Labor Market

08/12/03

Basic Model

Firm’s Demand For Labor

• Derived Demand: based on demand for outputs that consumers value

• Firm chooses output to maximize profits (P=MC in competitive market)

• Output level implies a level of labor input (cost minimization)

Labor Supply

• Choice: Work vs. Leisure

• Limited Resources: 24 hours a day

• Opportunity cost of leisure = wage

• As wage increases, opportunity cost of leisure rises: Demand for leisure falls– The person will work more– Upward sloping supply curve of labor

Subsitution v. Income Effects

• Substitution Effect:– as wage rises work more attractive⇒

• Income Effect– as wage rises higher income for same ⇒

amount of labor work is less attractive⇒

• Since the two effects go in opposite directions– Labor supply can be downward sloping!!

Backward bending labor supply curve

Unemployment

• Wage Rigidity (downwardly sticky wages)

• Explanations:– Relative Wage– Labor Contracts– Efficiency Wage– Minimum Wage– Union Wage

Relative Wages

• The relative-wage explanation of unemployment holds that workers are concerned about their wages relative to the wages of other workers in other firms and industries.  They may be unwilling to accept wage cuts unless they know other workers are receiving similar cuts

Labor Contracts

• Explicit contracts are employment contracts that stipulate workers’ wages, usually for a period of one to three years.  Wages set in this way do not fluctuate with economic conditions.

• Cost of living adjustments (COLAs) are contract provisions that tie wages to changes in the cost of living.  The greater the inflation rate, the more wages are raised.

Efficiency Wage Theory

• Theories in which high wages increase worker productivity: – attract higher quality job applicants

– increase worker effort and reduce “shirking”

– reduce turnover, which is costly – improve health of workers

(in developing countries)

• The increased productivity justifies the cost of paying above-equilibrium wages.

• The result: unemployment

When do Efficiency Wages Work?

• When supervisory and monitoring costs are high. – The company can save on supervisory costs

by paying its non-supervisory and production workers an efficiency wage.

• Workers may not often get caught for loafing on the job. – But when they do the punishment is severe

Is the Punishment Severe?

• Consider the following “back of the envelope” calculation:– Annual salary of a full-time male non-

supervisory worker in US: $30,000– Suppose company pays 15 percent above

market.– Efficiency wage premium: $4,500– PDV (r = 0.05) of losing a job at age 30:

$74,000.

The Minimum Wage

• The minimum wage is well below the equlibrium wage for most workers, so it cannot explain the majority of natural rate unemployment.

• However, the minimum wage may exceed the equilibrium wage of unskilled workers, especially teenagers.

• If so, then we would expect that increases in the minimum wage would increase unemployment among these groups.

• Minimum wage will make those who have jobs better off, it is not clear that it helps the working poor

Effect of Minimum Wage

Labor Unions

• Unions exercise monopoly power to secure higher wages for their members.

• When the union wage exceeds the equilibrium wage, unemployment results.

• Employed union workers are insiders whose interest is to keep wages high.

• Unemployed non-union workers are outsiders and would prefer wages to be lower (so that labor demand would be high enough for them to get jobs).

Effect of Unions on Wages