Unit 8: Labor Markets
8.1: Input employment and pricing
Factor markets are markets where firms buy factors of production from households. For example, in the labor market, firms pay employees for their time. This is the inverse of a normal product market. In a product market, firms are the sellers and households are the buyers. But in the labor market, households are sellers and firms are buyers. Firms also buy capital and land, but these decisions are more complicated because they involve a time element. In this unit, we will focus on labor markets.
Competition in Factor Markets
Just like product markets, labor markets can exhibit varying degrees of competition. In a perfectly competitive product market, many firms sell identical output and each firm has no influence over the price. Similarly, in a perfectly competitive labor market, many firms hire workers with identical skills and so each firm has no influence over the wage.
A good example is the market for supermarket cashiers or construction workers. In these cases, there is a going market wage and the firm simply hires as many workers as it wants to hire at the going market wage. It does not choose the wage. Just like a firm selling oranges simply sells as many oranges as it wants to sell at the market price.
For simplicity, we will focus on competitive labor markets, and we will not consider markets where individual firms have market power to set wages. The extreme example is a monopsony, which is a market with only one buyer. An example is that a rural hospital might be the only employer in a large area that hires trauma nurses. This firm would have the ability to choose the wage that it wants to pay.
Firm Employment Decisions
Marginal product is the additional output produced by each worker. Because of diminishing marginal returns, the marginal product falls as more workers are hired – each additional worker adds to output, but he adds less than what the previous worker added.
To see how a firm determines the optimal level of input employment, let us consider the following example. Note that total output (Q) and marginal product (MP) are measured in units of output. For example, when three workers are employed, the firm produces 45 units of output. The third worker’s marginal product is 10 units, meaning that the third worker adds 10 units to the level of output when he is hired.
Workers Q MP
0 0 --
1 20 20
2 35 15
3 45 10
4 50 5
5 53 3
The value of marginal product (VMP) is the dollar value of the output produced by an additional worker. For example, if the marginal product of a worker is 100 pizzas (i.e. hiring this worker adds 100 pizzas to our output) and each pizza sells for $6, then the value of marginal product for this worker is $600. This is the extra dollar value that the worker produces for the firm. Generally, value of marginal product is calculated as 𝑉𝑉𝑉𝑉𝑉𝑉 = 𝑉𝑉𝑉𝑉 × price
For the example above, let us assume that each unit of output sells for $5. The VMP is shown below, using the formula just given. The VMP is basically what a worker is worth to a firm.
Furthermore, we assume that the labor market is competitive, and that the wage is $20. In other words, the firm can hire as many workers as it wants to hire for $20 per worker.
Workers Q MP VMP Wage
0 0 -- -- --
1 20 20 $100 $20
2 35 15 $75 $20
3 45 10 $50 $20
4 50 5 $25 $20
5 53 3 $15 $20
6 54 1 $5 $20
In this example, the firm should hire 4 workers. The decision about how many workers to hire is simple marginal benefit / marginal cost. The firm should continue to hire workers as long as their VMP exceeds the wage they are paid. For our firm, this is true for the first four workers.
Basically, workers are worth hiring when the value of what they produce for the company (the VMP) exceeds the wage they are paid. Following usual marginal analysis, we continue hiring up to the last worker for whom the VMP exceeds the wage.
The corresponding diagram is standard. In the diagram below, the optimal level of employment is
𝐿𝐿∗. It is worth hiring all workers up to 𝐿𝐿∗ because they have a VMP higher than the wage they are
There are a few interesting features of this diagram. First, the VMP curve is the same as the firm’s demand for labor. At any wage, the VMP gives the number of workers that the firm wants to hire at that wage.
Second, the going wage in a competitive market is equal to the VMP at that level of employment. In other words, the wage in a competitive industry is a good indicator of the (marginal) productivity of workers in the industry. Basically, in some sense, people are paid what they’re worth. But this makes sense since we know that economic rents are not possible when both sides of the market are competitive.
Finally, the signature of a perfectly competitive labor market is the perfectly elastic supply of labor. In other words, there is a market wage and the firm hires as many workers as it wants to hire at this wage.
Minimum Wage
There is perhaps no issue that inspires more debate among economists than the minimum wage. Proponents of minimum wages argue that it is a social responsibility for firms to pay workers a reasonable wage. But opponents of minimum wages argue that minimum wages create unemployment, which ultimately harms the very workers that the policies seek to help. Their basic argument is that firms will not be willing to hire as many workers if they are forced to pay high wages.
It’s easy to see why. If a firm pays a wage of $8 an hour, then a worker whose VMP is $9 an hour is worth hiring. But if the government forces the firm to pay a minimum wage of $10 an hour, then it’s not worth it for the firm to hire the worker anymore.
Minimum wages are just a simple example of a price floor from our supply and demand unit. When the government sets a wage higher than equilibrium wage, there is a surplus of workers – lots of workers want jobs at this higher wage, but fewer employers want to hire workers when they have to pay higher wages.
The theoretical result seems obvious. The problem is that some economists debate whether this effect actually exists in practice. Does the minimum wage really create unemployment?
In 1995, David Card and Alan Krueger wrote a book that cited a number of examples of minimum wage increases, and they claimed that the number of jobs actually rose as a result of these increases. This set off a hailstorm of criticism among economists, one claiming that this would be the same as a physicist claiming that water runs uphill!
The issue is complicated. Other economists who study minimum wage increases have found no discernible increase in unemployment, and economists who do find that minimum wages create unemployment find that the effect is very small. A 10% increase in the minimum wage creates perhaps a 2% or 3% reduction in the number of jobs. Furthermore, the reduction in jobs is mostly for teenagers. Some other economists say that it’s basically impossible to find a straightforward answer – minimum wages only affect some workers, and minimum wage increases tend to be small. So, compared to other things that are going on, it’s hard to figure out what part of employment changes are due to minimum wage changes versus other things going on in the economy at the same time.
in a suboptimal job. So a minimum wage might raise workers’ lifetime incomes by preventing them from locking into a low-paying job, even if it means a short spell of unemployment before they find a job. Some economists have also suggested that firms will substitute capital in place of workers when they face high minimum wages, and then over the long-run this increase in capital will make workers more productive and create more and better jobs.
Another issue is market power. In markets where firms have wage-setting power, a minimum wage might actually increase employment by preventing firms from artificially reducing their hiring in order to keep the wage low. Opponents of minimum wages argue that workers are paid exactly what they’re worth in a free market. But that’s really only true for competitive markets. When firms have asymmetric market power relative to workers in bargaining over wages, it is not
necessarily the case that workers are paid a “fair” market wage equal to their productivity.
Overall, this is a complex issue. Like many things in economics, there may not be a simple, straightforward answer to the question of how minimum wages impact unemployment. But it’s always good to be analytical and critical when analyzing arguments that seem at first glance to be simple and obvious. Rarely is anything in economics so simple.
Labor Supply Decisions
Until now, this unit has been about labor demand – a firm’s decision about how many workers to hire. But what about labor supply? How many people want to work and how many hours will they choose to work?
An individual deciding how much to work is basically making a choice between income and leisure time. Working more means more income, but it means less leisure, and people value both. That’s why we don’t work 16 hours a day for our whole lives. The price of taking leisure is exactly your wage: when you choose to take an hour of leisure time, the price is the opportunity cost of what you could have earned by working during that hour instead of taking leisure.
Suppose that the wage rate increases. What will happen to your labor supply? There are actually dual effects that pull in opposite directions.
• Income effect: A higher wage might make you want to work less. When your wage goes up, you are richer, and one of the things you buy with this income is more leisure time. According to the income effect, people who earn higher wages will work less.
Basically, when people get a higher hourly wage, one way of thinking is that each hour of work is more rewarding, so you might as well work more. This is the substitution effect. But another way of thinking is that you don’t need to work as many hours to earn the amount of money you want to earn, so you can enjoy your higher wage by working less. This is the income effect. These two effects pull in opposite directions. Overall, economic theory does not give a clear answer about whether higher wages make people work more or work less.
In practice, what labor economists observe is that – at least for modest wage increases – the substitution effect is usually stronger. Workers who experience a modest wage increase are usually willing to work more in response to these wage increases. In other words, the labor supply curve is upward sloping. Higher wages mean that more people choose to work and that people who already work will choose to work more hours.
The Labor Market
The labor market is just like any other market. The difference is that firms represent the demand for labor, while households represent the supply of labor. This is the inverse of a product market, where households represent the demand and firms make up the supply.
The labor demand curve is downward sloping, like any other demand curve – at higher wages, firms want to hire fewer workers. The labor supply curve is upward sloping – at higher wages, more people are willing to work, and people already in the labor force are willing to work more hours.
The equilibrium wage is the wage at which supply and demand for labor are equal. If there is a free market, the labor market will tend to adjust towards equilibrium. At wages lower than equilibrium, lots of firms want to hire workers but not many workers are willing to work – firms will offer higher wages in order to compete for scarce workers. At wages higher than equilibrium, there are fewer jobs available than the number of workers who want to work. Some of the unemployed workers will accept lower wages in order to secure jobs.
The labor supply curve shifts when some factor other than wage changes the number of workers who are willing to work. In other words, the labor supply curve shifts when there is a change in the number of workers willing to work at a particular wage. Here are some examples.
• A change in the total number of workers: For example, immigration can cause an increase in the supply of labor.
• A change in the cost of acquiring skills: For example, if medical school gets more expensive, the supply of doctors will fall.
• A change in the wage rate in other industries: For example, if wages in the service industry rise, then there may be a decline in the supply of manufacturing labor.
The labor demand curve shifts when something other than wage changes the number of workers that employers want to hire. Here are some examples.
• A change in worker productivity: For example, if workers in an industry become more productive, it is more profitable to hire them and the demand for labor rises.
8.2: Wages and inequality
Capitalist economies, especially the United States, feature a high degree of inequality in incomes and in wages. In this section, we will explore some of the causes and see what economists can say about wage inequality.
A Thought Experiment
The following simple example is due to Alfred Marshall, and it’s a good place to start thinking about inequality. Consider a simple economy with just two jobs – Job A and Job B. Both jobs are equally desirable and both jobs require the same skill set. Furthermore, the labor market is competitive and workers can easily switch jobs.
In this economy, both jobs have to pay the same wage. There is no income inequality. It’s very simple to see why. If wages were higher in Job A than in Job B, then workers would leave Job B and take Job A since both jobs are equally attractive. This reduces the supply of labor in Job B, raising the wage there, and raises the supply of labor in Job A, reducing the wage there. As long as the economy is competitive and workers can easily move, there are no economic rents – both jobs pay the same wage.
For this example, there is no inequality. Thus, in thinking about inequality, we have to think about how the real-life labor market differs from this example.
Compensating Differentials
One way in which the labor market is different from the example described above is that, in real life, jobs are not equally attractive. For two jobs that are not equally attractive, the compensating differential is the difference in wages that would be needed to make the jobs equally attractive.
For example, being a garbage collector is much more unpleasant than being a cashier. If both jobs paid the same wage, then everyone would prefer to be a cashier. But maybe a wage difference of $5 an hour is just enough to make a cashier willing to accept a job as a garbage collector. This is a compensating differential.
Here are some common sources of compensating differentials.
• Attractiveness of work: As discussed above, unpleasant work has to pay a higher wage in order to attract workers. One interesting result is that you can benefit from a diversity of preferences – If you enjoy doing something that other people don’t like, then you can benefit from a higher wage
• Locational differences: The same job has to pay a higher salary in New York City than it pays in rural Nebraska. Nobody would work in New York City otherwise, because it is very expensive to live there. On the other hand, jobs in pleasant locations can get away with lower wages; workers will accept lower wages since they can benefit from the nice environment.
• Differences in skill requirements: If a job requires a person to get a very expensive degree or to be out of a job for a long time while studying for the degree, this job will have to pay a higher wage. Otherwise, it wouldn’t be worth it for people to invest in the job skills.
Importantly, wage inequality that stems from compensating differentials is not really economic rent. The garbage collector isn’t earning economic rents because he gets paid more than the cashier, and the college professor isn’t earning economic rents when he gets paid more than the high school teacher. These are differentials that compensate workers for costly conditions on the job – unpleasant, dangerous work or an expensive degree. The garbage collector isn’t doing any better than he would be doing in another career. He may be making more money, but the money is exactly enough to compensate him for the unpleasant work.
Differences in Ability
Another source of wage inequality is inherent differences in ability. If the pool of people with a skill set to do a particular job is very scarce, then this job will command higher wages. If it takes a lot of special talent to be a CEO, and not a lot of people have the skill set that is needed, then CEO’s will command high pay.
Barriers to Entry
Barriers to entry also allow workers to earn economic rents. What kept wages equal in the simple example at the beginning of the section was that workers could easily switch jobs when one job was paying more. But if a particular occupation erects barriers to entry, then permanently high wages can persist. Again, these are economic rents. Individuals in these industries earn higher wages than they would otherwise because of lack of competition.
Barriers to entry might be special licensing or degree requirements. For example, doctors and lawyers both create serious barriers to entry that make it very difficult for new people to enter these professions. Most of these barriers are created by doctors and lawyers themselves! Economists have suggested for a long time that at least some of these stringent requirements may not be an assurance of quality, but rather an attempt to keep wages high by limiting competition.
Labor unions are notorious for creating barriers to entry. It is definitely true that workers in unionized jobs earn more than similar workers in non-unionized jobs. Some of this may be improved bargaining power for workers facing powerful employers, but part of the wage differential is barriers to entry created by unions.
Discrimination
A final source of wage inequality is discrimination. The way economists use the word, discrimination occurs when different groups of people have different opportunities that are not
related to differences in ability.
This distinction is important. Just because different groups of people are paid different wages, this does not necessarily prove that there is discrimination. For example, women might be getting different degrees than men get or might be getting less job market experience because of time at home raising children. But if a man and a woman with similar ability, training and experience have systematically different opportunities, then this is discrimination.
Economists hate discrimination, not only because it’s unfair but because it is inefficient. What is efficient is to place the most capable workers in job openings, who can do the job the best. When capable people are denied opportunities because of their gender or their race, this is bad for everyone in the economy. It’s a wasted opportunity. Society works best when workers are matched to the jobs where they are most productive, irrespective of race or gender or religion.
though they are well-qualified for the job, then this creates an opportunity for other employers to grab skilled workers from this group. Employers who are out to maximize profits are always looking for opportunities to hire good workers who are searching for a job. Ultimately, discrimination by employers should wash itself out of the market. On the other hand, discrimination by customers is more difficult to address. If your customers refuse to work with members of a particular religious group, for example, then it’s not going to increase your profits if you start hiring members of this group.
One reason that discrimination appears to be so persistent is that there’s a cycle of bad expectations. If workers from a certain group expect to be discriminated against in the job market, then these workers have no reason to invest in training or skills. Employers then believe that this group of workers are not good candidates for jobs. But then this lack of opportunities means that these workers have no reason to invest in their futures. And the cycle goes on and on. It’s a vicious circle, as illustrated below.
Discrimination at some point in the past led to disadvantaged groups seeing that there was no reason to invest in job skills. But employers then didn’t hire people from these groups because
they didn’t have job skills.
