all workers equals the quantity of labor demanded by all firms U.S. wage and employment effects of labor outsourcing –Decreased demand for U.S. workers when cheaper labor is available overseas –Increased demand for some U.S. labor

56. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 28-56 Summary Discussion of Learning Objectives (cont'd) Contrasting the demand for labor and wage determination under monopoly with outcomes under perfect competition –A monopolist’s labor demand curve is to the left of that of a perfectly competitive industry. –Marginal revenue for a monopolist is less than price. –Fewer workers are employed by the monopolist.