Chapter 9

The Labor Market and

Wage Rates

Slides by John F. Hall

INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 9 / THE LABOR MARKET AND WAGE RATES
2005, South-Western/Thomson Learning Animations by Anthony Zambelli
 Labor Markets In Perspective
Labor Markets differ in an important way from the other
markets weve considered so far in this book
Firms need resources to make goods and services
We can identify three general categories of resource
markets
Markets for capital
Markets for land
Markets for labor
Labor is different from other things that are traded
Sellers of labor care about factors in the work place
Another feature of labor is the meaning of the price in this
market
Wage rate

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 Figure 1: Product and Factor
Markets
Product Markets
Demand for Goods S Supply of Goods
and Services D
and Services

Households Firms

S
Supply of D Demand for
Resources Resources
Factor Markets

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 Defining a Labor Market
How broadly or narrowly we define a
market depends on the specific questions
we wish to answer
Broadly defined markets may look at markets
that draw on labor from all over the world
Narrowly defined markets may look at markets
that draw on labor on a very localized level

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 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

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 Competitive Labor Markets and The
Equilibrium Wage
Wage rate determined like the price of other competitive markets:
Supply and demand
The labor demand curve in any labor market slopes downward because
a rise in the wage rate
1) increases firms costs, causing them to decrease production and employ
fewer workers
2) increases the relative cost of labor from that market, causing firms to
substitute other inputs, such as capital or other types of labor
The labor supply curve in any labor market slopes upward because a
rise in the wage rate
1) induces some of those not currently working to seek work
2) attracts some of those who are currently working in other labor markets
The forces of supply and demand will drive a competitive labor market to
its equilibrium pointthe point where the labor supply and labor demand
curves intersect

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Figure 2: A Competitive Labor Market

Hourly
Wage
LS

$12
LD

10,000 Number of
Workers

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 Why Do Wages Differ?
Significant inequality exists in wage
rates
Among different occupations
Among and within occupations in U.S.
labor market
Wage inequality is persistent
Both highest and lowest paid
occupations have been so for decades

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 An Imaginary World
To understand why wages differ in the real
world, lets start by imagining an unreal world
Except for differences in wages, all jobs are
equally attractive to all workers
All workers are equally able to do any job
All labor markets are perfectly competitive
In such a world, we would expect every
worker to earn an identical wage in long-run

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 An Imaginary World
Figure 3 shows two different labor markets
that initially have different wage rates
In our imaginary world, could this diagram
describe long-run equilibrium in these markets?
No
As these shifts occur, market wage rate of
elementary school teachers will rise and that
of systems analysts will fall

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 Figure 3: Disappearing Wage
Differentials
(a) (b)
Hourly Hourly
Wage LS2 Wage L1S
L1S LS2
B
$30
A'
$25 25 B'
20 A
LD
LD

Number of Elementary Number of Computer

School Teachers Systems Analysts

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 An Imaginary World
When will the entry and exit stop?
When there is no reason for an elementary school teacher to want to
be a systems analyst
When both labor markets are paying same wage rate
Long-run adjustments will occur even if no one actually
switches jobs
Changes will continue untilat points A and Bthe long-
run wage rate is equal in both markets
Take any one of these assumptions away, and equal-wage
result disappears
Tells us where to look for sources of wage inequality in real world
A violation of one or more of our assumptions

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 Compensating Differentials
In our imaginary world, all jobs were equally
attractive to all workers
In real world, jobs differ in hundreds of ways that
matter to workers
When one job is intrinsically more or less attractive
than another
Can expect wages to differ by a compensating wage
differential
Difference in wage rates that makes two jobs equally attractive to
workers

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 Nonmonetary Job Characteristics
When evaluating a career, whether you are
aware of it or not, you are evaluating
hundreds of nonmonetary job characteristics,
including
Risk of death or injury
Cleanliness of work environment
Prestige you can expect in your community
Amount of physical exertion required
Degree of intellectual stimulation
Potential of advancement

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 Nonmonetary Job Characteristics
You will also think about geographic location of job and
characteristics of the community in which you would live and
work
Weather
Crime rates
Pollution levels
Transportation system
Cultural amenities
Nonmonetary characteristics of different jobs give rise to
compensating wage differentials
Jobs considered intrinsically less attractive will tend to pay higher
wages, other things being equal

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 Nonmonetary Job Characteristics
What about unusually attractive jobs?
These jobs will generally pay negative compensating
differentials
Different people have different tastes for working
and living conditions
Cannot use our own preferences to declare a job
as less attractive or more attractive
Or to decide which jobs should pay a positive or negative
compensating differential
Rather, when labor markets are perfectly competitive
Entry and exit of workers automatically determines compensating
wage differential in each labor market

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 Nonmonetary Job Characteristics
Compensating wage differentials are one reason
most economists are skeptical about idea of
comparable worth
Holds that a government agency should determine skills
required to perform different jobs and mandate wage
differences needed between them
Economists generally prefer policies to increase
competition and eliminate discrimination
So that the market itself can determine comparable worth

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 Cost of Living Differences
Differences in living costs can cause
compensating wage differentials
Areas where living costs are higher than average
will tend to have higher than average wages
To compensate for the higher cost of living

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 Differences in Human Capital
Requirements
All else equal, jobs that require more education and training will be less
attractive
In order to attract workers, these jobs must offer higher pay than other jobs
that are similar in other ways, but require less training
Differences in human capital requirements can give rise to
compensating wage differentials
Jobs that require more costly training will tend to pay higher wages, other
things equal
Compensating differentials explain much of the wage differential
between jobs requiring college degrees and requiring only a high school
diploma
The idea of compensating wage differentials dates back to Adam Smith
First observed that unpleasant jobs seem to pay more than other jobs that
require similar skills and qualifications

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 Differences In Ability
Not everyone has the intelligence needed to perform well at
any job
Scientific discoveries and technological advances have
increased not only skill requirements of many jobs
But also abilities needed to acquire those skills
In general, those with greater ability to do a job wellbased
on their talent, intelligence, motivation, or perseverance
will be more valuable to firms
Firms will be willing to pay them a higher wage rate
Beyond any compensating differential for their human capital investment

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 The Economics of Superstars
Why was owner of Texas Rangers willing to pay $25 million per year to
have Alex Rodriguez play for his team?
Immediate answer
Because Rodriguez is so good
When we try to explain extremely high wage rates of these superstars
based on their exceptional abilities alone, we confront a puzzle
The very top writers, rock stars, comedians, talk-show hosts, and movie
directors all earn wage premiums that seem vastly out of proportion to
their additional abilities
Why?
Explanation in all these cases is based on ability
And also by exaggerated rewards market bestows on those deemed the best
or one of the best in a field

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 The Economics of Superstars
If most people rank recent mystery novels in the same
order, then the best will sell millions of copies, second best
will sell hundreds of thousands, and third best might sell
only thousands
Even though all three novels might be very close in quality
A publisher will earn ten times more revenue selling the best
novel (compared to the second best), and ten times more
revenue selling the second best (compared to the third
best), and so on
Same thing happens in markets for athletes, rock concerts,
action movies, and news broadcasters
But phenomenon is not limited to media markets or media stars
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 Barriers to Entry
In some labor markets, barriers keep out would-be
entrants
Resulting in higher wages in those markets
Since barriers to entry help maintain high wages for
those protected by the barriersthose who already
have jobs in the protected market
Should not be surprised to find that in almost all cases, it
is those already employed who are responsible for
erecting barriers

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 Occupational Licensing
In many labor markets, occupational licensing laws keep out potential
entrants
American Medical Association (AMA) is perhaps the strongest example
of occupational licensing as a barrier to entry
Professional organization to which almost half of American physicians
belong
Much of AMAs activity has been designed to decrease supply of doctors
AMA has also increased demand for physicians services by preventing
nonphysicians from competing
In late 1980s, rising health care costs led to increased public scrutiny of
AMA, and its anticompetitive practices came under heavy attack
Economists see AMA primarily as an instrument to maintain high
incomes for doctors

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Figure 4: The Market for Physicians
Physicians'
Salaries LS2
2. AMA restrictions L1S
on the supply of
C
physicians move 3. Other policies to
W3
the market here. increase demand
W2 for physicians
B A move the market
W1 LD2 here, at final
wage rate W3.
L1D

1. Without AMA activities

to increase salaries,
equilibrium is here, at
wage rate W1. Number of Physicians

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 Union Wage Setting
A labor union represents collective interests of its
members
Major objective of a union is to raise its members
pay
Higher union wage is contrary to interests of employer
so why does employer agree?
Because union has power to strike
In a competitive labor market, a unionby raising
the wage firms must paydecreases total
employment in the union sector
This, in turn, causes wages in non-union sector to drop
Result is a wage differential between union and non-union
wages
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Figure 5(a): Union Wage Differentials
(a)
Wage
2. A union wage of for long-haul truckers of
W2 creates an excess supply of workers.

LS
A'
W2
W1
A
1. With no labor union, both long- LD
and short-haul truckers earn the
same wage rate, W1.

250,000 350,000
300,000
Number of Long-haul Truckers
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Figure 5(b): Union Wage Differentials
(b)
Wage 3. Unemployed long-haul truckers move to the
nonunion short-haul market, and the labor
supply curve shifts rightward . . .
L1S
LS2
B
W1 B'
W3
4. pushing the short-haul wage
LD rate down to W3.

200,000 Number of Short-

225,000 haul Truckers

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 Union Wage Setting
Unions still maintain a significant, though declining,
presence in many industries
Such as automobiles, steel, coal, construction, mining, and trucking
Certainly responsible for at least some of the higher wages earned in
those industries
Full effect of unions on labor markets is much more complex
Many of the features of modern work that we take for
granted today originated in union struggles with
management
Such as paid vacations and overtime pay
Unions can raise workers morale and reduce labor turnover
Through grievance procedures and other forms of communications
with management
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 Discrimination and Wages
Discrimination occurs when members of a group of
people have different opportunities because of
characteristics that have nothing to do with their
abilities
First step in understanding economics of
discrimination is to distinguish two words that are
often confused
Prejudice
Emotional dislike for members of a certain group
Discrimination
Restricted opportunities offered to such a group

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 Employer Prejudice
When you think of job discrimination, your first
image might be a manager who refuses to hire
members of some group because of pure prejudice
Such as African-Americans or women
May surprise you to learn that economists generally
consider employer prejudice one of the least
important sources of labor market discrimination
When prejudice originates with employers, market forces
work to discourage discrimination and reduce or
eliminate any wage gap between favored and unfavored
group

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 Employee and Customer Prejudice
What if workersrather than employersare prejudiced?
In a competitive output market, non-discriminating firm will be forced
out of business
Cannot count on the market to solve the problem
Same argument applies if the prejudice originates with firms
customers
When prejudice originates with firms employees or its
customers
Market forces may encourage, rather than discourage, discrimination
Can lead to a permanent wage gap between favored and unfavored
groups

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Figure 6: Employer Discrimination and
Wage Rates
Sector A Sector B
(Discriminating) (Nondiscriminating)
Wage Wage

LS2
L1S
E' L1S LS2
W3
F
W1 W1
E
W2 F'

LD
LD

Number of Workers Number of Workers

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 Statistical Discrimination
Suppose you are in charge of hiring 10 new employees at
your firm
Young married women in your industry are twice as likely to quit their
jobs within two years than men and those that quit are very costly to
your firm
20 people apply for 10 positionshalf men and half women
Whom will you hire?
If your sole goal is to maximize the firms profit
You will hire men
Even if there isnt a trace of prejudice in you, in the firms
employees, or in its customers, profit maximization may still
dictate hiring the men

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 Statistical Discrimination
When individuals are excluded from an activity
based on the statistical probability of behavior in
their group
Rather than their personal characteristics
Some observers have suggested that statistical
discrimination is often a cover for prejudice
According to critics of the statistical discrimination
theory, the negative behavior of a favored group is
rarely considered by employers

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 Dealing With Discrimination
Discrimination due to pure employer prejudice is unlikely to
have much of an impact on labor markets
For other types of discrimination market incentives work in
the opposite way, leading to a permanent and stubborn
problem
Such as statistical discrimination or discrimination due to worker or
consumer prejudice
In these cases, many economists and other policy makers believe that
government action is needed
Some favor affirmative action programs
Others favor stricter enforcement of existing antidiscrimination laws and
stiffer penalties when discriminatory hiring occurs
Both approaches to policy force all firms to bear costs of
nondiscriminatory hiring

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Discrimination and Wage Differentials
Consider the black-white differential for men
Several studies suggest that if we limit comparisons to whites and
blacks with same educational background, geographic location, and, in
some cases, same ability (measured by a variety of different tests), 50%
or more of the earnings difference disappears
In addition to job-market discrimination, there is pre-market
discrimination
Occurs before an individual enters labor market
Such as unequal treatment in education and housing
For women, as well as blacks and other minorities, differences in skills
and experience can be the result of lower wages
Since women know they will earn less than men and will have more trouble
advancing on the job
They have less incentive to invest in human capital and to stay in labor force

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Discrimination and Wage Differentials
In the end, we do not know nearly as much about the impact
of discrimination on wages as we would like to know
But research is proceeding at a rapid pace
As weve seen, data must always be interpreted with care
In measuring impact of job market discrimination on earnings
Wage gap between two groups gives an overestimate
Since it fails to account for differences in skills and experience
However, comparing only workers with similar skills and experience
leads to an underestimate
Since some of the differences are themselves caused by discrimination
both in the job market and outside of it

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 Figure 7: Vicious Cycle of
Discrimination

Current Job Lower Wage

Discrimination

Pre-market Lower Human

Capital Unemployment
Discrimination
Investment

Lower Skill Level Less Job

Experience

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Using The Theory: The Minimum Wage
Minimum wage lawmakes it illegal to hire a
worker for less than a specified wage
In any labor market covered by the law
Most people think about the minimum wage as a
means to increase living standards for the lowest
paid workers, and their analysis stops there
But minimum wage creates a wage differential
among the least-skilled workers, depending on the
industry in which they work
By raising wages rates in covered industries, and
lowering them in uncovered industries

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Figure 8(a/b): The Minimum Wage
(a) (b)
Unskilled Labor Unskilled Labor Not
Covered by Law Covered by Law

Hourly Hourly
Wage A minimum wage raises Wage
pay, but decreases jobs L1S
in the covered sector. LS2

LS Some who can't

A'
$5.15 B find work go to
4.00 $4.00 B' the uncovered
A L
D
3.00 LD sector, lowering
wages there.
N2 N1 N3
Number of Workers Number of Workers

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Figure 8(c): The Minimum Wage
(c)
Skilled Labor
Hourly
Wage LS

$24.00 C'
20.00
C

LD2

As capital is substituted for L1D

unskilled labor, demand for
skilled workers goes up,
raising the skilled wage rate.

Number of Workers
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Using The Theory: The Minimum Wage
Only one group of workers in which everyone
benefits: skilled workers
Should come as no surprise that for many decades the
most vocal advocates of raising the minimum wage have
been labor unions
Membership is disproportionately made up of skilled workers
What do economists think about the minimum
wage?
Most regard it as an inefficient policy for helping poor
working families

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Using The Theory: The Minimum Wage
You might think that economists would
overwhelmingly oppose any increase in minimum
wage
But that is not the case
Those who favored an increase in minimum wage tended to
believe the effect on unemployment was much smaller than
those who opposed an increase
Others may believe that higher unemployment is more likely to
influence policy in a direction they favor
The minimum wage, like most issues of public
policy, is not as simple as it appears

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