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Chapter 16

LABOR MARKETS

Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. c


" ati  Time
ë ndividuals must decide how to allocate
the fixed amount of time they have
ë We will initially assume that there are
only two uses of an individual¶s time
± engaging in market work at a real wage
rate of 
± leisure (nonwork)

d
" ati  Time
ë Assume that an individual¶s utility
depends on consumption (Ô) and hours
of leisure ( )
utility = (Ô, )
ë n seeking to maximize utility, the
individual is bound by two constraints
½D = 24
Ô = ½
Ñ
" ati  Time
ë Combining the two constraints, we get
Ô(24 ± )
Ô 24
ë An individual has a ³full income´ of 24
± may spend the full income either by
working (for real income and consumption)
or by not working (enjoying leisure)
ë The opportunity cost of leisure is 
[
ÿti ity Maximizati
ë The individual¶s problem is to maximize
utility subject to the full income constraint
ë Setting up the Lagrangian
= (Ô, ) D §(24 ± Ô  )
ë The first-order conditions are
0 Õ0Ô = 0Õ0Ô - § = 0
0 Õ0 = 0Õ0 - § = 0
’
ÿti ity Maximizati
ë ividing the two, we get
/ Ô
    o Ô
/
ë To maximize utility, the individual should
choose to work that number of hours for
which the ~  (of for Ô) is equal to 
± to be a true maximum, the ~  (of for Ô)
must be diminishing
m
me a
 titti Eet
ë Both a substitution effect and an income
effect occur when changes
± when  rises, the price of leisure becomes
higher and the individual will choose less
leisure
± because leisure is a normal good, an
increase in  leads to an increase in leisure
ë The income and substitution effects move
in opposite directions „
me a
Consumption  titti Eet
The substitution effect is the movement
from point " to point
The income effect is the movement
from point to point 

" ÿ2 The individual chooses
less leisure as a result
ÿ
of the increase in 
Leisure

 titti eet > ime eet ô


me a
Consumption  titti Eet
The substitution effect is the movement
from point " to point
The income effect is the movement
from point to point 
 The individual
" chooses more
ÿ2
leisure as a result
ÿ
of the increase in
Leisure


 titti eet < ime eet å


" Mathematia "a y i
 ar pp y
ë We will start by amending the budget
constraint to allow for the possibility of
nonlabor income
Ô½ 
ë Maximization of utility subject to this
constraint yields identical results
± as long as  is unaffected by the labor-
leisure choice
c
" Mathematia "a y i
 ar pp y
ë The only effect of introducing nonlabor
income is that the budget constraint
shifts out (or in) in a parallel fashion
ë We can now write the individual¶s labor
supply function as ½(,)
± hours worked will depend on both the
wage and the amount of nonlabor income
± since leisure is a normal good, 0½Õ0 ü 0
cc
Úa tatemet  the Pr em
ë The dual problem can be phrased as
choosing levels of Ô and so that the
amount of expenditure (Ô ½)
required to obtain a given utility level
(0) is as small as possible
± solving this minimization problem will yield
exactly the same solution as the utility
maximization problem
cd
Úa tatemet  the Pr em
ë A small change in  will change the
minimum expenditures required by
0Õ0 = -½
± this is the extent to which labor earnings
are increased by the wage change


Úa tatemet  the Pr em
ë This means that a labor supply
function can be calculated by partially
differentiating the expenditure function
± because utility is held constant, this
function should be interpreted as a
³compensated´ (constant utility) labor
supply function
½Ô(,)
c[
 t
y Eqati 
ar pp y
ë The expenditures being minimized in the
dual expenditure-minimization problem
play the role of nonlabor income in the
primary utility-maximization problem
½Ô(,) = ½*,(,)] = ½(,)
ë artial differentiation of both sides with
respect to  gives us
0½ 0½ 0½ 0
 
0 0 0 0 c’
 t
y Eqati 
ar pp y
ë Substituting for 0Õ0, we get
0½  0½ 0½ 0½ 0½
 ½  ½
0 0 0 0 0
ë ntroducing a different notation for ½Ô ,
and rearranging terms gives us the
Slutsky equation for labor supply:
0½ 0½ 0½
 ½
0 0  {
0 cm
C Ú a ar pp y
ë Suppose that utility is of the form
Ë
 Ê
ë The budget constraint is
½ 
and the time constraint is
½  =
± note that we have set maximum work time
to hour for convenience c„
C Ú a ar pp y
ë The Lagrangian expression for utility
maximization is
Ô¬ D §(   Ô)
ë irst-order conditions are
0 Õ0Ô = ¬Ô -§=0
0 Õ0 = Ô¬ ¬ - § = 0
0 Õ0§ =    Ô = 0

C Ú a ar pp y
ë ividing the first by the second yields
x x 1
! !
F 1 E 

c E
 ! ™Ô
E


C Ú a ar pp y
ë Substitution into the full income
constraint yields
Ô¬()
 ()Õ
± the person spends ¬ of his income on
consumption and = -¬ on leisure
± the labor supply function is
Ë
½  º   ˺ 

d
C Ú a ar pp y
ë ote that if  = 0, the person will work
( - ) of each hour no matter what the
wage is
± the substitution and income effects of a
change in  offset each other and leave ½
unaffected

dc
C Ú a ar pp y

ë f  > 0, 0½Õ0 > 0


± the individual will always choose to spend
 on leisure
± Since leisure costs  per hour, an increase
in  means that less leisure can be bought
with 

dd
C Ú a ar pp y

ë ote that 0½Õ0 ü 0


± an increase in nonlabor income allows this
person to buy more leisure
ë income transfer programs are likely to reduce
labor supply
ë lump-sum taxes will increase labor supply


CE ar pp y
ë Suppose that the utility function is
 Ê
  Ê º 
 
ë Budget share equations are given by

  
 Pº

Ê  
   Pº
± where P = Õ( - ) d[
CE ar pp y
ë Solving for leisure gives
 

  P
and
c P 
½     c 
  c P


Mar
et pp y Crve r ar
To derive the market supply curve for labor, we sum
the quantities of labor offered at every wage
ndividual "¶s
 supply curve  ndividual ¶s 

" supply curve Total labor 


supply curve

½" ½ ½ ½ ½ ½

½A* D ½B* = ½*

dm
Mar
et pp y Crve r ar
ote that at 0, individual B would choose to remain
out of the labor force
ndividual "¶s
 supply curve  ndividual ¶s 

" supply curve Total labor 


supply curve

{

½ ½ ½

As  rises, ½ rises for two reasons: increased hours


of work and increased labor force participation d„
ar Mar
et Eqi irim

ë Equilibrium in the labor market is


established through the interactions of
individuals¶ labor supply decisions with
firms¶ decisions about how much labor
to hire


ar Mar
et Eqi irim
At *, the quantity of labor demanded is
equal to the quantity of labor supplied
real wage
At any wage above *, the quantity

of labor demanded will be less
than the quantity of labor supplied

At any wage below *, the quantity



of labor demanded will be greater

than the quantity of labor supplied

½· quantity of labor


Maate eeit
ë A number of new laws have mandated
that employers provide special benefits
to their workers
± health insurance
± paid time off
± minimum severance packages
ë The effects of these mandates depend
on how much the employee values the
benefit Ñ
Maate eeit
ë Suppose that, prior to the mandate, the
supply and demand for labor are
½ =  
½ Ô 
ë Setting ½ ½ yields an equilibrium wage
of
 (Ô )Õ(  )

Ñc
Maate eeit
ë Suppose that the government mandates
that all firms provide a benefit to their
workers that costs Y per unit of labor
hired
± unit labor costs become Y
ë Suppose also that the benefit has a
value of per unit supplied
± the net return from employment rises to
 Ñd
Maate eeit
ë Equilibrium in the labor market then
requires that
 ( ) = Ô (Y)
ë This means that the net wage is
Ô   Y  Y
 ··   ·
  

ÑÑ
Maate eeit
ë f workers derive no value from the
mandated benefits ( = 0), the mandate
is just like a tax on employment
± similar results will occur as long as üY
ë f Y, the new wage falls precisely by
the amount of the cost and the
equilibrium level of employment does not
change
Ñ[
Maate eeit
ë f Y, the new wage falls by more than
the cost of the benefit and the
equilibrium level of employment rises

ђ
îa e Variati
ë t is impossible to explain the variation
in wages across workers with the tools
developed so far
± we must consider the heterogeneity that
exists across workers and the types of jobs
they take

Ñm
îa e Variati
ë uman Capital
± differences in human capital translate into
differences in worker productivities
± workers with greater productivities would be
expected to earn higher wages
± while the investment in human capital is
similar to that in physical capital, there are
two differences
ë investments are sunk costs
ë opportunity costs are related to past investments
ф
îa e Variati
ë Compensating ifferentials
± individuals prefer some jobs to others
± desirable job characteristics may make a
person willing to take a job that pays less
than others
± jobs that are unpleasant or dangerous will
require higher wages to attract workers
± these differences in wages are termed
compensating differentials
Ñô
Mp y i the
ar Mar
et
ë n many situations, the supply curve for
an input (½) is not perfectly elastic
ë We will examine the polar case of
monopsony, where the firm is the single
buyer of the input in question
± the firm faces the entire market supply curve
± to increase its hiring of labor, the firm must
pay a higher wage
Ñå
Mp y i the
ar Mar
et
ë The marginal expense (~) associated
with any input is the increase in total
costs of that input that results from hiring
one more unit
± if the firm faces an upward-sloping supply
curve for that input, the marginal expense will
exceed the market price of the input

[
Mp y i the
ar Mar
et
ë f the total cost of labor is ½, then
0½ 0
 ½   ½
0½ 0½

ë n the competitive case, 0Õ0½ = 0 and


~½ = 
ë f 0Õ0½ > 0, ~½ > 
[c
Mp y i the
ar Mar
et
ote that the quantity of
Wage
~½
labor demanded by this
firm falls short of the

level that would be hired
in a competitive labor
market (½*)

The wage paid by the
1 firm will also be lower
than the competitive

level (*)
Labor
½1 ½·
[d
Mp i ti Hiri
ë Suppose that a coal mine¶s workers can
dig 2 tons per hour and coal sells for
$ 0 per ton
± this implies that ~ ½ = $20 per hour
ë f the coal mine is the only hirer of
miners in the local area, it faces a labor
supply curve of the form
½ 50

Mp i ti Hiri
ë The firm¶s wage bill is
½ ½2Õ50
ë The marginal expense associated with
hiring miners is
~½ = 0½Õ0½ = ½Õ25
ë Setting ~½ ~ ½, we find that the
optimal quantity of labor is 500 and the
optimal wage is $ 0
[[
ar ÿi
ë f association with a union was wholly
voluntary, we can assume that every
member derives a positive benefit
ë With compulsory membership, we
cannot make the same claim
± even if workers would benefit from the
union, they may choose to be ³free riders´


ar ÿi
ë We will assume that the goals of the
union are representative of the goals of
its members
ë n some ways, we can use a monopoly
model to examine unions
± the union faces a demand curve for labor
± as the sole supplier, it can choose at which
point it will operate
ë this point depends on the union¶s goals
[m
ar ÿi
The union may wish to maximize the total
Wage
wage bill (½).
This occurs where
 ~ 0

1 ½ workers will be
hired and paid a
wage of 

This choice will
~ create an excess
Labor supply of labor
½1


ar ÿi
The union may wish to maximize the total
Wage
economic rent of its employed members
This occurs where
d
 ~ 
½2 workers will be
hired and paid a
wage of 2

Again, this will
~ cause an excess
Labor
½d supply of labor

ar ÿi
The union may wish to maximize the total
Wage
employment of its members
This occurs where
 
½Ñ workers will be

hired and paid a
wage of Ñ


~
Labor
½Ñ


Me i a ÿi
ë A monopsonistic hirer of coal miners
faces a supply curve of
½ 50
ë Assume that the monopsony has a
~  curve of the form
~ ½ = 70 ± 0. ½
ë The monopsonist will choose to hire 500
workers at a wage of $ 0
’
Me i a ÿi
ë f a union can establish control over
labor supply, other options become
possible
± competitive solution where ½ = 58Ñ and
 = $ .66
± monopoly solution where ½ = Ñ 8 and
 = $Ñ8.20

’c
" ÿi ar aii Me
ë Suppose a firm and a union engage in a
two-stage game
± first stage: union sets the wage rate its
workers will accept
± second stage: firm chooses its employment
level

’d
" ÿi ar aii Me
ë This two-stage game can be solved by
backward induction
ë The firm¶s second-stage problem is to
maximize its profits:
Ã= (½) ± ½
ë The first-order condition for a maximum is
(½) = 

’Ñ
" ÿi ar aii Me
ë Assuming that ½* solves the firm¶s
problem, the union¶s goal is to choose 
to maximize utility
(,½) = *,½*()]
and the first-order condition for a
maximum is
 D 2½ = 0
 Õ2 = ½
’[
" ÿi ar aii Me
ë This implies that the union should choose
 so that its ~  is equal to the slope of
the firm¶s labor demand function
ë The result from this game is a ash
equilibrium

’’
mprtat Pit t Nte:
ë A utility-maximizing individual will
choose to supply an amount of labor at
which the ~  of leisure for
consumption is equal to the real wage
rate

’m
mprtat Pit t Nte:
ë An increase in the real wage rate
creates income and substitution
effects that operate in different
directions in affecting the quantity of
labor supplied
± this result can be summarized by a
Slutsky-type equation much like the
one already derived in consumer
theory
’„
mprtat Pit t Nte:
ë A competitive labor market will
establish an equilibrium real wage
rate at which the quantity of labor
supplied by individuals is equal to the
quantity demanded by firms

’ô
mprtat Pit t Nte:
ë Monopsony power by firms on the
demand side of the market will
reduce both the quantity of labor
hired and the real wage rate
± as in the monopoly case, there will be a
welfare loss

’å
mprtat Pit t Nte:
ë Labor unions can be treated
analytically as monopoly suppliers of
labor
± the nature of labor market equilibrium in
the presence of unions will depend
importantly on the goals the union
chooses to pursue

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