The labor market. National and local labor markets. Internal labor markets. Primary and secondary labor markets. Labor force and unemployment

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1 The labor market The labor market differs from most product markets in several important ways. Among these differences are: labor services are rented, not sold, labor productivity is affected by pay and working conditions, and the suppliers of labor care about the way in which the labor is used. National and local labor markets A national labor market is one in which most job search by employers and firms takes place on a national level. Most job search takes place at a local level in a local labor market. The markets for college professors, top management positions in large corporations, and similar occupations are national labor markets. Secretaries, carpenters, truck drivers, electricians, and lathe operators are employed through local labor markets. A national labor markets exists only when there are few employers and employees in most geographical regions. Local labor markets exist when there are many employers and employees in most geographical regions. Internal labor markets An internal labor market is said to exist within a firm if the firm fills higher level positions in the firm primarily by promotion from within the firm. Firms often rely on internal labor markets because: this reduces hiring costs, it improves employee morale and motivation, and it reduces the effect of uncertainty (since the firm has already observed worker productivity). Primary and secondary labor markets Another distinction that is often used to categorize jobs is that between the primary and secondary labor market. Jobs in the primary labor market are characterized by high wages and stable employment relationships. Workers employed in the secondary labor market receive low wages and experience unstable employment relationships. Examples of jobs in the primary labor market include: accountant, lawyer, teacher, carpenter, and plumber. Workers in fast-food restaurants, gas station attendants, dishwashers, janitors, etc. are employed in the secondary labor market. While primary labor market jobs have obvious advantages, the secondary labor market offers job opportunities that would not be available in the primary labor market to high school and college students, adults engaged in extensive child-care activities, and retired individuals. High school and college students are not likely to find primary labor market jobs during summer vacations or for parttime work during the academic year. Those adults who are "stuck" in secondary labor market occupations because of limited job skills and education, however, are not as pleased with finding their only employment prospects in this sector. Labor force and unemployment

2 The labor force consists of all noninstitutionalized individuals aged 16 or above who are either working or actively seeking work. Those who choose to be full-time students, or retire, or withdraw from the labor force for child-rearing purposes, or who give up looking for work are not counted as part of the labor force Individuals are unemployed only if they are not working for pay at any job and are actively seeking work. The unemployment rate is defined as: As was discussed in your introductory macroeconomics class, the unemployment rate generally rises during recessions and falls during periods of economic expansions. It is interesting to note, though, that when unemployed persons become discouraged and leave the labor force (these workers are called discouraged persons), the measured unemployment rate declines. (To see this, observe that while both the numerator and the denominator in the equation above decline, the fraction declines because the numerator falls by a larger percentage.) Thus, the unemployment rate may decline when the number of discouraged workers rises. Similarly, the observed unemployment rate may increase when discouraged workers become more optimistic about the state of the economy and start looking for work. Thus, to measure the state of the labor market, it is important to examine movements into and out of the labor force as well as changes in the unemployment rate. A convenient measure of this is provided by the labor force participation rate, defined as: Typically, the labor force participation rate increases during periods of economic expansion and declines during periods of recession. The Bureau of Labor Statistics (BLS) collects and reports unemployment and labor force participation rate data for a wide variety of subgroups of the population, sorted by age, gender, marital status, and race. Data on these variables may be found at the BLS website ( Labor force statistics can also be found on Eurostat database ( Romanian Ministry of Labor Family and Social Protection ( ), National Institute of Statistics in Romania ( ) Be careful to not confuse the unemployment rate with the number of people eligible to receive unemployment compensation (registered unemployed, registered unemployed who receive the unemployment benefit). While all of those who receive unemployment compensation are considered unemployed, a person could be unemployed but not eligible to receive unemployment compensation

3 (since eligibility is not available to those who voluntarily quite their job or who have not worked for a long enough time period prior to being laid off). An examination of unemployment statistics during the past century indicates that unemployment rates in the latter half of the 20th century were, on average, higher than those during the first half of the century. The variation in unemployment rates, however, has been much lower since the end of the Great Depression. The increased level of the unemployment rate may be the result of higher rates of structural unemployment or may be due to the reduced cost of being unemployed (as a result of the introduction of unemployment compensation). Structural unemployment is a form of unemployment resulting from a mismatch between demand in the labour market and the skills and locations of the workers seeking employment. Even though the number of vacancies may be equal to, or even greater than, the number of the unemployed, the unemployed workers may lack the skills needed for the jobs; or they may not live in the part of the country or world where the jobs are available. Structural unemployment is a result of the dynamics of the labor market and the fact that these can never be as flexible as necessary. Structural unemployment is hard to separate empirically from frictional unemployment, except to say that it lasts longer. During the last decades, the labor force participation rate for females has increased during the same period. The largest increase has been for married females (partly because single and divorced females always had relatively high labor force participation rates). Nominal and real wages If we are to measure changes in wages (or income) over time, it is important that some adjustment be made for the effect of inflation. Nominal wages are not adjusted for inflation and are said to be expressed in terms of "national currency" (since they are measured in terms of the value of the currency at that particular time). Real wages are wages that have been adjusted to take into account the effect of inflation. Real wages are expressed in terms of currency from a given base year and are said to be expressed in "constant currency." Some form of price index is used to convert nominal wages into real wages. A price index is constructed using the following formula: In practice, this price index is often expressed as a percentage by multiplying the formula above by 100. The most commonly used price index is the Consumer Price Index (CPI). The basket of goods used for the CPI is determined by the mix of goods consumed by a typical family. Suppose the cost of the basket of goods used to compute the CPI is twice as high today as it was in the base year. An inspection of the equation above indicates that the CPI will be 2 (or 200 expressed as a percentage). (In the base year, the price index will always be equal to 1, or 100 as a percentage.) Suppose that an individual's current wage is $12 an hour when prices are, on average, twice as high today as in the base year. A bit of reflection should convince you that the real wage, as measured in terms of the base year's dollars equals $6. In general, the real price of an item is measured as:

4 (Note that the price index is not measured as a percentage in this calculation.) One of the problems with the CPI is that it contains an inflationary bias (known as a substitution bias). There are also some serious problems associated with the effect of quality changes. In general, economists assume that individual workers and firms respond to changes in real wages and not nominal wages. Workers are concerned with the purchasing power of their wage over time, not just the number of dollars they receive. For this reason, whenever we refer to wages in the future, we will mean the real wage unless the nominal wage is specifically mentioned. Wages, earnings, total compensation, and income There are a few basic definitions. wage = payment per unit of time earnings = wage x hours (labor payment over an interval of time, typically a week, month, quarter, or year) total compensation = earnings + fringe benefits fringe benefits = payments-in-kind + deferred compensation (where: payments-in-kind include any payments in the form of goods and services such as the use of a company provided car, or employer-provided meals, uniforms, health insurance, or similar benefits; and deferred compensation involves items such as pension plans and other programs that provide payments at some point in the future.) income = total compensation + unearned income (in practice, when data on income is reported, income is generally measured as: income = earnings + unearned income since researchers generally do not have accurate measures of the value of fringe benefits) Demand for labor As the diagram below illustrates, it is argued that there is an inverse relationship between the wage rate and the quantity of labor demanded. This negative relationship between the wage and the quantity of labor demanded is the result of two effects: a substitution effect, and a scale effect.

5 Suppose that the wage rate increases. The substitution effect of the wage increase involves the substitution of other resources (such as capital, energy, materials, and other categories of labor) for the category of labor that has become more expensive. As the wage rate rises, the substitution effect results in a reduction in the quantity of labor demanded. The scale effect resulting from a wage increase is a bit more complex. As the wage rate rises, the scale effect involves the following chain of effects: higher wages result in higher average and marginal costs of production, higher average and marginal and average costs result in an increase in the equilibrium price of the product, as the price of the product rises, the equilibrium quantity of the product demanded declines (a reduction in the "scale" of production), and the reduction in output results in a reduction in the quantity of all inputs used to produce this product (including this category of labor). Thus, both the substitution and scale effects result in a reduction in the quantity of labor demanded when the wage rate rises. Be sure to not confuse a change in the quantity of labor demanded with a change in the demand for labor. A change in the wage changes the quantity of labor demanded, but does not affect labor demand. Labor demand changes only if the labor demand curve shifts in some manner (as discussed below). Changes in labor demand Labor demand is affected by: the demand for the product, and the prices of other resources. The demand for labor (and any other resource) is a derived demand. This means that the demand for a resource is derived from the demand for the output that the resource produces. For example, the

6 demand for workers in automobile factories is derived from the demand for automobiles. When the demand for the final product rises, the demand for labor increases. As the diagram below indicates, an increase in demand for labor is represented by a rightward shift in the labor demand curve (since the quantity of labor demanded is greater at each wage along the curve D'). The effect of changes in the prices of other resources is not quite as straightforward. Consider, for example, the effect of an increase in the price of capital on the demand for labor. The substitution effect resulting from a higher price of capital raises the demand for labor. The scale effect, on the other hand, will lower the quantity of both labor and capital demanded. Thus, the effect of a higher price of capital on labor demand will depend on whether the substitution effect or the scale effect is larger in magnitude. Another example might help to illustrate this point. Suppose that the wage rate rises for adult workers in the fast-food industry. How will this affect the demand for teenage workers in this industry? On the one hand, each fast-food restaurant will try to replace adults with teenagers. Since adults and teenagers are not perfect substitutes, firms will still need some adult workers. This results in higher production costs and a higher equilibrium price of output. As the price of fast-food products rises, firms cannot sell as much and will be forced to shut down some locations and layoff workers (including both teenagers and adults). This scale effect results in a reduction in the demand for teenage workers. When the price of adult workers rises, the demand for teenager workers will rise if the substitution effect is larger than the scale effect; the demand for teenage workers will fall if the scale effect is larger than the substitution effect. Market, industry, and firm demand for labor When discussing labor demand, it's important to distinguish whether we are talking about labor demand at the level of a market, an industry, or a firm. To understand these distinctions, it is important to understand the following definitions: An industry consists of all of the firms that produce a given type of output. An industry's demand for labor consists of the total demand for a

7 particular type of worker in a given industry. For example, we could investigate the demand for carpenters in the construction industry, or the demand for carpenters in the education industry (note that carpenters are hired in many industries). The market for a given category of labor consists of all of the firms that might hire a given type of labor, regardless of the industry in which the firm operates. Thus, the market for carpenters includes the demand for carpenters in all industries. An industry's labor demand curve is determined by adding together the labor demand curves for all of the firms in the industry (this involves a horizontal summation of all of the individual firms' labor demand curves -- if you don't recall this concept, you may wish to review the material on demand in a micro principles text). The market demand for labor is determined by adding together all of the industry demand for labor curves. Market labor supply The market labor supply curve is expected to be upward sloping because an increase in the wage in a particular labor market will: 1. cause some workers in this market to work additional hours, 2. induce some workers to shift from other labor markets to this relatively more remunerative alternative employment, and 3. will cause some individuals who are not currently in the labor force to enter this market. A possible labor supply curve is illustrated below. Changes in the wage in this market result in changes in the quantity of labor supplied, but do not affect labor supply. Labor supply changes only if some other factor changes and the labor supply curve shifts. The diagram below illustrates an increase in labor supply from S to S'.

8 Market labor supply will increase when the wage rate in other labor markets falls and will decrease when the wage rate rises in other labor markets. Changes in worker tastes and preferences will also affect market labor supply. Labor supply to individual firms In a perfectly competitive labor market, the labor supply curve facing each firm is horizontal. Recall that there are so many buyers and sellers in a perfectly competitive market that each buyer and seller is a "price taker." In this case, each firm may hire as many or as few workers as it wishes at the prevailing market wage rate. This possibility is illustrated in the diagram below. Labor market equilibrium

9 An equilibrium occurs in a labor market at the combination of wages and employment at which market demand and supply intersect (as illustrated in the diagram below). In this example, the equilibrium wage is w* and the equilibrium level of employment is L*. If the wage rate is above the equilibrium, the quantity of labor supplied exceeds the quantity demanded and a surplus occurs. In this case, the existence of unemployed workers will be expected to result in downward pressure on the wage rate until an equilibrium is restored. If the wage rate is below the equilibrium, a labor shortage will occur. Competition among firms for workers is expected to result in increases in the wage until an equilibrium occurs. Shifts in equilibrium o an increase in labor demand results in an increase in both the equilibrium wage and the equilibrium level of employment, o a reduction in labor demand results in a decrease in both the equilibrium wage and the equilibrium level of employment, o an increase in labor supply results in a lower equilibrium wage, but a higher equilibrium level of employment, and o a reduction in labor supply results in a higher equilibrium wage, but a lower equilibrium level of employment. Unions There are two major types of unions: industrial unions and trade unions (trade unions are also known as craft unions). Industrial unions attempt to organize all of the workers in an industry, regardless of the type of work that is done. Trade unions attempt to organize all of the workers performing a particular type of job, regardless of the industry in which the worker operates. The United Auto Workers (UAW) and United Mine Workers (UMW) are examples of industrial unions.

10 Examples of trade unions include: the International Brotherhood of Electrical Workers (IBEW) and the Meat Cutters union. So, who represents electricians at GM? Is it the IBEW or the UAW? It turns out that the workers themselves vote on who will represent them. In each unionized firm, workers are organized into shops, groups of workers performing similar tasks. Each shop votes on which union will serve as their bargaining agent for collective bargaining purposes. Each shop is represented by only one union in negotiations with the employer. Under a collective bargaining agreement, unions negotiate a wage with the employer. An effective union negotiates a wage that is above the equilibrium wage. In the diagram below, this is represented by a union negotiated wage of w'. As this diagram suggests, one of the costs of receiving a higher wage is a reduction in the level of employment (from L* to L'). Note also that there are more people who wish to work at a wage of w' than there are jobs available. This factor limits the ability of the union to negotiate higher wages. In some cases, however, unions are able to convince the government to pass laws that give unions some control over labor supply (in general, it is illegal under the Taft-Hartley Act for unions to otherwise limit labor supply). State and local zoning laws generally require that plumbing and electrical work be completed only by licensed plumbers and electricians. Since unions control the process of licensing, this gives unions substantial ability to control labor supply inm these industries. The American Medical Association, the American Dental Association, and the American Bar

11 Association have a similar ability to limit supply in their labor markets. The diagram below illustrates the effect of a labor supply restriction. As with a collective bargaining agreement, a supply restriction results in a higher wage (w') and a reduced level of employment (L'). The difference, though, is that there are no unemployed workers in this market since the supply restriction prevents these additional workers from ever appearing in this market. Overpaid and underpaid? As your text notes, economists argue that workers are overpaid only if the wage is above the equilibrium and are underpaid if the wage rate is below the equilibrium. To economists, this is a concept involving positive economics, not normative economics. Non-economists often appeal to some standard of "fairness" in evaluating whether people are overpaid or underpaid. Economists note that labor is not efficiently allocated to alternative tasks when the wage is either above or below the equilibrium. Economic rents Workers receive economic rent when they receive a payment that exceeds the opportunity cost of supplying their labor. The opportunity cost of supplying labor is the value of this time in its next-best alternative use. Another name for this opportunity cost is the "reservation wage." The reservation wage is the lowest wage offer an individual will accept. If the wage falls below the reservation wage, the individual will not work. As long as the wage is at or above the reservation wage, the individual will choose to work. Suppose that a professional athlete receives $300,000 a year, but could have received only $50,000 in their next-best alternative employment. In this case, the athlete is receiving $250,000 in economic rent. John Kane