Principles of Economics

Labor Market

Programme: EMBA/MBA/MPA
Instructor : Dr. Sheeba Zafar
 Labor Market Participants

Individuals

Firms

Government

2
 Labor Market Behavior
Positive Aspects Negative Aspects

Obtaining a job
Unemployment

Promotion
Job displacement

Increase in wage rate
Discrimination

Benefits
Poverty

3
 Decisions by Employers

# of workers Global

Wages/benefits Competition

Hours Legislative

Layoff /bankruptcy Environment

Subcontract Changing

Pension/retirement policy Workforce

4
 Global Competition Influences

Free trade

Industrial restructuring

Deregulation

Privatization

5
 Pricing Decisions

In addition to making output & pricing decisions, firms
must also determine how much of each input to
demand.

Firms may choose to demand many different kinds of
inputs. The two most common are Labor & Capital.

The demand & supply of labor are determined in
the Labor Market.

The participants in the labor market are workers and
firms. Workers supply labor to firms in exchange
for wages. Firms demand labor from workers in
exchange for wages.

6
 The Firm's Demand for Labor

The firm's demand for labor is a derived demand;
it is derived from the demand for the
firm's output.

If demand for the firm's output increases, the firm

will demand more labor and will hire more
workers.

If demand for the firm's output falls, the firm will

demand less labor and will reduce its work force.

7
Marginal Revenue Product of Labor (MRPL)

When the firm knows the level of demand for its
output, it decides how much labor to demand by
looking at the marginal revenue product of labor
(MRPL).

The marginal revenue product of labor (or any input)
is the additional revenue the firm earns by
employing one more unit of labor.

The marginal revenue product of labor is related to
the marginal product of labor.

In a Perfectly Competitive market, the firm's Marginal
Revenue Product of Labor is the Value of The
Marginal Product of Labor. 8
The firm's profit‐maximizing labor‐demand
decision is presented graphically

When the MRPL is graphed, it
represents the firm's labor
demand curve.

The demand curve is
downward sloping due to the
Law of Diminishing Returns;

As more workers are hired, the
MPL begins declining, causing
the MRPL to fall as well.

The intersection of the MRPL
curve with the market wage
determines the number of
workers that the firm hires, in
this case 3 workers.
9
 Labor Market Equilibrium

Workers prefer to work when the wage is high,
and firms prefer to hire when the wage is low.

Labor market equilibrium “balance out” the

conflicting desires of workers and firms and
determines the wage and employment observed
in the labor market.
 (Pareto) Efficiency

Pareto efficiency exists when all possible gains
from trade have been exhausted.

When the state of the world is Pareto Efficient, to
improve one person’s welfare necessarily
requires decreasing another person’s welfare.

In policy applications, ask whether a change can
make any one better off without harming anyone
else. If the answer is yes, then the proposed
change is said to be “Pareto-improving”.

11
Equilibrium in a Competitive Labor Market
The labor market is in
Dollars
equilibrium when supply
equals demand; E* workers
are employed at a wage of w*.
S In equilibrium, all persons
who are looking for work at
P
the going wage can find a job.
w The triangle P gives the
*
Q
producer surplus; the triangle
Q gives the worker surplus. A
competitive market maximizes
D0 the gains from trade, or the
sum P + Q.
Employment
EL E* EH
12
 Efficiency Revisited

The “single wage” property of a competitive equilibrium
has important implications for economic efficiency.
– Recall that in a competitive equilibrium the wage
equals the value of marginal product of labor. As
firms and workers move to the region that provides
the best opportunities, they eliminate regional wage
differentials. Therefore, workers of given skills have
the same value of marginal product of labor in all
markets.

The allocation of workers to firms that equates the
value of marginal product across markets is also the
sorting that leads to an efficient allocation of labor
resources. 13
1. Equilibrium in a Single Competitive Labor Market
Dollars

The supply curve gives the S
total number of employee-
hours that agents in the
economy allocate to the W*
market at any given wage
level.

The demand curve gives
the total number of D
employee-hours that firms E* Employment
in the market demand at
that wage. Equilibrium in a Competitive Labor Market

Equilibrium occurs when Note: There is no unemployment
S=D in a competitive labor market.
generating the competitive Persons who are not working are
wage w * & employment E *. also not looking for work at the
going wage.
14
2. Competitive Equilibrium Across Labor Markets
The economy typically consists of many labor markets, even
for workers who have similar skills. As long as either
workers or firms are free to enter and exit labor markets, a
competitive economy will be characterized by a single wage.

Dollars SN Dollars
S’N S’S
SS
WN

W* W*

WS
DN DS

Employment Employment

Competitive Equilibrium in Two Labor Markets Linked by Migration 15

 Derivation of Labor Supply

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

16
 “Leisure” includes school!

Investing in human capital ore human capital
increase marginal product of a worker

17
 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!!!!!!!

18
Different Shapes of Labor Supply
Curves

19
 Backward Bending Labor Supply
Curve
12_06
W AGE
In c o m e e ffe c t
d o m in a te s in
th is r e g io n .

In c o m e a n d
s u b s titu tio n e ffe c ts
b a la n c e o u t.

S u b s titu tio n e ffe c t

d o m in a te s in th is
r e g io n .

LABO R SUPPLY

20
 Backward-Bending Supply
Curve of Labour

In economics, a backward-
bending supply curve of
labour, or backward- bending
labour supply curve, is a
graphical device showing a
situation in which as real, or
inflation-corrected, wages
increase beyond a certain
level, people will substitute
leisure (non-paid time) for paid
work time and so higher
wages lead to a to a decrease
in the labor supply & so less
labour-time being offered for
sale. 21
Backward-Bending Supply
Curve of Labour

22
Implications For Economic Performance

The “single wage” property of competitive
equilibrium has important implications for
economic performance.

That is, workers of given skills have the same
value of marginal product of labor in all markets.

The allocation of workers to firms which equates
the value of marginal product across markets is
also the allocation which maximizes national
income.

This type of allocation is called an efficient
allocation.
23
 Payroll Taxes and Subsidies

Payroll taxes assessed on employers lead to a
downward, parallel shift in the labor demand curve.
– The new demand curve shows a wage between the
amount the firm must pay to hire a worker and the
amount that workers actually receive.
– Payroll taxes increase total costs of employment, so
these taxes reduce employment in the economy.
– Firms and workers share the cost of payroll taxes,
since the cost of hiring a worker rises and the wage
received by workers declines.
– Payroll taxes result in deadweight losses.
24
 The Impact of a Payroll Tax
Assessed on Workers
S1 A payroll tax
Dollars assessed on
workers shifts the
w0 + 1 S0
supply curve to
w1
the left
(from S0 to S1).
w0 The payroll tax
has the same
w1 − 1
impact on the
equilibrium wage
D0
and employment
D1
regardless of who
E1 E0 Employment it is assessed on.
25
 The Impact of a Payroll Tax put on
Firms with Inelastic Supply
Dollars
A payroll tax assessed
S on the firm is shifted
completely to workers
D0 when the labor supply
curve is perfectly
A
w0 inelastic.
The wage is initially w0.
The $1 payroll tax shifts
w0 – 1 B
the demand curve to D1,
D0
and the wage falls to
D1
w0 – 1.
E0 Employment
26
 Payroll Subsidies

An employment subsidy lowers the cost
of hiring for firms.

This means payroll subsidies shift the
demand curve for labor to the right (up).

Total employment will increase as the
cost of hiring has fallen.

27
 The Impact of an Employment
Subsidy
S An employment
subsidy of $1 per
w0 + 1 worker hired shifts up
the labor demand
w1 B curve, increasing
employment. The
w0 A wage that workers
receive rises from w0
w1 – 1
D1 to w1. The wage that
D0
firms actually pay
falls from w0 to w1 – 1.
E0 E1 Employment
28
 Policy Application: The Impact of Minimum Wages

The standard economic model of the impact of minimum
wages on employment is illustrated in the following figure:
Note: A minimum wage
creates unemployment
Dollars because:
S
1. Some previously
W
employed workers
lose their jobs, and
W*
2. Because some workers
who did not find it
worthwhile to work at
D
the competitive wage
E E* ES Employment find it worthwhile to
work at the higher
The Impact of the Minimum Wage minimum wage. 29
on Employment
 Absence of a Minimum Wage

In the absence of a minimum wage, the
migration of workers across sectors equates the
wage in the two sectors.

The migration of workers when the wage in one
of the markets is set at the minimum wage
equates the expected wage across sectors. i.e.,
the free migration of workers across sectors
ensure that the expected wage in the covered
sector equals the for sure wage in the
uncovered sector.

30
 The Impact of Minimum Wages on the
Covered and Uncovered Sectors
Dollars Dollars
SU (If workers migrate
SC to covered sector)
SU
w1
E1
SU
w* (If workers migrate to
w* uncovered sector)
wu

DC DU
E1 EC Employment E1 E * EU Employment

(a) Covered Sector (b) Uncovered Sector

If the minimum wage applies only to jobs in the covered sector, the displaced
workers might move to the uncovered sector, shifting the supply curve to the
right and reducing the uncovered sector’s wage. If it is easy to get a minimum
wage job, workers in the uncovered sector might quit their jobs and wait in the
covered sector until a job opens up, shifting the supply curve in the uncovered
31
sector to the left and raising the uncovered sector’s wage.
 Monopsonist

A monopsonist is a single buyer of labour, such as De
Beers, the diamond producer, and the major employer
of diamond workers in South Africa.

Monopsonists are common in some small towns,
where only one large firm provides the majority of
employment.

Because of their buying power, monopsonists are able
to influence the price they pay compared with buyers
in more competitive markets.

Pure monopsonists are rare because suppliers
normally have alternative outlets for their good or
service. However, monopsony power is significant in
certain sectors of the economy.
32
The Monopsonist's MC of Labour & Supply Curve

The individual wage paid to the workers is only £30. In

this case, the monopsonists is said to be exploiting the
workers by paying less than the MRP – i.e. wages are £30
per hour, and the MRP is £50 per hour, meaning that the
monopsonist has gained £20. It can achieve this because
it does not have to pay the full value of the MRP.
33
The Monopsonist's MC of Labour & Supply Curve

Assuming the monopsonist tries to maximize profits, it will

demand labour up to the point where MCL = MRP.

This will occur at 3 Hairdressers, where the MCL and MRP
are both £50 per hour, as shown above:
34
The Monopsonist's MC of Labour & Supply Curve

However, if there are several hair salons in the

town, each salon will have to bid up the wage
rate in order to attract sufficient hairdressers so
that they can maximize their individual profits.

The competitive wage rate would exist where the
wage to attract workers (the labour supply curve)
equals the MRP curve, at a rate of £40, and
employing 4 hairdressers.

35
 Noncompetitive Labor Markets:
Monopsony

Monopsony market exists when a firm is the only
buyer of labor.

Monopsonists must increase wages to attract

more workers.

Two types of monopsonist firms:

– Perfectly Discriminating

– Nondiscriminating

36
 A Union Minimum Wage

A union can represent workers and seek to
increase the benefits to workers.

For example, what would happen if the union of
hairdressers sets a minimum wage at £40, the
competitive rate?

If a trade union enters the labour market and
becomes the monopoly supplier of labour, it can
force the monopsonist to pay a wage at, or
nearer to, the market rate, and employ more
workers.

37
 A Union Minimum Wage

At a minimum wage of £40, the supply of labour is
horizontal at this wage, with the MCL = ACL (S), and
the profit maximizing monopsonist would employ up to
the point where the MCL = MRP, which is at 4
workers - i.e. the market wage rate and the market
level of employment.

38
 The Impact of the Union Minimum
Wage

The effect of the minimum wage clearly depends
upon its level, & whether it is set above the market
rate - the greater it is above the competitive market
rate, the lower the level of employment.

The impact of the union minimum wage also
depends on the elasticity of demand & supply of
labour.

For example, if the demand for labour is relatively
inelastic, jobs lost due to the minimum wage will be
relatively small.

If supply is inelastic, the minimum rate may not
result in a significant change in employment.
39
 Perfectly Discriminating
Monopsonist

Discriminating monopsonists are able to hire
different workers at different wages.

To maximize firm surplus (profits), a perfectly

discriminating monopsonist “perfectly
discriminates” by paying each worker his or
her reservation wage.

40
 Noncompetitive Labor Markets
(1) Monopsony

Because the firm is the only demander of labor
in this market, it can influence the wage rate.

Monopsnoists face an upward-sloping supply
curve.

This is because the supply curve tackles them
is the market supply curve.

Note: To expand its work force, a monopsonist

must increase its wage rate, i.e., the marginal
cost of hiring labor excess the wage.
41
 The Hiring Decision of a Perfectly
Discriminating Monopsonist
A perfectly discriminating
Dollars monopsonist faces an upward-
sloping labor supply curve & can
S hire different workers at different
wages.
w* A Therefore the labor supply curve
w30 gives the MC of hiring.
VMPE Profit maximization occurs at
w10 point A. The monopsonist hires
the same number of workers as
10 30 E* Employment a competitive market, but each
worker is paid his or her
reservation wage. 42
 Nondisriminating Monopsonist

Must pay all workers the same wage, regardless
of each worker’s reservation wage.

Must raise the wage of all workers when

attempting to attract more workers.

Employs fewer workers than would be employed

if the market were competitive.

43
 The Hiring Decision of a Nondiscriminating
Monopsonist
Dollars
A nondiscriminating
monopsonist pays the
MCE S
same wage to all workers.

A The MC of hiring exceeds

VMPM the wage, & the MC curve
w* lies above the supply
curve.
wM
Profit maximization
occurs at point A; the
monopsonist hires EM
VMPE
Employment workers & pays them all a
EM E* wage of wM.
44
To maximize profits, we know that any firm should hire
labor until the points at which marginal revenue
product equals marginal cost.
MRP = MCL
MCL
W
S
Wages are below
marginal revenue
product for a
WC monopsonist.
Wm
MRP Wm < WC and Em < EC
L
Em Ec

45
 The Impact of the Minimum Wage on a
Nondiscriminating Monopsonist

Dollars The minimum wage

MCE
may increase both
S wages and
A
employment when
imposed on a
w* nondiscriminating
w−
wM
monopsonist. A
VMPE Minimum wage set
EM E− Employment
at w− increases
employment to E−.
46
The Monopsonist, a Minimum Wage Law

In the presence of monopsony power, it is
possible that an increase in the minimum wage
can raise both the wage and the level of
employment, contrary to the outcome predicted
by the Perfect Competition Model.

47
 The Output Decision of a Monopolist
A monopolist faces a
downward-sloping
Dollars demand curve for their
output.
MC
The MR from selling an
pM
additional unit of output is
less than the price of the
p*
product.
A
Profit maximization occurs
at point A where the
MR D
monopolist produces qM
q M q*
Output units of output and sells
each unit of output at a
price of pM dollars. 48
The wage rates that monopolies pay are not necessarily
different from competitive levels even though employment
levels are. An employer with a product market monopoly may
still be a very small part of the market for a particular kind of
employee, and thus be a price taker in the labor market even
though a price maker in the product market.
Dollars

A
W

VMPE
MRPE

Em E* Employment

The Labor Demand of a Monopolist 49

12_09
Effects of Minimum Wage
W AGE W AGE

Labor
Q uantity of Q uantity of Labor m arket supply
labor dem anded labor supplied equilibrium
Labor
supply

Surplus

Labor
M inim um dem and
w age

Labor
dem and

Q U A N TITY O F LA B O R Q U A N TITY O F LA B O R

M arket for U nskilled W orkers M arket for Skilled W orkers

50
 What are other reasons for
differences in wage?

Labor Market Imperfections
- Insufficient/misleading job information
- This prevents workers from seeking better employment

Geographical Immobility
- Many people are reluctant or too poor to move so they
accept a lower wage

Unions

Collective bargaining and threats to strike often lead to
higher that equilibrium wages

Wage Discrimination
- Some people get paid differently for doing the same job
based on race or gender 51
 The Minimum Wage Controversy
From Perfect Competition to Monopsony

Competitive Full-Coverage Model
(a) The labor market is competitive and is populated
by a large number of homogeneous workers and
homogeneous profit-maximizing firms.
(b) All workers are covered by the minimum wage.
(c) All firms comply with the law.

After the imposition of a minimum wage, the
equilibrium wage rises and the level of employment
falls.

Workers are now unemployed as the minimum wage
harms the workers it was designed to help.
52
 Controversy

Proponents argue the minimum wage:
– Is needed to provide a “living wage”
– Stops exploitation by monopsonistic firms
– “Shocks” employers into greater efficiency

Opponents argue the minimum wage:
– Increases unemployment
– Reduces wages in sectors not covered by the law
– Encourages teenagers to dropout of school
– Most minimum wage workers don’t live in
poverty

53
 Basic Model
• At a minimum wage of Wm,
employers will hire only Qd Wage rate
rather than Q0 workers. SL
• The higher minimum wage a b c
will encourage Qs workers to Wm
look for employment.
W0 e
• The impact on employment
(ab) will be smaller than the f
impact on unemployment (ac).
• The minimum wage will DL
cause an efficiency loss of fae.
• The more elastic is SL and
DL, the larger is the
unemployment consequences.
Qd Q0 Qs Quantity of
Labor Hours

54
 Incomplete Coverage
• The minimum wage Wm

Wage rate
Wage rate
imposed on the covered
sector reduces
employment from C0 to C1.
• The displaced workers
from the covered sector Wm
will seek employment in
the uncovered sector and
thus increase the supply of W W0
0
labor in the sector.
Wu
• Though total employment DC Du
in the economy will remain
unchanged, the wage in
the uncovered sector will
fall from W0 to Wu.
• Society will suffer an C1 C0 U0 U1
efficiency loss due to Quantity Quantity
themisallocation of labor. Covered of Labor Uncovered of Labor

55
 Shock Effect
• A minimum wage such as Wm Wage rate
may “shock” firms out of their SL
organizational inefficiency.
a x c
• As a result, the marginal Wm
product of labor may rise,
shifting the labor demand W0
curve rightward (DL to D’L).
• As a result, a portion of the
unemployment predicted by
basic model may be mitigated D’L
(xc rather than ac). DL
• It is unlikely that the shock
effect is large since inefficiency
can only exist in less
competitive product markets
and the minimum wage is Qd Q’d Q0 Qs Quantity of
usually binding in more Labor Hours
competitive markets.
56
 Wage and Employment
for a Monopsonist
Wage rate MWC
• Without the minimum wage,
this monopsonist will choose
to hire Q0 and pay a wage
equal to W0. SL=PL
• Any legal minimum wage W2
above W0 and below W2, will
transform the firm into a
“wage-taker,” and the firm will
choose to increase its level of W1
employment. W0
• For example, if the minimum
wage is W1, this firm will hire
the same number of workers as DL=MRP=VMP
if competition existed in this
labor market.
• Thus, it is possible that a Q0 Q1 Quantity of
minimum wage might cause Labor Hours
employment to increase in
some industries.
57
 Other Considerations

Union support
– Unions lobby for higher minimum wages.
– Higher minimum wages help unions by raising the cost
of nonunion of labor.
– The higher cost of nonunion goods will increase the
demand for union products.

Efficiency wage considerations
– Higher minimum wage will increase the unemployment
rate and thus increase the penalty for shirking. Firms
could lower their efficiency wage payments and thus
decrease the unemployment rate.
58
 Empirical Evidence

Employment and unemployment
• A higher minimum wage reduces the employment of
teenagers more than those of adults.
• Teenagers are more likely to earn the minimum.

Human capital
– A higher minimum wage reduces on-the-job
training and increases the dropout rate from high
school.

Poverty
– The minimum wage has little effect on the poverty
rate. 59
 Discrimination in competitive markets
12_08 WAGE
1. Prejudiced firm acts
as if marginal revenue
product is lower than
it actually is. Labor supply

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.

Actual marginal
2. Discrimination revenue product
causes wages
to fall by this
amount.

NUMBER OF WOMEN WORKERS

3. Discrimination also
causes lower
employment for women.
60