Labor Economics

Chapter 1

Labor Economics
Goals:

Why did female LFP increase in the 1900s?

How does immigration affect wages, labor supply,
opportunities, etc of native workers?
How do minimum wages affect the unemployment rate?
Do wage and tax subsidies affect the demand for labor?
What impact do occupational and health regulations have
on hiring, wages, etc.?
2

Labor Economics, cont.

Do human capital investment subsidies improve the wellbeing of disadvantaged workers?

Why does wage inequality exist?
What impact does affirmative action have on earnings,
the number of minorities a firm hires, etc?
How do unions affect labor markets?
How do unemployment benefits affect the incidence of
and length of spells?

Labor Market Participants

Labor Market Participants: Workers

Determine:

Goal:

Whether or not to work

How many hours to work
Which skills to acquire
Whether or not to quit a job
Which occupation to work in
Whether to join a union
How much effort to put forth
at work
5

Labor Market Participants: Firms

Determine:

Goal:

How many workers to employ

Which workers to hire
How much to pay each worker
Whether to hire additional
workers
Whether to fire workers
How much capital to employ
Working conditions
Length of the workweek
6

Labor Market Participants:

The Government
Regulations determine ground rules in the labor
market

Taxes on earnings
Training subsidies
Payroll taxes
Affirmative action laws
Minimum wages
Worker condition regulations
Immigration laws
7

Appendix: Econometrics
y mx b

Regression analysis:
y=
x=
m=

interpretation:

Regression Example: GPA

GPA Hours
Hours = number of
hours spent studying

GPA if hours 0
Regression analysis attempts to fit the data with a
line by minimizing the sum of squared errors

GPA Hours

Regression Analysis, cont.

Measuring the quality of the estimated
coefficients:

Standard Error:
Margin of error = 2 x SE
Needed because of errors in the data, etc.

T-statistic =
Measures significance of the independent variable in
explaining variation in the dependent variable
Coefficient is significantly different from zero if tstat > 1.96

10

Multiple Regression
GPA is influenced by more than the number
of hours someone studies
GPA Hours Office Visits

Interpretation of each coefficient:

Can only hold constant variables included

in the regression
11

Labor Supply (Static)

Chapter 2

Labor Supply
Why has the LFPR of men declined?
Why has the LFPR of women increased?
Why has the length of the workweek
decreased?
How will changes in the welfare system affect
job mobility and/or unemployment spells?
Does a change in family structure affect LFP
decisions?
13

Measuring the Labor Force

Bureau of Labor Statistics (BLS)

Conducts the Current Population Survey (CPS) which

surveys 60,000 households monthly

Workers are considered:

Employed:

Unemployed:

Out of the Labor Force:

14

Labor Force Statistics

Labor Force =
Labor Force Participation Rate =
Employment-Population Ratio =
Unemployment Rate (UR) =
15

Hidden Unemployed
Note that employment is not different for
full- and part-time workers, so part time
workers who want full-time employment are
not differentiated.
People who give up searching are considered
out of the labor force.
Using the employment-population ratio
would have flaws as well, since unemployed
and out of the labor force would be grouped
together.

May
understate UR

16

Labor Supply Trends (up to 1990s)

Male LFPR declined

Decline in labor market attachment after age 65

10% decline between ages 45 and 64
Decline in LFPR from 46% to 17% men over 65
Decline in LFRP from 97% to 93% for ages 25-44

Female LFPR increased, particularly among married women

Hours per week declined
Men (4%) less likely than women (16%) to be employed PT
Positive correlation between educational attainment and LFP
Racial Differences

White men have higher LFPR than black men.

White men work more hours than black men.
17

Worker Preferences
Workers choose:

Goal:

U = f (C , L)
18

Indifference Curves
Do not intersect
Unique
All points along an
indifference curve
represent the same utility
level
Higher indifference curves
represent higher levels of
utility
19

Indifference Curves, cont.

Downward-sloping

Convex to the origin -

20

Indifference Curves, cont.

Slope =
MUL

rise

run

and MUC

Move from (L1,C1) to

(L2,C2)

Gain + Loss = 0 to maintain

Utility = U
21

Differences in Tastes

Large slope = Large MRS

MUL large relative to MUC
Individual enjoys _______
(willing to sacrifice a large
amount of consumption
for leisure)

Small slope = Small MRS

MUL small relative to MUC
Individual enjoys _______
(willing to sacrifice a large
amount of leisure for
consumption)
22

Budget Constraint
Assumptions:

No saving
where

V = non-labor income
(endowment)
w = wage
H = hours worked

Constant wages (no overtime)

23

Budget Constraint, cont.

Solve for slope of BC:

C = V + wH
=
=
=
where T = total time available for work and leisure

rise
slope =

run

Interpretation:
24

Budget Constraint, cont.

Properties:

Consumption bundles
below the budget line are

Consumption bundles
outside the budget line are

Consumption bundles
along the budget line

25

Hours of Work Decision

Choose C* and L* such
that utility is maximized,
subject to BC

U(C) _ U(A) and

U(C) _ U(B), and U3
_______________
Interior solution (H* > 0)
26

Hours of Work Decision, cont.

Tangency (between IC and BL) conditions:

Slope of indifference curve = Slope of budget line

C
C
=

L
L
MU L

w
MU C

MU L

MU C

27

Comparative Statics
Comparative Statics: How does individual
behavior change when a parameter of the
model changes?
Suppose V increases, holding w constant
Suppose w increases, holding V constant

28

Comparative Statics, cont.

Suppose V increases, ceteris paribus
Individuals have more money to spend on C
(C*)
Income effect:

If leisure is a normal good, the demand for leisure will

__crease (L* ) and the number of hours worked will
__crease (H* )

V w

when V , H ,
0
holding w constant

29

Comparative Statics, cont.

Suppose w increases, ceteris paribus

Substitution effect:

H
Since the wage rate is the OC of leisure, an

0
increase in w increases the OC of leisure, and
w V
workers substitute ______ for __________ (L* & H* )

Income effect:

An increase in w is an increase in wealth, which will

_________ the demand for leisure (L* & H* )
30

Income and Substitution Effects

Suppose V increases Budget line _______ up

Case 1: Both C* and

L* __crease, so leisure
must be a ________
good

31

Income and Substitution Effects

Suppose V increases Budget line _______ up
Case 2: C* __creases
and L* __creases, so
leisure must be an
_________ good

32

Income and Substitution Effects

Suppose w increases Budget line ________ up

Case 1: L* __creases,
so the ____________
effect dominates

33

Income and Substitution Effects

Suppose w increases Budget line _______ up

Case 2: L* __creases, so
the __________ effect
dominates

34

Isolating the Income

and Substitution Effects
Suppose w increases Budget line rotates up
To isolate the income effect,
draw a hypothetical budget
line with same slope as old
budget line and tangent to
new indifference curve

Income Effect: _ to _
Substitution Effect: _ to _

_________ Effect dominates

H* when w

35

Isolating the Income

and Substitution Effects
Suppose w increases Budget line rotates up
To isolate the income effect,
draw a hypothetical budget
line with same slope as old
budget line and tangent to
new indifference curve

Income Effect: _ to _
Substitution Effect: _ to _

________ Effect dominates

H* when w

36

Decision to Work

*
(H >0

or

*
H =0)

Can obtain U0 if H*=0

Trade leisure for
consumption by
entering labor market?

If w = wlow, U* _ U0
(cannot reach a higher
IC) H* _ 0
If w = whigh, UH _ U0
(higher IC) H* _ 0

37

Reservation Wage
Individuals with high wage offers choose to
work (H*>0); individuals with low wage
offers do not work (H*=0)
There exists a wage ~
w at which the
individual is indifferent between H*=0 and
H*>0, the reservation wage

38

Reservation Wage Characteristics

w, do not work
When w < ~
When w > ~
w, work
High ~
w less likely to enter labor market
~
w depends upon tastes for work (slope of the indifference curve)
~
w as V (when V, L*, so the wage required to induce labor
market participation increases)
For a given ~
w, a high wage offer increases the probability of working
( LFPR when w)
There is a positive relationship between wages and the probability of
working (the higher the wage, the more likely it is to exceed the
reservation wage) no income effect for non-workers, so there are
not competing income and substitution effects when considering how
many hours to work
39

Individual Labor Supply Curve

Recall:

Work if reservation wage <

wage offer; otherwise H*=0
Work more when wage if
substitution effect dominates
Substitution effect always
dominates (income effect
DNE) for non-workers
LFPR when wage
Work less when wage if
income effect dominates
(only true for workers)

40

Market Labor Supply Curve

Workers have unique preferences, reservation

wages, indifference curves, and thus optimal hours
of work decisions
Market supply curve =
41

Elasticity of Labor Supply

How responsive is labor supply to changes in wages?
%H

%w

0 when substitution effect dominates

0 when incomeeffect dominates

Interpretation:

Elastic (______ responsive) when ||_ 1

Inelastic (______ responsive) when ||_ 1
42

Elasticity of Labor Supply: Example

Suppose:

H1 = 2000

W1 = $15

H2 = 2200

W2 = $17.50

Interpretation:

___________ labor supply

Note: Since hours worked increased with wages, the
____________ effect dominates

43

Elasticity of Labor Supply Estimates

Prime-Age Men:

-0.1
(1% increase due to substitution effect, and 2% decrease
due to income effect)
May explain decline in the length of the workweek (men
now earn more in real terms, so more leisure is demanded)
Elasticity estimate not significantly different from zero
(most prime-age men work full-time, full-week jobs)
Different estimate for younger and older men, as well as
women
Much variation in empirical estimates
44

Elasticity of Labor Supply Estimates

Problems with estimates

Hours of work

Per year? Per month? Per week? ( -0.1calculated using hours

of work per year)
Hours of work likely more inelastic for shorter time periods
Measurement error, especially for salaried workers

Wages

annual income
For salaried workers, wage definition " wage"
annual hours

likely measured with error

Wages should measure price of leisure as the marginal wage for an
additional hour of work, which is not likely average wage (may
include overtime, etc.)
45

Elasticity of Labor Supply Estimates

Problems with estimates, cont.

Wages, cont.

Nonworkers? Wage 0, but no reported wage (only know wage

offer < reservation wage); these workers have low wage offers or
high reservation wages, and are not a random sample of the
population

Non-labor income

Workers with much non-labor income probably earned a lot in

the past and saved earnings (which are now wealth) If these
workers continue to work a lot now, there will be a positive
relationship between V and H (suggests leisure is inferior).
When tastes for work are accounted for, evidence of a negative
income effect is found.
46

Female Labor Supply

Different LFPRs across countries (for ages 25-54)

Italy: 50%; US: 75%; Sweden: 90%

Elasticity of Labor Supply

0.2 after correcting for the decision to work

(substitution effect dominates)
Women more responsive (in terms of LFP) to changes in
wages than men, less responsive in terms of H*
Responsiveness to husbands wages

LFP elasticity with respect to whusband = 0.53

H* elasticity with respect to whusband = 0.17
47

Female Labor Force Participation

LFPR considerably since 1960

As a cohort ages, LFPR

As time has passed, LFPR
Why?

Theory: The increase in real wages over time (between 2.1% per year
and 6.2% per year) has ___________ the probability of working (wages
more likely to exceed reservation wage)
The increase in LFPR may be due to _________________________
_____________________________________ (Because of fertility?
Or has the number of children because women now work more?)

48

Policy Application: Welfare

AFDC, TANF, etc.
Personal Responsibility and
Work Opportunity
Reconciliation Act
Take-it-or-leave-it offer

Assume V = 0 w/o benefits

Lump sum benefits = 0 if
individual works
L1 _ L2 _ T leave labor
force with benefits

Why?:

49

Policy Application: Welfare

Cash Grants

Assume V = 0 w/o benefits

Full benefits if individual does
not work endowment
For workers, cash grant is
reduced for each dollar
earned working BL flatter

Net wage < actual wage OC

of leisure so L*_

Note:
50

Policy Application Summary: Welfare

Welfare programs __crease LFPR (an increase in
non-labor income increases a workers reservation
wage) and __crease the demand for leisure (a
decrease in net wages is a decrease in the OC of
leisure)
Empirical evidence

Negative income tax experiment: Cash grants were

95% or 140% of the poverty line, and the tax rate on
labor earnings was 50% or 70%)
Prob(work) by 3% for husbands and 7% for wives
H* by 5% for men, 21% for women

51

Policy Application: Earned

Income Tax Credit (EITC)
Began in 1975
By 1990s, $25 billion distributed
to low income families
Dependent upon income,
number and ages of children
Program

Up to Max Y ($8890), credit =

40% of earnings (net wage =
1.4w, up to $3556
Between $8890 and $11,160,
receive max credit ($3556)
For earnings in excess of $11,160,
benefits are reduced by 21.06 per
dollar earned

52

Policy Application: Earned

Income Tax Credit (EITC)
Effects of EITC on labor
supply
Case 1: Income < $8890

Steep indifference curve

strong preference for ______
Choose H* _ 0 w/o benefits
EITC induces

Recall: income effect does not

exist for non-workers, so
LFPR must _ when w_

53

Policy Application: Earned

Income Tax Credit (EITC)
Effects of EITC on labor
supply
Case 2:
$8890 < Income < $11,160

Choose H* _ 0 w/o benefits

EITC induces

54

Policy Application: Earned

Income Tax Credit (EITC)
Effects of EITC on labor
supply
Case 3: Income > $11,160

Choose H* _ 0 (many hours)

w/o benefits
EITC induces

_________ effect likely

dominant for those who work
many hours

55

Policy Application Summary

EITC __creases LFPR for non-workers (only a
substitution effect exists) and __creases hours
worked (either because of a pure income effect or
because the individual is already working many
hours)

Evidence: 2.4% increase in LFPR

Cash grants _______ work incentives (LFPR ),

but EITC subsidizes work and __creases work
incentives (LFPR )
56

Topics in Labor Supply

Chapter 3

Extensions of Static Model

Labor supply over the lifecycle
Fertility
Household production
Retirement
Policy: Decline in work attachment among older
workers

58

Labor Supply over the Lifecycle

Workers can save earnings
when H* is high and enjoy
more C and L later in life
Age-earnings profile
OC of leisure _____ when
young and old
OC of leisure _____ during
prime working years
Inverse U

Note: Workers anticipate evolution of wages, so high

wages during prime years do not increase lifetime
income

59

Labor Supply over the Lifecycle

Given age-earnings profile,
younger and older workers
enjoy leisure more than prime
age workers

H* and w

In the lifecycle model, an

increase in w is expected
(evolutionary wOC of
leisure), but does not increase
lifetime income (lifetime
opportunity set)
60

Labor Supply over the Lifecycle

Recall: In the lifecycle model, an increase in w is expected

and only induces a substitution effect for a particular worker
Comparing the level of two wage profiles generates an
income effect

Jeffs hours profile = Jeff if substitution effect dominates

Jeffs hours profile = Jeff if income effect dominates

61

LFPR over the Lifecycle

w,
Reservation wage: in years when w > ~
people will work

less likely for younger and older workers, so it is

as young and old ages that LFPR tends to be
lower (than at prime-age years)

~
w changes over the lifecycle (# children, etc),
so LFP varies over the lifecycle
62

Empirical Evidence
Should show LFPR and H* when wages are high

Intertemporal Substitution hypothesis:

LFP

Males: participation peaks between ages 20 and 50

Females: participation peaks during early 40s
Substantial decline after age 50 retirement, health, disability
insurance programs, etc.

Hours worked

Males: increase to age 30, decline after age 50 (2100 annual

during prime years)
Females: peak during 40s (many PT before)

63

Fertility
Evidence: as per capital
income rose, fertility rates
have declined
Model:

N = number of children (will

depend upon income and prices)
X = quantity of goods and
services
pN = price of another child
(~100K including foregone
earnings)
pX = price of consumption
goods
I = income

At tangency,
64

Comparative Statics
Suppose I, ceteris
paribus

If children are a normal

good, N*
65

Comparative Statics
Suppose pN, ceteris
paribus

Income Effect: _ to _
Substitution Effect: _ to _
Income and substitution
effects ____________
66

Empirical Evidence
Theory suggests the demand for children will
__crease with wages [corr(income , N*) _ 0] or
with a __crease in the cost of raising children
[corr(pN , N*) _ 0]
Strong negative correlation between mothers wage
and the number of children (10% in wages decreases
N* by 3%)
Weak negative correlation between N* and income
(10% increase in wages decreases N* by 0.4%)
Why?:

67

Household Production
Model

Leisure = childrearing, cooking, cleaning, etc.

Household production yields commodities consumed in the
household such as meals household production is an input to
these commodities

Evidence

Labor market activity Married men: 40 hours; Single men: 33

hours
Women allocate fewer hours than men to the labor market.
Married women allocate fewer hours than single women to the
labor market.
Household production Married women: 35 hours; Married
men: 14 hours
68

Household Production, cont.

Goal: Determine how households allocate time to
the labor market and to household production

Determined by comparative advantage:

Spouse with lower wage rate or greater household

productivity specializes in __________

Production Possibilities frontier

69

Household Production, cont.

OC of $1 of HH goods =
OC of $1 of HH goods =
slope =
= $ of
slope =
= $ of
market good production
market good production
Tim has a comparative advantage in
__________________, and Jane has a comparative
70
advantage in _____________________

Household Production, cont.

Joint PPF

Case 1: Jane and Tim both

work in the labor market
Jane: $210

Total: $

Tim: $252

Case 2: Jane and Tim both

work at home
Jane: $225
Tim: $360

Total: $

Case 3: Specialize
Jane: $210 in labor mkt

Tim: $360 in HH prod.

71

Household Production Decision

Who does what?

Depends where joint PPF

and indifference curves are
tangent

A: flat indifference curve

(households enjoy market
goods, so must work outside
home)

B: households enjoy both

goods

C: steep indifference curve

(households enjoy goods
produced at home)

72

Comparative Statics
Suppose Janes wage
increases

Her contribution to the PPF

becomes __________.
Tims productivity at home
remains the same ($360,
and slope does not change)

Jane will work ______ in

the market and may
eventually only work in
the labor market
73

Comparative Statics
Suppose Tims home
productivity increases

His contribution to the

PPF ________________.
Jane continues to earn a
maximum of $210 in the
labor market.

Tim will spend _______

time on household
production and may
eventually only work at
home.

74

HH Production Empirical Evidence

Gender differentials

Wage gap is shrinking

Improvements in household technology decrease the household
productivity differential

10% increase in wages (OC of HH production) HH

hours decrease by 2%

When wage, HH production is less valuable and OC of

leisure LFP
Technological advances reduce HH productivity relative to
labor market productivity, so HH hours (H*), primarily for
women

75

Retirement
Model
Assume H = 0 after retirement (no PT work)
After retirement, individuals spend previous savings
and employer-provided and/or government-provided
pension benefits
More can be consumed by those who work longer
since incomes usually exceed pensions

Tradeoff between leisure (longer retirement) and

consumption budget constraint downward sloping

Determinants of retirement age:

Wage
Pension benefits

76

Retirement Decision
Assume someone who
lives to age 80 decides to
retire sometime between
age 60 and age 80
Vt =

77

Comparative Statics
Suppose w, benefits constant

If worker retires when wage

increase goes into effect, the
increase

If retirement is delayed until

after wage increase,

Here, _____________ effect

dominates
78

Comparative Statics
Suppose benefits, wage
constant

If years of retirement = 0,

Income effect:

Substitution effect:

Years of retirement __crease

79

Retirement Empirical Evidence

LFPR of older men (ages 55-64) decreased
between 13 and 35 percentage points between
1960 and 1996
Theory:

10% increase in wages reduces prob(retire before 65)

by 6 percentage points ______________ effect
dominates

Higher benefits _________ retirement

10% increase in benefits reduces retirement age by 1

80
month

Shortcomings of Model
Model does not

In US, changed from age 65 to 70 in 1978

Abolished in 1986

Model does not

SS: 9% per year increase if individual retires between 62

and 65, additional 4% per year after age 65
2/3 of men retire between 62 and 65
81

Policy Application: Labor Supply

Response to Child Care Subsidies
Examples: school lunches, day care subsidies, tax
credits
40% of American families utilize day care totaling,
on average, 7% of income
Example 1: Reduce hourly cost of day care (assume
no fixed cost component)

H* will

increase if _________effect dominates

decrease if _________effect dominates
82

Policy Application: Labor Supply

Response to Child Care Subsidies
Example 2: Reduce fixed
costs (assume no variable
cost)

Equivalent to an increase
in non-labor income (V)

Non-workers

83

Policy Application: Labor Supply

Response to Child Care Subsidies
Example 2, cont.: Reduce fixed
costs (assume no variable cost)

Equivalent to an increase in nonlabor income (V)

Workers

Summary: Subsidies should

__crease LFPR and __________
_____________effect on H*

Empirical evidence supports LFP

prediction, especially among low
income workers

84

Policy Application: Decline in Work

Attachment Among Older Workers
Why has LFPR among older workers (men) ?

________: Life expectancy at age 50 of white men rose from

22 to 26.7 years
___________________________: 26% covered in 1950, 66%
in 1990

Prob(men aged 58-63 with private penions work) by 18 percentage

points

______________________: rose in 1970s and remained

constant (when real wages ) in 1980s, but at most 15% of LFP
attributable to SS
______________________: disabled worker receives SS
benefits as if he/she retired at age 65, regardless of when
disability occurred

Recipients (age 55-64) of DI increased from 3.5% to 10.5% between

1960 and 1985
Mixed evidence regarding effect of DI in LFPR

85

Policy Application: Decline in Work

Attachment Among Older Workers
Social Security Earnings
Test

Provision of SS system
which discourages
recipients (aged 65-69)
from working

Workers can earn up to

$17K without affecting
benefits
Earnings beyond $17K
taxed $1 for every $3 earned
(33% tax rate)

Workers over age 70

unaffected

86

Policy Application: Decline in Work

Attachment Among Older Workers
How does the SS
Earnings Test affect H*?

Worker A:

Worker B:

Worker C:
87

Policy Application: Decline in Work

Attachment Among Older Workers
Empirical Evidence on the effect of the
elimination of the SS Earnings Test on H*
Only individuals working a moderate number of
hours would increase the number of hours worked
(because of the substitution effect)
20% of retirees work, and 60% of those workers
are affected by the SS earnings test
Estimate: removing the Earnings Test would
increase H* by approximately 1 hour per week
(from 3.2 to 4.4 hours)

88

Labor Demand
Chapter 4

Labor Demand Questions

Which workers should a firm hire?
How many workers should a firm hire? How
much capital?
How will firms respond to employment
subsidies?
How should firms respond to policy changes
such as minimum wages, affirmative action,
etc?
90

Production Function
Describes the technology used to produce goods
and services

q = f(E,K) where
q = output
E = number of employee hours hired
= number of workers x average hours per worker
K = capital land, machines, other physical inputs
Assume homogenous workers (ignore education, etc)

Output is a function of the number of employee hours

hired by the firm and the quantity of capital employed
91

Production Function, cont.

Recall: q = f(E,K)
Marginal Product:

MPE =

MPK =

MP = slope of total product curve

Interpretation:
92

Production Function Example

E
0
1
2
3
4
5
6
7

q
0
10
22
33
41
48
53
56

MPE

APE

VMPE

q
MPE
E

q
APE
E
VMPE P
MPE
let P 3

93

Example, cont.
E
0
1
2
3
4
5
6
7

q MPE APE VMPE

0
10 10
10
30
22 12
11
36
33 11
11
33
41
8
10.25
24
48
7
9.6
21
53
5
8.83
15
56
3
8
9

94

Production Function Characteristics

TP increases rapidly, then at a decreasing rate

When TP increases at an increasing rate, MP

When TP increases at a decreasing rate, MP
When TP decreases, MP

Law of Diminishing Marginal Returns:

MP, AP relationship

AP increases when MP AP
AP decreases when MP AP
MP = AP at
95

Short Run Employment Decision

Firms goal:

where

w = cost of hiring an additional worker

r = price of capital
p = output price

taken as given
for PC firms

Short run:
E*: Choose E* such that

VMPE=PMPE
96

SR Employment Decision Example

E TP VMPE
0 0
1 10
30
2 22
36
3 33
33
4 41
24
5 48
21
6 53
15
7 56
9

Let w = $32, P=$3

If E = 2, VMP = $33, but
w = $32, so 3rd worker
If E = 3, VMP = $24, but
w = $32, so 4th worker
w = $32 falls between
VMP(E=1)=30 and VMP(E=2)=36,
but
If law of diminishing MP did not
hold, E* would have no bounds, so
diminishing MP ensures firm cannot influence market
97

SR Employment Decision, cont.

Recall:
APE increases when MPE APE
APE decreases when MPE APE
MPE = APE at

VAPE = PAPE is a blown-up version of APE,

so
VMPE = VAPE at
E* only valid if
If VMP(E*) = w > VAP(E*),

98

Individual Firm Demand Curve

E
VMP

0
-

1 2
30 36

3
33

4
24

5
21

6
15

7
9

Demand curve: Allow price

(wage) to vary and determine
how many employees the
firm demands
If w = $15, E* =
If w = $21, E* =
If w = $24, E* =
SR demand curve for labor is:
99

Individual Firm Demand Curve, cont.

VMP curve drawn for a particular
price, so when output price
changes, VMP (labor demand)
curve shifts

Positive relationship between P

and the short-run demand for labor

Capital costs (r) constant, and when

P, revenue
Firms only increase E* when revenue
from new worker exceeds cost of
worker (VMP > w)
100

Labor Market Demand Curve

Recall: Market labor supply curve derived by
Market Demand Curve

Roughly

Caveat:

101

Labor Market Demand Curve, cont.

Because of the caveat, the true labor market demand curve is
______ than the horizontal sum of individual demand curves

102

Profit Maximization Approach

Recall: Profit maximizing firms choose q* such
that MR = MC, where

MC

and MR

and TC

For a fixed K (short run condition),

TC
MC
q

For a PC firm, P = MR, so operating at MR = MC

implies:
103

Objections to MP Theory
Note:

MP Theory: Choose E* such that w = VMPE

E* implies q* based on the production function

Employers do not really calculate VMPE and find where

w = VMPE

Adding employees to the production process while

holding K constant will not increase marginal productivity
104

Elasticity of SR Labor Demand

How responsive is labor demand to changes in wages?

SR
__________ (by definition): When wages increase, firms
demand ______ workers
Interpretation:

Elastic (_____ responsive) when |SR| 1

Inelastic (_____ responsive) when |SR| 1
105

Long Run Employment Decision

Long run:

The firm can choose E* and K*

Isoquants:

Note: iso = equal, quant

derived from quantity, so isoquant =
equal quantity
106

Characteristics of Isoquants
Do not intersect
Downward-sloping
Higher isoquants represent
_______ levels of output
Convex to the origin

When E is large, a _____ K

could replace many workers
and maintain the same q
When E is small, a _____ K
would be required to maintain
the same q
107

Characteristics of Isoquants, cont.

Slope: Move from point X to Y

Gain:
Loss:
To remain on the same isoquant, MPEE
+ MPKK = 0

Slope = Marginal Rate of Technical

Substitution (MRTS)

Interpretation:

Convexity implies diminishing MRTS

108

Isocosts (Constraint)
Isocosts:

Isocosts further away from

the origin imply _____ costs
Cost = wE + rK

K
K
Slope

109

Profit Max/Cost Min

Profit max Cost min

Choose q* and produce at the

lowest cost (isocost closest to
origin) combination of K, E
Isocost-Isoquant tangency:
MPE
w

MPK
r

MPE MPK

w
r
110

Profit Max/Cost Min, cont.

To profit max, firms choose q* such that MR=MC,
then choose K* and E* to minimize costs
Recall: MR = MC implied w = PMPE;
analogously, it also implies r = PMPK
P

and P

Therefore, profit max implies cost min

111

Profit Max/Cost Min, cont.

So far, profit maximization implies cost minimization
Does cost minimization imply profit maximization?

Profit maximization Cost minimization, but

Cost minimization Profit maximization
112

Long Run Demand Curve for Labor

Recall: Demand curve is derived
by allowing price (wage) to vary
and determine how many
employees the firm demands
Suppose initially, q*=q0 with C=C0
and w=w0
Cost effect of w

If w, firm may buy more labor and

incur C=C0,

If C to C1, holding constant r, the

entire budget line
113

Long Run Demand Curve for Labor

Cost effect of w, cont.

With new cost (C1), new

intercept =

Production effect of w

When w, MC of production
likely ________ (additional
cost of producing one more
unit )
With _MC, MR _ MC at q0, so
firm responds by _q

When w, E*_, K*_

114

Scale and Substitution Effects

So far, weve seen that when wages decrease, production
costs (MC) __crease, so firms have an incentive to
__crease production and hire _____ workers (E* )
Substitution Effect

Capital is now a relatively ______________ input, so firms

SUBSTITUTE away from ________ and toward a more
_______-intensive production process (K* and E* )

Scale Effect (eliminates the change in relative prices)

When firms produce more output (because of decreased MC of

production), they may hire _____ employees and _____ capital
simply because the SCALE of production changes (K* and
E* )
115

Decomposing the Scale

and Substitution Effects
To isolate the scale effect, draw
a hypothetical isocost with same
slope as original isocost and
tangent to new isoquant

Scale Effect: __ to __
Substitution Effect: __ to __

As drawn, ___________ effect

dominates, and K*
Note: Scale and substitution
effects both suggest E*_, but the
dominant effect determines how
K* changes
116

Long Run Demand Curve for Labor

Recall: Both scale and
substitution effects suggest
E*_ when w

Scale effect: When q, firm

demands more K and more E
Substitution effect: Firms
demand more of the relatively
less expensive input when w

Therefore, the LR demand

curve for labor is _________
sloping (E*_ when w)
117

Elasticity of Labor Demand

LR

%E LR E LR w 1

LR
%w
w
E1

LR _ 0 because of the ______

relationship between w and E
LR vs SR: LR _ SR because
firms can be more responsive
to wage changes with fewer
constraints (K not fixed in the
long run)
Therfore, the LR demand
curve for labor is ______ than
the SR demand curve curve
for labor

118

Elasticity of Labor Demand

Short-run elasticity of labor demand:

-0.5 < SR < -0.4

Long-run elasticity of labor demand:

LR -1

1/3 due to the substitution effect, 2/3 due to the

scale effect

119

Elasticity of Substitution
Perfect Substitutes

Here, 2K = 1E
Recall: Convexity of a normal
isoquant implied

Here, inputs can be substituted

at a ___________ rate
_________ substitution effect

One of the two extremes will be

chosen (K = 100 OR E = 50,
depending upon w and r)
120

Elasticity of Substitution, cont.

Perfect Complements

If E = 5, K = 5, can produce
just as much output as E = 5
and K = 25
To increase output, must add
Always use ____________
for q0, regardless of w and r
_____ substitution effect
(___ substitutability) between
K and E
121

Elasticity of Substitution, cont.

Elasticity of Substitution=

_0

Measure of

When labor becomes relatively more expensive (w/r),

relatively ______ capital will be used (K/E)
Large elasticity of substitution means firms are _________
responsive to changes in relative input prices
More curved isoquants have _______ elasticities of
substitution

122

Policy Application: Affirmative Action

Affirmative action encourages firms to alter
the race, ethnicity, or gender of workforce by
hiring relatively more of the workers typically
under-represented in past hiring
Assume:
Two types of inputs black and white workers
Black and white workers may have different
education levels, skills, etc.
wB = black wage, wW = white wage

123

Policy Application, cont.

Case 1

Note: Intercepts suggest

wW _ wB
Point _ would be profitmaximizing (cost-minimizing)
for a color blind, nondiscriminating firm
A discriminating firm might
choose point _ to have fewer
black employees
A fine-tuned AA program
could
124

Policy Application, cont.

Case 2

Note: Again, intercepts suggest wW

> wB
Firm may be non-discriminating
and still hire relatively more whites
(point _), perhaps because of
productivity differences, etc.
An AA program may force the firm
to hire relatively more blacks (point
_), which is no longer profitmaximizing

Therefore, AA programs may

improve profitability if the firm is
________________, but will
reduce profits if firms are _____
__________________
125

Marshallian Rules of Derived Demand

Derived Demand:

What happens in the market for the good itself directly

influences demand for labor (for instance, when P
changes, VMPE (DE) shifts)

Marshallian rules describe factors which are likely to

generate an elastic demand for labor
126

Marshallian Rules of Derived Demand

Rule 1: Greater elasticity of substitution between
labor and capital (less curved isoquants)

Rule 2: Greater elasticity of demand for output

When wages , the MC of production , so supply

and output P

127

Marshallian Rules of Derived Demand

Rule 3: Greater labors share of total costs of
production

When labor is a large share of production costs, a

wage change has a substantial impact on MC, on
market supply (of output), and ultimately, on P

128

Marshallian Rules of Derived Demand

Rule 4: Greater supply elasticity of other inputs to
production

When w, the firm will want to

If the price of that input increases dramatically when more is

demanded, the incentive to replace labor with other inputs is
___________
If the supply of the other input is ________ (relatively _____
supply curve), the increase in demand will result in only a
moderate price increase, so firms will be more likely to make
substantial changes in the relative share of inputs in the production
process

129

Factor Demand with many inputs

So far, q =f(E,K)
Can add to the production function different types of workers,
machines, etc.

q = f(x1,x2,,xi,xm) where

xi = quantity of input i

xi* determined by: wi=PMPi where

wi = cost per unit of input i (wage, rental rate, etc)

Results in the 2-input case hold in this more general set-up

Empirically, labor demand for unskilled workers is more elastic

than the demand for skilled workers Labor market much more
unstable for unskilled workers
130

Cross-Price Elasticity of Demand

How does the demand for input i (xi) respond to a change
in the price of input j (wj)?
Cross-price elasticity of input demand
X P

0 if inputsare

0 if inputsare

If inputs are substitutes (X-P _ 0), demand curve for

input i shifts _____ in response to an increase in the price
of good j) ____________ effect dominates
If inputs are complements (X-P _ 0), demand curve for
input i shifts _____ in response to an increase in the price
of good j) ___________ effect dominates
131

Empirical Evidence
Skilled and unskilled labor

Empirically, skilled and unskilled labor are _________ (X-P _ 0)

Unskilled labor and capital

Empirically, unskilled labor and capital are ________ (X-P _ 0)

Cross-price elasticity of input demand 0.5

Skilled labor and capital

Empirically, skilled labor and capital are __________ (X-P _ 0)

Cross-price elasticity of input demand -0.5

132

Labor Market Equilibrium

Intersection of supply,
demand defines (E*,w*)
If w > w*, QS _ QD

competition drives w_
to w*
If w < w*, QS _ QD

competition for
workers drives w_ to w*
133

Application: Minimum Wages

Fair Labor Standards Act
(FLSA)

Established in 1938
Created a minimum wage,
established overtime laws, child
labor laws, etc.

Minimum wage: price ______

on wages (min w _ w*)
Higher wage has two effects

Unemployed =
134

Application: Minimum Wages, cont.

U
Recall: UR
LF

With minimum wage,

Depends upon minimum

wage, elasticities of S, D
UR higher when S, D more
________ (______ curves)
suggests firms and/or
workers are responsive to
wage changes
135

Application: Minimum Wages, cont.

Empirical Evidence

Approximately 40% of workers who qualify for

minimum wage are not paid it
Firms that are caught can delay paying a portion of
payroll for two years (like an interest-free loan) and
typically do not pay fines
Not all workers work in sectors covered by the
minimum wage law (~10% in 1990)

136

Application: Minimum Wage, cont.

Workers in covered sector displaced by the minimum wage may

move to the uncovered sector.
The equilibrium wage in the uncovered sector would __crease.
Note that the wage in the covered sector would also __crease due
to ________ workers supplying their services to that market (not
shown).
137

Application: Minimum Wage, cont.

Workers in uncovered sector may leave their current jobs to try to

find new work in the covered sector to take advantage of minimum
wage.
The equilibrium wage in the uncovered sector would __crease.
Note that the wage in the covered sector would also __crease due
to an _________ in the number of workers supplying their services
to that market (not shown).
138

Application: Minimum Wage, cont.

Wages will eventually equate in the two sectors (covered
and uncovered)
E(wC) = wmin + (1- )(0) =
, where

= probability of holding a job in the covered sector

E(wU) = wU
When wages equate, E(wC) = E(wU)

Pattern of migration (movement from covered sector to

uncovered sector, or vice versa) will depend upon , such
as the average tenure at jobs in the covered sector, etc.
139

Application: Minimum Wage, cont.

Empirical Evidence

In 1987,

Elasticity of teenage employment with regard to changes in the

minimum wage is between -0.1 and -0.3, and the minimum wage
rose 27% ($3.35 $4.25) between 1990 and 1991

1/3 of workers age 16-19 earned w wmin

5% over the age of 25 earned w wmin

If the elasticity were -0.15, teenage employment would have decreased by

240,000

More recent studies using fast food restaurants find no impact of

the minimum wage on teenage employment
Minimum wage laws may not effectively help poor families

Many teenagers affected by the law are themselves poor, but may not come
from families in need
140

Labor Market Equilibrium

Chapter 5

Labor Market Equilibrium

Competitive Markets (firms and workers can freely
enter and exit )

Equilibrium outcome will be efficient

Monopsonies

E*, w* relative to competitive markets

Monopolies:
Applications:

Taxes
Subsidies
Immigration
142

Equilibrium in a Single
Competitive Labor Market
Equilibrium:
Each firm hires up to the point
where
No unemployment

Anyone who wants to work at w* can

Individuals not working are looking
for w_w*
Firms not finding employees are
offering w_w*

Realistically, equilibrium will not

last because of shocks in modern
industrialized nations
143

Competitive Equilibrium
Across Labor Markets
Labor markets may be differentiated by:
Region (north, south, etc)
Industry (2 different production industries)

Assume:
Markets in two regions (north, south)
Workers in the two regions have similar skills and
can substitute for one another
Initially, ws < wn

144

Competitive Equilibrium
Across Labor Markets, cont.

If workers have full mobility, southern workers will ___________

____________ where they can earn a higher wage

If firms have full mobility, northern firms will _______________

where they can pay a lower wage (not shown)

In the end,

145

Competitive Equilibrium Across

Labor Markets Efficiency
Efficiency:
Also maximizes national income
If ws < wn, VMPs _ VMPn since profit-maximizing
firms hire up to the point where
As workers migrate north, MPn_ and MPs_ until the
two are equated, and
In the end, ___________________, and profits are
maximized

146

Empirical Evidence
Do wages equate over time?

In the US, there is a strong ____________ correlation between

wages and annual growth of wages

Roughly 30% of the wage gap between states disappeared over a 30-year
period (states with lowest wages had highest growth rate)

Similar evidence in Japan, a less mobile country

Across countries: Conditional convergence

Does not apply to the wage gap between the rich and poor
countries because countries with lower human capital levels
do not grow as rapidly
147

NAFTA: Mexico and the US

Mobility of firms should:
__crease demand for Mexican workers
__crease demand for US workers with similar skills
Eventually _______ wages across the two countries

Some workers will clearly benefit and some will

be harmed, but the total income of the two
countries should increase as North America
moves to a more __________ outcome
148

Policy Application: Payroll Tax

Payroll tax

Employers pay a tax on total wage

bill

Employers who first paid w1 will

now be willing to pay only _____
to E1 workers

_____ward shift of labor demand

curve

New wage paid to workers:

Firms pay _____, because they
pay tax t to the government
______ workers hired (E2 _ E1)
Tax burden

Firms:
Employees:

149

Policy Application: Employee Tax

Tax on workers

E1 workers first earned w1,

Workers now demand ______

______ward shift of labor supply

curve

New wage is ____

Workers earn _____, because
they pay tax t to government
_____ workers hired (E2 _ E1)
Tax burden

Firms:
Employees:

150

Tax policy application: Summary

Note that the outcome is the same regardless of who is
taxed
Employee Tax:

w_, so ______ bears the cost by having to ________________

Full amount of tax not recovered for ________ (tax is greater
than the wage increase)

Payroll Tax:

w_, so _______bear the cost by ____________

Full amount of tax is not covered for ___________ by the wage
decrease (tax is greater than the wage decrease)
151

Tax with no burden on the firm

Assume firm is taxed
Assume perfectly inelastic
supply
With tax, firm is only willing
to pay ______
Number of workers ________
_____________

Firm passes entire incidence of

the tax onto workers

Therefore, a more ________

supply curve passes more tax
burden onto employees

Recall that labor supply curve

for men is inelastic
152

Empirical Example
Note: Evidence suggests firms pass approximately 90%
of tax burden onto employees
Suppose annual income = $30,000

Employee tax = 7.65% $2295 annually

Employer tax = 7.65% $2295 annually

90% of tax shifted to worker: .92295 = $2066

Total employee tax = $2295 + 2066 = $4361 annually

If $4361 were invested annually at 3%, worker would
accumulate $263,675 by age 65
If worker lives to age 80, would need SS benefits of $21,000
annually

Average worker only receives $7,200

153

Policy Application: Government

subsidy paid to employers
Subsidy lowers the cost of hiring
workers
Firms are willing to pay ______ (s
recouped in the form of the
subsidy, so in essence, the firm is
only paying original wage, w1)
New wage paid to worker: __
Cost of employment for the firm:
_______
Benefits of subsidy

Firm:
Worker:
154

Empirical Example
Assume:

Elasticity of demand = -0.5

Elasticity of supply = 0.3

A 10% subsidy (reduction in hiring costs) would:

Increase wage by 4%
Increase employment by 2%

Gains of a government subsidy may be limited

Firms may be unaware of programs

Firms may place a stigma on hiring targeted workers and do not
hire them even to benefit from employer subsidy programs
155

Noncompetitive Labor
Markets: Monopsony
So far, competitive firms took p and w as given regardless of E*
Recall that perfectly competitive firms face a horizontal demand
curve given by the market price
Analogously, an individual firm faces a horizontal labor supply
curve, given w

It can hire as many workers as it long as it pays wage = w

Monopsony:

Must pay higher wages to attract more workers (p taken as given)

Note that all markets have upward-sloping supply curves, but

monopsonies are firms that face upward-sloping supply curves

Ex: one-company town

156

Perfectly discriminating monopsonist

Monopsonist can hire different workers
at different wages

w15 for worker 15,

w20 for worker 20, etc.

Supply curve = ____

Wage paid for each worker is his ______

____________

Demand curve = ______

Price is taken as given

Firm hires up to the point where _____

____ (E*,w*), or where _____ = ______
Same __ as a competitive market, but __
is the wage for the last worker, and all
others were paid w _ w*
157

Non-discriminating Monopsonist
Monopsonist pays all workers the same wage,
regardless of their reservation wages
Supply MC, but MC __creases as E increases
S _ MC

If the 9th worker costs $7, total labor bill = $63

If 10th worker demands $7.50, total labor bill = $75
MC of the 10th worker is $12, but wage was $7.50
Analogous to D > MR for a monopolist

158

Non-discriminating Monopsonist, cont.

Firms hire up to the point
where ___ = ____
(EM,wM)
Monopsonist determines
wage from _______
curve, not MCE curve

Similar to how
monopolists choose P
from the demand curve,
not MR

EM _ EC and wM _ wC
159

Monopsony and Minimum Wage

Set wmin > wM, and firm can hire E*
employees
MC = wmin up to E* employees, then
returns to MC curve above supply
curve
Firm wants to hire where ______ =
_____, which is E* employees (point
A) at min wage, wmin
Outcome: wmin _ wM and E* _ EMno unemployment
Better outcome: set wmin = __ so E
= __ and w = __
Minimum wage law outcomes may
be explained by fast food restaurants
acting as monopolists to teenagers

160

Competitive firms facing upwardsloping supply curves

Even if employees are mobile, the costs
associated with moving to take advantage of a
new higher paying job can be huge

Competitive firms must offer large wages to attract

someone to move

As the number of employees increases,

monitoring workers to discourage shirking
becomes expensive

Employers may want to pay higher wages to make

the cost to an employee of shirking more expensive
161

Professional Athletes
Free agency

If a player can go where he wants, he will present his current

team with an outside offer
Current team evaluates VMP, and if VMP exceeds offer,

If not,

No free agency

New team can offer current team a trade pay salary +

bonus to total their value for the player
Current team evaluates VMP and agrees to trade if

If VMP exceeds offer,

162

Professional Athletes, cont.

Allocation of resources (players)

Player may not be paid according to worth, but he ends

up with the team that values him the most (VMP) in
either case

Different income distribution

__________ benefits from no free agency, but ________

benefits as a free agent

Empirical evidence: supports migration and income

distribution predictions
163

Noncompetitive Labor
Markets: Monopoly
Monopoly:

Recall: Monopsonist did not control

p, but could choose w
164

Monopoly, cont.
When output increases,
monopolist must ______ price
on that unit and all previous
units

MR _ P, where P is represented
by ______ since the firm chooses
P* from demand curve after Q*
is chosen (MR=MC)

Competitive outcome: ______

PC _ PM and QC _ QM
165

Monopoly, cont.
Since PMR, revenue generated
by last worker hired is not equal
to MPEP = VMPE
Instead, marginal revenue
product = MRPE =

MPRE _ VMPE because MR < P

-max: w = ___, not w = VMP

EM _ EC, where EC is found be
equating wage to value of
marginal product
166

Empirical Evidence
Monopolists and oligopolists (few firms
produce all of the output for an entire
market) pay higher wages than competitive
firms (approximately 10% more)
Monopolists can pass high production costs
onto consumers, so with little incentive to
keep costs down, monopolists must pay high
wages for the most desirable workers
167