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Chapter 12: Labor Markets, Poverty, and Income Distribution

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Learning Objectives
1. Understand the relationship between wages and the marginal productivity of workers 2. Analyze how wages and employment are determined in competitive labor markets 3. Compare and contrast the various hypotheses economists have proposed to explain earnings differences 4. Discuss recent trends in income inequality and philosophical justifications for income redistribution 5. Describe and analyze some of the methods used to reduce poverty
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Story
Winning a gold medal at the Olympics can bring fame and fortune to many athletes
Nawal

Al Moutawakil, a Moroccan gold medalist in the 400-meter hurdles at the Los Angeles Summer Olympic Games in 1984

Since her 1984 win, she gained her fortune from:

Product endorsements / TV appearances / Earning several international awards / Serving as a member of the International Olympic Committee / Her appointment as the Minister of Youth and Sports in Morocco

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Story
However, a silver or bronze medalist, despite potentially being within a hairbreadth to winning can drop completely from view
The

silver medalist from 1984 has dropped completely from view Judi Brown, an American athlete, and although potentially just as talented as Al Moutawakil, wealth and international recognition were not to be hers

Individual income vary widely

Comparable

skills seem to earn different

4

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Story
Many physicians in Arab countries such as Egypt are likewise every bit as talented and hardworking as physicians in the West
However,

American physicians earn an average annual income of almost $200,000 Egyptian physicians earn as little as $63 a month that most of them (about 89%) supplement their incomes by holding multiple jobs

Why do some people earn so much more than others?

No

other single question in economics has stimulated nearly as much interest and discussion 5 2012 The McGraw-Hill Companies, All Rights Reserved

The Economic Value of Work

In some respects, the sale of human labor is profoundly different from the sale of other goods and services
For

example, although someone may legally relinquish all future rights to the use of her television set by selling it, the law does not permit people to sell themselves into slavery

The law does, however, permit employers to rent our services In many ways, the rental market for labor services functions much like the market for most other goods and services
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The Market for Labor

Economic analysis applies to labor markets

Equilibrium wage and quantity are determined by supply of and demand for a each category of labor
Labor categories include unskilled and skilled

Changes in supply and demand will change the equilibrium wage and quantity

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Khazaf Works
Rafiq and Lina each work full time at potting
Rafiq

delivers 100 pots per week and Lina delivers

120
If the labor market for potters is perfectly competitive, how much will each be paid? - Assume that the values of the pots that Rafiq and Lina deliver are $100 and $120 respectively (so Price is $1)

If

Khazaf paid Rafiq only $90 per week, the company would then enjoy an economic profit of $10 per week as a result of hiring him

Seeing this, a rival firm could then offer Rafiq $91, thus earning an additional economic profit of $9 per week by bidding him away from Khazaf
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Khazaf Pottery Works

Rafiq earns $100 and Lina earns $120 per week
Khazaf will have difficulty keeping Rafiq if it pays him less than $100 per week That will be his competitive equilibrium wage

One reason for different earnings is differences in output per person

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The Labor Market

Marginal product of labor (MP)
The

additional output a firm gets by employing one additional unit of labor

100 pots for Rafiq and 120 pots for Lina

Value of marginal product of labor (VMP)

MP * (Net P) = VMP
The

dollar value of the additional output a firm gets by employing one additional unit of labor
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The Labor Market

General rule in a competitive labor market is:
A

workers pay in long-run equilibrium will be equal to his or her VMPthe net contribution he or she makes to the employers revenue wage = VMP

Employers would be delighted to pay workers less than their respective VMPs
But

if labor markets are truly competitive, they cannot The McGraw-Hill Companies, All Rights Reserved for long get away with doing so 2012

11

Potters' Production
To summarize:
Value

of Marginal Product

Marginal product of labor multiplied times the net price of each unit sold ($1)
Rafiqs VMP is $100 and Linas VMP is $120

In a competitive market, each worker is paid the value of his marginal product

Each workers VMP is independent of the number of other workers employed by the firm
In

such cases, we cannot predict how many workers a firm will hire
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Ouzai Woodworking Company

Makes cutting boards from free scrap wood
Price

of a cutting board is $20 Going wage is $350 per week

# of Workers 0 1 2 3 4 5 Output 0 30 55 76 94 108 MP 30 25

VMP
$600 500

21
18 14

420
360 280
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Ouzai Woodworking Company

The company will hire workers until the value of the marginal product of the last worker is equal to the wage
Cost-Benefit

Principle Workers earn $350 per week

# of Workers 1 2 3 4 5

VMP $600 500 420 360 280

14

Hire four workers

The

fifth worker costs more ($350) than the benefits he delivers ($280)
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Firms Decision to Hire

Note the similarity between the perfectly competitive firms decision about how many workers to hire and the perfectly competitive firms output decision

When labor is the only variable factor of production, the two decisions are essentially the same

There are three important factors:

The number of boards cut The price of cutting boards The wage rate

An increase in product price will lead employers to hire more workers Employers also will increase hiring when the wage rate falls
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The Equilibrium Wage and Employment Levels The equilibrium price and quantity in any competitive market occur at the intersection of the relevant supply and demand curves

The same is true in competitive markets for labor

curve for labor employer Supply curve for labor employee
Demand
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Demand for Labor employer An employers reservation price for a worker is the most the employer could pay without suffering a decline in profit
The

reservation price for the employer in a perfectly competitive labor market is simply the value of the workers marginal product (VMP) Because of the law of diminishing returns, the VMP declines in the short run as the quantity of labor rises DL = VMP
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Demand for Labor

Wage ($/hour)

Firm 1
12 6 Wage ($/hour) D1 = VMP1 12

Market D = VMP1 + VMP2

100 150

Wage ($/hour)

12

Firm 2
D2 = VMP2

250 150 Total Employment 50 100 Work hours/day

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Supply for Labor employee

Individuals trade-off income and leisure
More

work hours means more income AND less leisure Income

Effect

Suppose the wage increases:

Substitution

effect: work more

Substitution Effect

Leisure is more expensive

Income

effect: work less

Purchasing power increases for a given work schedule

higher wage may increase or decrease the quantity of labor supplied by the individual
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Labor Supply of Programmers

Labor supply for a single profession has a positive slope

S Wage ($/hour) W2

Higher wages attract workers from other careers

W1

An increase in wages from W1 to W2 increases quantity of labor supplied from L1 to L2

L1 L2 Employment of programmers (work-hours/year)

Movement along the labor supply curve

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Market Shift: Increase in the Demand for Programmers

Demand for programmers increases from D1 to D2 Initial impact is a shortage of programmers at W1 In the short-run, wages are bid up to W3 In the long run Movement up the supply curve and down the demand curve Quantity of labor supplied increases from L1 to L2 Wages settle at W2

W3

S
Wage ($/hour) W2 W1

D2
D1
L1 L2

Employment of programmers (work-hours/year)

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Market Shift: Increase in the Demand for Programmers

Labor markets are often relatively slow to adjust
When the demand for workers in a given profession increases, shortages may remain for months or even years
It

all depends on how long it takes people to acquire the skills and training needed to enter the profession (or to change profession to the one in demand)
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Explaining Differences in Earnings

When labor markets are competitive, differences in wages are determined by differences in VMP
Lina

earned 20% more than Rafiq because she made 20% more pots each week than he did This difference could be because of difference in talent or training, or perhaps Lina simply worked harder than Rafiq Yet often we see large salary differences even among people who appear equally talented and hardworking
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Explaining Differences in Earnings

Why, for instance, do lawyers earn so much more than those plumbers who are just as smart as they are and work just as hard? And why do surgeons earn so much more than general practitioners?
Only differences in talent, luck, or hard work can account for long-run differences in earnings
If

plumbers could earn more by becoming lawyers, why dont they just switch occupations?

The answer to that is Human Capital Theory

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Human Capital and Differences in Earnings

Human capital theory holds that an individuals VMP (or wage) is proportional to his or her stock of human capital
Human

capital stock is a mixture of factors

such as

Factors Affecting Differences in Earnings Education Experience Training Intelligence Energy Work Habits Initiative Political Skills

Trustworthiness
Individuals

make decisions about acquiring human The McGraw-Hill Companies, All Rights Reserved capital 2012

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Human Capital and Differences in Earnings Some jobs require more human capital

For example, a general practitioner could become a surgeon, but only by extending her formal education by several more years An even larger investment in additional education is required for a plumber to become a lawyer

These

jobs usually pay more Demand for specific kinds of human capital also cause earnings differences
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Labor Unions and Differences in Earnings

In general, two workers with the same amount of human capital may earn different wages if one of them belongs to a labor union and the other does not A labor union is a group of workers who bargain collectively with employers for better wages and working conditions entry to the union is restricted Unions restrict the supply of labor and raise wages

Similar to a cartel Unions increase the supply of labor to the non-union companies

Wages in non-union companies go down

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Market Equilibrium Without Unions

Market 1 D1 = VMP1 9

Wage ($/hour)

Total Market S0 D = VMP1 + VMP2 Wage ($/hour)

125 Wage ($/hour) Market 2 D2 = VMP2

75 Employment
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200 Total employment (workers/day)

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Market 1 Is Unionized
Workers in market 1 unionize Negotiate a wage of $12 25 workers out of work
Market 1 D1 = VMP1
12 9

Wage ($/hour)

In market 2, labor increases by 25 workers from market 1 Wage decreases to $6 Employment increases to 100

Wage ($/hour)

100

125

Market 2 D2 = VMP2 9 6

75 100 Employment
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Size of the Union Wage Advantage

Our analysis of two markets resulted in union workers earning twice the non-union wage
Suggests

unionized firms have a cost disadvantage attract most productive workers increase productivity
30

Unionized firms remain competitive

Unions

Union workers are more skilled and experienced

Improved communications and motivation Lower labor turnover means lower costs
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Unions

Compensating Wage Differentials

If people are paid the value of what they produce, why do chefs earn more than lifeguards?

Preparing food is important, for sure, but is it more valuable than saving the life of a drowning child?

Similarly, why might plumbers get paid more than teachers?

Is replacing faucet washers really more valuable than educating children?

The wage for a particular job depends not only on the value of what workers produce, but also on how attractive they find its working
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Compensating Wage Differentials

Compensating wage differentials describe the difference in wage rates from differences in working conditions
Wages

depend on VMP and also on working conditions Workers have preferences about their work schedule, environment and other conditions

Working in less desirable conditions increases wage

Safety and work schedule are conditions that matter to workers

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Discrimination in the Labor Market

Wage differentials not based on differences in VMP leave cash on the table
On

average, women and minorities receive lower wages than white males
This pattern holds even if we compare people with similar human capital levels

One way to explain differentials is that some human capital differences are not measured Another view attributes the differential to discrimination
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Employer Discrimination
Employer discrimination is an arbitrary preference by an employer for one group of workers over another Assumptions:
Productivity

is distributed the same for men

and women

Average productivity is the same

One

employer prefers to hire male employees

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Discrimination by Others
If employer discrimination is not the primary explanation of the wage gap, then what is? Customer discrimination causes buyers to pay more for goods produced by a favored group (for the same product)

Reduces incentives for non-favored groups to enter the profession

Socialization within the family can affect individual's career choices and therefore the supply of labor

Traditional female roles: nurses, teachers, secretaries

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Other Sources of the Wage Gap

Basis for compensating wage differentials
Willingness

to accept risk

Coal mining, entrepreneurs, construction, farming

Quality

versus quantity of education

Difficult to measure

Courses

taken and degrees (humanities versus sciences) pursued by sex and race
Wage gaps remain across industries and occupations If one group disproportionately pursues higher2012 The McGraw-Hill Companies, All Rights Reserved

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Winner-Take-All Markets
Winner-take-all markets are ones in which small differences in human capital translate into large differences in pay
Technology

plays a role Some participants earn high salaries

Many more do not

Examples
Entertainment
Medicine Publishing

Law
Investment Banking Design, Fashion

Consulting
CEOs Academia
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Trends in Inequality
An attractive feature of the free-market system is that it rewards initiative, effort, and risk taking
The

harder, longer, and more effectively a person works, the more he or she will be paid

Yet relying on the marketplace to distribute income also entails an important drawback:
Those

who do well often end up with vastly more money than they can spend Those who fail often cannot afford even basic goods and services
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Trends in Inequality
Market outcomes produce disparities in income

Median Income by Quintile for US

(2005 dollars)

Quintile Bottom 20%

1980 $14,386

1990 $14,241

2000 $16,008

Second 20% Middle 20% Fourth 20% Top 20% Top 5%

31,316 47,308 65,634 110,507 157,094

33,217 51,157 73,569 136,725 214,527

36,602 57,525 84,781 177,879 315,205

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US Median Income by Quintile

$350,000 $300,000

$200,000

Growing inequality

$100,000

Bottom 20%

Second 20%

Middle 20%

Fourth 20%

Top 20%

Top 5%

1980

1990

2000
40

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Recent Trends in Inequality

From WWII to the 1970s income Median Income Growth growth was 3% per year for all 1980 - 2000 groups Bottom 20% 11% Between 1980 and 2000, growth rates increased from bottom quintile Second 20% 17% to top Middle 20% Does not show mobility between 22% groups Fourth 20% 29% Median income is not a measure of individual welfare Top 20% 61% In 1980, CEOs earned 42 times the salary of an average worker Top 5% 101% By 2000, this multiple increased to 41 more than 500 times Companies, All Rights Reserved 2012 The McGraw-Hill

The Challenge of Income Redistribution

Raising incomes of the needy reduces incentives to work
Difficulty

distinguishing between needy and

others

Risk takers may appear "needy" People who prefer not to work are ineligible Hurricane victims

No perfect solution
Choose

among imperfect alternatives

42

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Welfare Payments and In-kind Transfers

In-kind transfers are direct transfers of goods or services
Food

subsidies, subsidized public housing, subsidized school meals, free education, and health care

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Means-Tested Benefit Programs

A means-tested program means that the more income a family has, the smaller the benefits it receives under these programs are

Intends to avoid paying benefits to those who can support themselves

Administrative structure discourages work

If benefits are reduced by $1 for each $2 earned, participants in multiple programs may lose more benefits than the income they earn

Administrative costs are high

Simplify the program and distribute the cost savings to the needy
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The Negative Income Tax (NIT)

Negative income tax is a tax credit for each person financed by tax on earned income With no taxes, pre-tax income equals after-tax income With NIT, low income families receive a cash transfer while high income families pay tax A family with no income would receive the federal poverty threshold

No Taxes After-Tax Income ($000s) 20 16 15 14 tax NIT

10 10 15 20 Pre-Tax Income ($000s)

transfer

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Negative Income Tax

Advantages:
Incentive

to work is greater than with

welfare Lower administrative cost

Disadvantages:
Creates

an incentive not to work The political cost is high

NIT guarantees income to those who do not work
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Minimum Wage Legislation

Wage ($/hour)

Minimum wage above equilibrium creates unemployment

Loss

Unemployment
Wmin

in total surplus L L L1 workers earn more Employment (L0 L1) are unemployed Change in total earning depends on the elasticity of demand for labor
1 0

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Minimum Wages and Total Surplus

No Minimum Wage Minimum Wage ($7)

10
Employer surplus $12.5K W ($/hour)

10

Employer surplus ($4.5K)

W ($/hour)

7
5 3 Total surplus lost ($4K) Worker D surplus ($16.5K) 3,000 5,000 L (work-hours/day)

Worker surplus $12.5K 0 5,000

D
0

L (work-hours/day)

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Public Employment for the Poor

Government could employ the poor
If

wages are the same as the private sector, some workers will prefer government jobs

Increases the cost of the program

Make-work

programs are not productive Increases size of government

Acting alone, government-sponsored jobs for the poor or the negative income tax cannot solve the income-transfer problem
But

a combination of these programs might do

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so

A Combination of Methods
Use

a NIT with payment set below the poverty threshold Set the public service wage below the minimum wage Privatize the management of the public service employment program
NIT + Public Job NIT + Private Job

Poverty threshold NIT

Public Job

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