Questions: (1) Where do the labor demand and supply curves come from? (2) How well do they explain the facts?

12_01WAGE (PRICE OF LABOR)

QUANTITY OF LABOR

Labor demand

Market wage

Amount of labor where quantity of labor supplied equals quantity of labor demanded

Labor supply

The Slowdown in Wage Growth12_02

INDEX,1992 = 100

110

100

90

80

70

601960 1965 1970 1975 1980 1985 1990 1995 2000

Real wage

High growthtrend

Low growthtrend

Two sides of the labor market: Firms and Workers

• Labor Demand – The firm’s decision

• Labor Supply – The worker’s decision

Derived Demand for Labor

• Labor demand is a derived from firm’s profit maximization decisions

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

• This amount of output implies a level of labor input (short run)– a production function all over again

Market power? Not yet, let’s first start with competition

• A firm in a competitive market for its good: takes price as given

• But now also assume that the labor market is competitive: firm takes wage as given

Example: Competitive Firm with P = $100 (T12.1)

Workers Quantityproduced

MarginalProduct

TotalRevenue

MarginalRevenueProduct

0 0 -- 0 --1 17 17 1700 17002 31 14 3100 14003 42 11 4200 11004 51 9 5100 9005 58 7 5800 700

To derive the labor demand curve, first plot MRP by hand

Marginal Revenue Product Equals Wage

• Condition for Profit Maximization

• In symbols: MRP = W

• For firms in competitive markets:– MRP = PxMP– example 1700 = 100x17 or 1400 = 100x14

• This implies that MP = W/P– Marginal product of labor equals real wage

To get market demand for labor, sum up firms’ demands for labor

12_04

WEEKLY WAGE (DOLLARS)

WEEKLY WAGE (DOLLARS)

WEEKLY WAGE (DOLLARS)

1,500 1,500 1,500

1,000 1,0001,000

500 500 500

50 0 010 5 10 5 10 15 20

QUANTITY OF LABOR (NUMBER OF WORKERS)

QUANTITY OF LABOR (NUMBER OF WORKERS)

QUANTITY OF LABOR (NUMBER OF WORKERS)

LABOR DEMAND IN THE MARKETLABOR DEMAND AT CAREERPROLABOR DEMAND AT GETAJOB

What if firm has market power as in a monopoly?

• Still must have MRP = W

• But in this case MRP does not equal P=MP– because P is not fixed– P must decrease as L and Q go up

Derivation of Labor Supply

• analogy with earlier analysis of consumer behavior: purposeful choices (work versus “leisure”) with limited resources (only 24 hrs in a day)

• The “price of leisure” is the opportunity cost of not working = wage

• As the wage rises, the price of leisure rises– thus the person will work more

“Leisure” includes school!

• Investing in human capital

• more human capital increase marginal product of a worker

Substitution versus income effect in labor supply

• Recall the two effects for a good– the two effects go in the same direction

• in case of labor supply the two effects go in opposite directions– hence labor supply can slope down!!!!!!!

3 different labor supply curves

12_05

WAGE WAGE WAGE

Labor supply

Labor supply

Labor supply

QUANTITY OF LABOR QUANTITY OF LABOR QUANTITY OF LABOR

INCOME EFFECT DOMINATESSUBSTITUTION EFFECT EQUALS INCOME EFFECT

SUBSTITUTION EFFECT DOMINATES

Backward bending labor supply curve

12_06

WAGE

LABOR SUPPLY

Substitution effect dominates in this region.

Income and substitution effects balance out.

Income effect dominates in this region.

A Test: compare trend in labor productivity with trend in real

wage12_07

INDEX,1992 = 100

110

100

90

80

Labor productivity

70

60

50

1960 1965 1970 1975 1980 1985 1990 1995 2000

High growthtrend

Low growthtrend

But productivity theory does not explain everything

• Compensating wage differentials– salaries in the business school versus the

economics department

• “Efficiency” Wages

• Long Term Employment Contracts– wage is related to productivity over long

periods, but not short periods

Effects of Minimum Wage12_09

Quantity of labor demanded

Quantity of labor supplied

Minimum wage

Labor market equilibrium

Labor demand

Labor demand

Labor supply

Labor supply

WAGEWAGE

QUANTITY OF LABORQUANTITY OF LABOR

Surplus

Market for Unskilled Workers Market for Skilled Workers

Discrimination in competitive markets

12_08 WAGE

Labor supply

Actual marginal revenue product

NUMBER OF WOMEN WORKERS

4. Because actual marginal revenue product is higher than the wage, other firms can hire these women at a higher wage but still below the marginal revenue product.

1. Prejudiced firm acts as if marginal revenue product is lower than it actually is.

2. Discrimination causes wages to fall by this amount.

3. Discrimination also causes lower employment for women.

Effects of Labor Unions12_10

WAGE WAGE

New labor supply

New labor supply

Old labor supply

Old labor supply

QUANTITY OF LABOR QUANTITY OF LABOR

Labor demand Labor demand

5. lowering the nominal wage.

3. and reducing employment in this market.

2. raisingthewage...

1. The union shifts supply to the left...

Market for Union Workers Market for Nonunion Workers

4. Workers from the union sector come to this sector, shifting supply to the right and...