INTRODUCTION THE LABOR MARKET LABOR SUPPLY INCOME VS. LEISURE THE SUPPLY OF LABOR

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Chapter 15

I

NTRODUCTION

This chapter covers why there are differences in wages:

How do people decide how much time to spend working?

What determines the wage rate an employer is willing to pay?

Why are some workers paid so much and others so little?

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ABOR

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UPPLY

The labor supply is the willingness and ability to work specific amounts of time at alternative wage rates in a given time period, ceteris paribus.

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NCOME VS

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EISURE

The opportunity cost of working is the amount of leisure time that must be given up in the process.

Higher wage rates are needed to compensate for the increasing opportunity cost of labor.

The marginal utility of income may decline as you earn more.

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NCOME VS

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EISURE

The upward slope of an individual’s labor-supply curve is a reflection of two phenomena:

GThe increasing opportunity cost of labor as leisure time declines.

GThe decreasing marginal utility of income as a person works more hours.

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UPPLY OF

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ABOR

w1

w2

B

A

q1 q2

Quantity of Labor (hours per week)

Wage Rate (dollars per hour)

Labor supply

0

People supply more Labor when wages rise

(2)

A B

ACKWARD

B

END

?

The force that drives people up the labor-supply curve is the marginal utility of income.

Higher wages represent more goods and services and thus induce people to substitute labor for leisure.

Substitution Effect of Wages – An increased wage rate encourages people to work more hours (to substitute leisure for labor).

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A B

ACKWARD

B

END

?

A worker might also respond to higher wage rates by working less, not more.

I

This negative labor-supply response to

increased wage rates is referred to as the

income effect of a wage increase.

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A B

ACKWARD

B

END

?

Income Effect of Wages – An increased wage rate allows a person to reduce hours worked without losing income.

If income effects outweigh substitution effects, an individual will supply less labor at higher wages.

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ACKWARD

-B

ENDING

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UPPLY

C

URVE

Quantity of Labor Supplied (hours per week)

Wage Rate (dollars per hour)

0

Substitution effects dominate Income effects dominate

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ARKET

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UPPLY

The market supply of labor is the total quantity of labor that workers are willing and able to supply at alternative wage rates in a given time period, ceteris paribus.

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ARKET

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UPPLY

The labor supply curve shifts when the determinates of labor supply change:

GTastes – for leisure, income, and work.

GIncome and wealth.

GExpectations – for income or consumption.

GPrices of consumer goods.

GTaxes.

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S

HIFTS IN

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ARKET

S

UPPLY

Over time, the labor supply curve has shifted leftward:

A rise in living standards.

Income transfer programs that provide economic security when not working.

Increased diversity and attractiveness of leisure activities.

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E

LASTICITY OF

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ABOR

S

UPPLY

We use the concept of elasticity to measure the movements along the labor-supply curve resulting from wage rate changes.

The elasticity of labor supply is the percentage change in the quantity of labor supplied divided by the percentage change in wage rate.

A workers responsiveness to wage changes is often constrained by institutional constraints such as specified work hours such as 8 – 5 shifts. 14

L

ABOR

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EMAND

Regardless of how many people are willing to work, it is up to employers to decide the demand for labor.

The demand for labor is the quantity of labor employers are willing and able to hire at alternative wage rates in a given time period, ceteris paribus.

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D

ERIVED

D

EMAND

The quantity of resources purchased by a business depends on the firm’s expected sales and output.

It is a derived demand.

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D

ERIVED

D

EMAND

Derived demand is the demand for labor and other factors of production resulting from (depending on) the demand for final goods and services produced by these factors.

The principle of derived demand suggests that one way to increase someone’s wages is to increase the demand for the goods he or she produces.

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EMAND

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URVE

The number of workers hired is not completely dependent upon the demand for the product.

The quantity of labor demanded also depends on its price (the wage rate).

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EMAND FOR

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ABOR

Demand for labor

0 L1 L2

W2

W1

Wage Rate (dollars per hour)

Quantity of Labor (hours per month) A

B

More workers are sought at lower wages

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M

ARGINAL

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HYSICAL

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RODUCT

The shape and location of the demand curve for labor determines how much labor is demanded and the wage rate that is paid.

Marginal physical product (MPP) is the change in total output associated with one additional unit of input.

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ARGINAL

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EVENUE

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RODUCT

The dollar value of a worker’s contribution to output is called marginal revenue product (MRP).

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MRP = MPP X p

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ARGINAL

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EVENUE

P

RODUCT

Marginal revenue product sets an upper limit to the wage rate an employer will pay.

Marginal revenue product (MRP) - the change in total revenue associated with one additional unit of input.

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AW OF

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IMINISHING

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ETURNS

The marginal physical product of labor eventually declines as the quantity of labor employed increases.

According to the law of diminishing returns, the marginal physical product of a variable factor declines as more of it is employed with a given quantity of other (fixed) inputs.

As marginal physical product diminishes, so does marginal revenue product as MRP=MPP x p.

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AW OF

D

IMINISHING

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ETURNS

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IMINISHING

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ETURNS

Number of Pickers (per hour)

0 1 2 3 4 5 6 7 8 9 10

0 2 4 6 8 10 12 14 16 18 20 22

Output of Strawberries (boxes per hour) Total output

Marginal output (per picker) A

B C

D

E F G

H I

b c d e

f g h i – 4

– 2

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D

IMINISHING

MRP

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IRING

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ECISION

Marginal revenue product determines how much labor will be hired.

A firm that is a perfect competitor in the labor market can hire all the labor it wants at the prevailing market wage.

An employer will continue to hire people until the MRP has declined to the level of the market wage rate.

Each (identical) worker is worth no more than the marginal revenue product of the last worker hired, and all workers are paid the same wage rate.

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MRP = F

IRM

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D

EMAND

0 1 2 3 4 5 6 7 8 9

1 2 3 4 5 6 7 8 9 10

$11

Wage rate MRP

A B

C

MARGINAL REVENUE PRODUCT (per hour)

QUANTITY OF LABOR (workers per hour) D

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C

HANGES IN

W

AGE

R

ATES

There is a tradeoff between wages and the number of workers hired.

If the wage rates go up, fewer workers will be hired.

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NCENTIVES TO

H

IRE

Quantity of Labor Demanded (pickers per hour)

Wage Rate (dollars per hour)

0 1 2 3 4 5 6 7 8 9

2 4 6 8 10

$12

MRP = demand

Initial wage rate A B

C G

D New wage rate Lower wages spur more hires

(6)

C

HANGES IN

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RODUCTIVITY

To get higher wages without sacrificing jobs, productivity (MRP) must increase.

Increased productivity implies that workers can get higher wages without sacrificing jobs or more employment without lowering wages.

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NCENTIVES TO

H

IRE

Quantity of Labor Demanded (pickers per hour)

Wage Rate (dollars per hour)

0 1 2 3 4 5 6 7 8 9

2 4 6 8 10

$12

Initial demand curve

Initial wage rate D1

C

Higher productivity spurs more hires

New demand curve D2

F E

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C

HANGES IN

P

RICE

An increase in product price will also increase MRP and thus demand for labor.

Price changes depend on changes in the market supply and demand for the product being sold.

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M

ARKET

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QUILIBRIUM

The market demand for labor depends on:

The number of employers.

The marginal revenue product of labor in each firm and industry.

The market supply of labor depends on:

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GThe number of workers.

GEach worker’s willingness to work at alternative wage rates.

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QUILIBRIUM

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AGE

The intersection of the market supply and demand establishes the equilibrium wage.

The equilibrium wage is the wage at which the quantity of labor supplied in a given time period equals the quantity of labor demanded.

Competitive employers act like price takers with respect to wages as well as prices.

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E

QUILIBRIUM

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AGE

Quantity of Labor (workers per time period)

A competitive firm

Quantity of Labor (workers per time period)

Wage Rate (dollars per hour)

Market demand Market supply The labor market

we

Labor supply confronting firm we

MRP of firm's labor q0

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M

INIMUM

W

AGES

A government-imposed minimum wage (wage floor):

Reduces the quantity of labor demanded.

Increases the quantity of labor supplied.

Creates a market surplus.

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M

INIMUM

W

AGES

The size of the job loss caused by a higher minimum wage depends on labor-market conditions.

When the minimum wage is below the equilibrium wage, an increase in the minimum may have little or no adverse employment effects.

The further the minimum wage rises above the market’s equilibrium wage, the greater the job loss.

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Wage Rate (dollars per hour)

0

Quantity of Labor (hours per year)

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INIMUM

W

AGE

E

FFECTS

Market surplus

Labor demand Labor supply

Minimum wage

Equilibrium wage rate

New entrants who can't find jobs we E

qe

qd qs

Workers who keep jobs at higher wage

Job losers wm

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C

HOOSING

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MONG

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NPUTS

Employers can use more machinery in place of labor.

To determine whether to hire a worker or use a machine, a firm compares the ratio of the marginal physical products to their cost.

This ratio expresses the cost efficiency of an input.

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C

OST

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FFICIENCY

Cost efficiency is the amount of output associated with an additional dollar spent on input – the MPP of a product divided by its price (cost).

The most cost-efficient factor is the one that

produces the most output per dollar. 41

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LTERNATIVE

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RODUCTION

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ROCESSES

Typically a producer does not choose between individual inputs but rather between alternative production processes.

Production process - A specific combination of resources used to produce a good or service.

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A

LTERNATIVE

P

RODUCTION

P

ROCESSES

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FFICIENCY

D

ECISION

The producer seeks to use the combination of resources that produces a given rate of output for the least cost.

Efficiency decision - The choice of a production process for any given rate of output.

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APPING

CEO P

AY

Critics of CEO pay believe that CEO paychecks are out of line with realities of supply and demand.

They want corporations to revise the process used for setting CEO pay levels.

One of the difficulties in determining the appropriate level of CEO pay is the elusiveness of marginal revenue product.

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NMEASURED

MRP

It is easy to measure the MRP of a strawberry picker, but a corporate CEO’s contributions are less well-defined.

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Congress confronts the same problem in

setting the president’s pay.

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NMEASURED

MRP

The wage of the president and other public officials is set by their opportunity wage.

I

The opportunity wage is the highest wage

an individual would earn in his or her best

alternative job.

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NMEASURED

MRP

Opportunity wages help explain CEO pay but don’t fully justify such high pay levels.

Critics of CEO pay conclude that the process of setting CEO pay levels should be changed.

If markets work efficiently, such government intervention should not be necessary.

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NMEASURED

MRP

Corporations that pay their CEOs excessively will end up with smaller profits than companies who pay market-based wages.

Over time, “lean” companies will be more competitive than “fat” companies, and excessive pay scales will be eliminated.

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End of Chapter 15

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