Labor Demand The Labor Market

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1 Labor Demand The Labor Market 1. Labor demand 2. Labor supply Assumptions Hold capital stock fixed (for now) Workers are all alike. We are going to ignore differences in worker s aptitudes, skills, ambition and so on Labor market equilibrium ignoring unemployment 4. Unemployment 5. Europe and the U.S. 6. Discrimination 2 Labor market is competitive. Firms view the wage of the workers they hire as being determined in a competitive market labor market and not set by the firms themselves. (No monopsony power.) Firms are perfectly competitive in the product market (No monopoly power.) Firms maximize profits. A firm s profit is the difference between its revenue and its costs: π(q) =R(Q) C(Q) 3 where π(q) = profits R(Q) = total revenue C(Q) = total economic cost A firm in perfectly competitive environment revenue is price times output: R(Q) =P Q. Recall that we have worked with a production function: Q = F (K, L) where Q = output K = productive services of capital L = labor 4 Note that outputs and inputs are measure per units of period of time. That is Output is in number of units production per month, quarter, or year. Labor is measured in hours per week, month or year or in workers per week, month or year Marginal product of labor (MPL) change in output MPL = change in labor input = Δq ΔL The marginal product of labor measure the productivity of the last incremental increase in labor. F is a function.

2 Recall we write the total cost as C = w L + r K Analysis at the margin. A firm compares the costs and benefits of hiring one extra worker. If the real wage(w) is greater than the marginal product of labor (MPL), the firm is paying the marginal worker more than the worker produces, so a profit-maximizing firm will reduce the number workers to increase profits. If w<mpl, the marginal worker produces more than he or she is being paid, so a profit maximizing firm will increase the number of workers. The labor demand schedule specifies how many units of labor (such as man-hours) firms would hypothetically like to hire at any given prevailing wage. The labor demand curve is the MPL curve. Labor demand schedule slopes downward: firms want fewer workers and a shorter workweek when the real wage is high. 5 So we rewrite the firm s profits as: π(l) =P F (K, L) (w L + r K) So the firm wants find the choose the level of output to maximize profits. It chooses this level of output by choosing how much labor to hire. Plot P F (K, L) and (w L + r K) as functions of L. Profits are maximized where the slope of the profit function is zero Δπ(L) ΔL = P ΔQ ΔL ΔC(Q) ΔL =0 ΔF (K, L) = P w =0 ΔL = P MPL w =0 So profits are maximized when P MPL = w. 6 Labor Supply - The Income-Leisure Tradeoff Utility depends on consumption, C and leisure, l: Utility = U(C, l) 7 Comparative Statics Labor demand shifts out when P increases MPL increases Labor demand shifts out when P decreases MPL decreases 8 Need to compare the costs and benefits of working an additional day. Cost: loss of leisure time benefit: more consumption, since income is higher Let s be a little more specific. Resources of an individual and prices the individual faces: L s = time spent work (i.e labor supplied) h = total hours in a day w = real wage Φ = real non-labor wealth or profits

3 Time constraint l + L s = h So the budget constraint of this individual is C = wn s +Φ C = w(h l)+φ Comparative Statics An increase in Φ So suppose you win the lottery. What would happen to your supply of labor? What would happen to your demand for leisure? For most people, they would probably demand more leisure. In other words, leisure is a normal good for most people. 9 We can graph a person s preferences for consumption leisure using indifference curves. The optimal choice occurs where the marginal rate of substitution - the tradeoff between consumption and leisure equals the real wage. The value of the extra consumption to the person from working a little more just has to be equal to value of the lost leisure that it takes to generate the consumption. The real wage is the amount of consumption that this person can purchase if she gives up an hour of leisure. 10 There are two effects an income effect and a substitution effect. The income effect is the tendency of workers to supply less labor in response to become wealthier. The substitution effect is the tendency of workers to supply more labor in response to a higher real wage. An increase in the real wage shifts the budget constraint. The kink in the constraint remains fixed, and the budget constraint becomes steeper. Consumption will increase, but leisure may rise or fall, because of the opposing substitution and income effects. The substitution effect captures the movement along the indifference curve in response to the increase in the real wage. The real wage has increased so the relative cost of leisure has risen relative to consumption. The income effect holds the real wage constant. Note an increase in non-labor income, Φ has a pure income effect, with no substitution effect. Which effect will dominate? In general, as countries become wealthier, its citizen supply less labor. But in the short run the substitution effect dominates. As we said, this implies an upward sloping supply curve for labor. 11 An increase in the wage rate, w When the wage rate rises the leisure become more expensive, which by itself leads people to want less of it (the substitution effect). If leisure is a normal good, we would then predict that an increase in the wage rate would lead to a decrease in the demand for leisure and thus an increase in the supply of labor. A normal good must a negative sloped demand curve. If leisure is a normal good, then the supply curve of labor must be positively sloped. But wait there is a problem with the analysis. At an intuitive level, it may not seem reasonable that an increase in the wage rate would always lead to an increase in the supply of labor. If my wage becomes very high I might spend some of extra income consuming leisure. Get a backward bending supply curve for labor. 12

4 The aggregate labor supply curve 13 The aggregate labor supply curve is the sum of the labor supplied by everyone in the economy. The aggregate labor supply schedule specifies how many units of labor households would hypothetically wish to provide at any given prevailing current wage, holding all other variables constant. Aggregate labor supply slopes upward. In general, workers are willing to supply more man-hours at a higher real wage. A main determinant of labor supply is demographics (working age population, immigration, fertility) An outward shift in the labor supply curve means that households wish to provide more labor than previously at every hypothetical wage level. 14 The labor supply curve shifts out when: lifetime wealth decreases (a lot like a change in Φ) increase in the working age population The labor supply curve shifts in when: lifetime wealth increases decrease in the working age population Note that one possible source of an increase in lifetime wealth is an increase in a worker s expected future wages. Frictional Unemployment Labor market equilibrium ignoring unemployment Problem with supply and demand model above. No worker who wishes to work another hour at the prevailing wage w is unable to find an employer. Unemployment (defined as people looking for work but not working) would be zero! How can this be? Supply and demand is a useful way of thinking about the determination of w and N but doesn t tell the whole story. Example: Landlords and tenants - if a tenant leaves suddenly, the landlord does not usually rent the apartment right away. Normal, efficient matching of tenants to apartments takes a little time. The landlord could rent the place out right away. The landlord could drop the price below the market value. The landlord could take the first person who comes by to look at it. But this is not always the optimal thing to do. It is a good idea to be a little choosy. With constant turnover, there will always be a percentage of apartments that are vacant even though the landlords are willing to rent them at the going rental rate. 15 The hours demanded by firms and the hours workers supply reach equality at the intersection of the labor demand and labor supply curve denoted ( w, L). If w< w firms wish to hire more workers than are willing to work. Firms bid up the real wage w to attract workers. If w> w firms find more workers willing to work than firms care to hire. Jobseekers drive down the real wage. Upshot: the labor market moves toward equilibrium ( w, L). 16

5 Structural Unemployment 17 This shows up in almost every market we use supply and demand to analyze. In labor markets, such unemployment is called frictional unemployment. Not all unemployment is bad or inefficient. You often hear people say unemployment represents wasted resources. But looking for the right job or the right employee is no more of a waste then looking for the right apartment or looking for the right tenant. You rarely rent the first apartment you look at that is in your price range. It is important that capital and labor are in the place for efficient production. Taking the time to make labor is in the right place can be time well spent. This is one of the reasons governments offer unemployment insurance. As a society we want to make sure resources are allocated efficiently. We don t want people necessarily taking the first job that comes along just so they can pay their bills. Unemployment insurance allows job-seekers some time to find the right job, not just the first job. 18 The structural unemployed are the chronically unemployed. There are unemployed people without the skills to get and hold a job. There are a large number of people in this country who have such low job skills that they may not even understand that when a shift is from 9 to 5, that means you have arrive at nine o clock and you don t get to leave until five o clock. For these folks, the reason they are unemployed is not because they can t find the right job, it is that is hard to find someone willing to hire these folks at any wage. Often these people are not counted as unemployed since they become discouraged a drop out of the labor force all together. Can all unemployment be explained as frictional or structural? Hard to argue that the Great Depression was just friction and structural unemployment. Currently the unemployment rate in 4.8%; most of that (but certainly not all) is probably frictional and structural unemployment. But unemployment is a difficult thing to measure. So most business economists (e.g. Wall Street, the Fed) focus on employment growth rather than the unemployment rate. Why do we work so much harder than the Europeans? 19 Cyclical Unemployment These are the folks who are unemployed due to recessions. That is macro topic so we will leave that for Econ The typical U.S. worker (between the ages for 15 and 64) works 1,820 hours per year. The typical German works 1,480 and the typical French works 1,467. Three explanations Taste Taxes Coordination

6 Economics of Discrimination So far we have assumed that workers are all alike. But to the extent that personal traits affect job productivity such as intelligence, ability, strength, schooling, occupational training, and health differ systematically among age-race-sex groups in the population, so will earning capacity. younger workers make better football players young attractive women make for better celebrities than old fat balding middle age men What about the situation where labor market groups such as women and blacks have low earning power relative to to white males even if we account for productivity differences? We term this labor market discrimination. This is the case that the demand for labor for certain groups in lower for every given wage rate Why might firms discriminate? Some employers might have a distaste for associating with certain groups. Clients of the firm may have a distaste for associating with certain groups (Robert Barro does not like his flight attendants to be male!) Employers might collude in order to increase profits at the expense of certain groups. Employers might have incorrect information concerning the true productive capabilities of certain groups. Discrimination can also affect the labor supply curve Certain groups may be restricted (or feel restricted) to obtain job skills In particular, if certain groups perceive the return on obtaining jobs skills is lower, they may be less likely obtain the skills. Articles in the reading packet focus of discrimination due to names and looks. In particular, do hunky profs get better teaching evaluations? We could devote an entire course to this issue. 23

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