Topic 5 Labour Market Equilibrium by hRZ8UtFO


									ECN706 – Topic 5

 To discuss labor market equilibrium.
 To analyse the effects of changes in labor demand and
    supply on labor market outcomes.
   To discuss the optimal hiring decision of an individual
   To discuss and show why competitive labor market
    allocates labor efficiently.
   To analyse the effect on wage differentials when similar
    skilled workers are mobile across labor markets
   To analyse the effects of government. interventions in
    the labor market in the forms of minimum wages,
    payroll taxes, subsidies.

 To discuss and demonstrate how entry wages
  of highly skilled workers adjust in a lag–
  forming a cobweb pattern around the long
  run equilibrium
 To analyse the hiring decisions of
  discriminating and non-discriminating
 To demonstrate the effects of labor market
  outcomes of minimum wages on a
 Labor market equilibrium coordinates the desires of
  firms and workers, determining the wage and
  employment observed in the labor market
 Market types:
   Monopsonies – where there is one buyer of labor
   Monopolies – where there is one seller of labor
 These market structures generate unique labor
  market equilibriums

       Equilibrium in a Single
      Competitive Labor Market

 Competitive equilibrium occurs when supply
  equals demand generating a competitive wage
  and employment level
 It is unlikely that the labor market is ever in an
  equilibrium, since supply and demand are
 The model suggests that the market is always
  moving toward equilibrium

  Equilibrium in a Single Competitive
             Labor Market
    A perfectly competitive labor market has the following
     characteristics that contrast it with other labor markets:
 1) a large number of firms competing with one another to hire
            a specific type of labor to fill identical jobs;
     2) numerous qualified people who have identical skills
     (workers are homogenous) and independently supply their
                            labor services;
 3) “wage takers” – neither workers nor firms exert control over
                        the market wage; and
  4) perfect, costless information and labor mobility (free entry
                    and exit in the labor market.

Equilibrium in a Competitive
Labor Market

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

     The Determinants of Labour
         Supply and Demand
                 Determinants of labor Supply
                      1. Other wage rates
 An increase (decrease) in the wages paid in other occupations for
     which workers in a particular labor market are qualified will
                  decrease (increase) labor supply.
                      2. Nonwage income
An increase (decrease) in income other than from employment will
                  decrease (increase) labor supply.

    Determinants of Labor Supply and

3. Preferences for work versus leisure
    A net increase (decrease) in people's preferences for work
     relative to leisure will increase (decrease) labour supply.
4. Nonwage aspects of the job
   An improvement (worsening) of the nonwage aspects of the job
     will increase (reduce) labour supply.
5. Number of qualified suppliers
    An increase (decrease) in the number of qualified suppliers of a
     specific grade of labour will increase (decrease) labour supply.

Determinants of labor Demand

1. Product demand
 Changes in product demand that increase (decrease) the product
   price will raise (lower) the marginal revenue product (MRP) of
   labor and therefore increase (decrease) the demand for labor.
2. Productivity
  Assuming that it does not cause an offsetting decline in product
   price, an increase (decrease) in productivity will increase
   (decrease) the demand for labor.

Determinants of Labor Demand
3. Prices of other resources
    Where resources are gross complements, an increase (decrease)
     in the price of a substitute in production will decrease
     (increase) the demand for labor; where resources are gross
     substitutes , an increase (decrease) in the price of a substitute
     in production will increase (decrease) the demand for labor.
4. Number of employers
    Assuming no change in employment by other firms hiring a
     specific grade of labor, an increase (decrease) in the number of
     employers will increase (decrease) the demand for labor.

The Hiring Decision by an individual Firm:
 Given the presence of the market wage w* in slide 7,
  how will a firm operating in a perfectly competitive
  labor and product market decide on the quantity of
  labor to employ?
 In a perfectly competitive labor market or industry,
  the equilibrium wage rate Wo and employment Qo
  are determined by supply and demand as shown
 Graph (b) shows the individual firm in the industry
  hiring at the market wage Wo; its supply curve, SL =
  MWC = AWC, is perfectly elastic at Wo.
 The firm maximises its profit by hiring Qo units of
  labor [(MRP = (VMP) = w).

 The Hiring Decision by an Individual Firm

 The total number of workers hired by all firms in the
  industry must equal the market’s equilibrium
  employment level at Qo as shown in graph (a).
 The firm’s wage Wo is also known as the Marginal wage
  cost (MWC) which is the absolute change in total wage
  cost resulting from the employment of an additional
  unit of labor.
 The Average wage cost (AWC) is the total wage cost
  divided by the number of unit of labor employed.

 An efficient allocation of labor is realised when
  workers are being directed to their highest valued
 Labor is efficiently allocated when the dollar value
  to society of its marginal product (VMP) is the same
  in all alternative employments:
 Given n products, allocative efficiency condition for
  any given type of labor :

VMPAx = VMPAy = ………VMPAn = PLA
Where A is the given type of labor; x,y…..n represent
 all possible products that labor might produce
 VMP’s across firms are not only equalised but
  also equal to the price of labor (market wage
  rate) because labor type A will only be made
    available if wage is sufficiently high to cover the
    opportunity costs of those supplying their labor
    total value of labor’s product is maximised
   producer surplus is maximised
   Worker surplus is also maximised
   Total gains from trade are maximised in the
    labour marker

Equilibrium in a Competitive
        Labor Market

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

    Equilibrium in a Competitive
             Labor market
 The total revenue earned in a competitive
  equilibrium is the sum of the value of marginal
  product produced by all workers up to E*.
 the area under the labor demand curve up to E*
  gives the sum of the value of marginal product
  (value of the total product).
 the total cost of labor incurred by all firms is the
  area w* to the intersection of D and S, E* and
  the graph origin.
 Hence, the profits accruing to firms, which is
  called producer surplus, are given by the area of
  the triangle P.

   Equilibrium in a Competitive Labor
 Workers gain in the labor market.
 The supply curve gives the wage required to bribe
  additional workers into the labor market away from the
  next best alternative use of their time.
 The height of the supply curve at each employment
  level measures the value of the marginal worker’s time
  at alternative uses.
 Therefore the area under the supply curve up to the
  equilibrium employment level E* gives the sum of the
  value of the workers’ time at alternative uses.

 Each worker receives w*, therefore the initial gains
  to workers E* is the area w* to the intersection of D
  and S, E* and the graph origin. Hence the net gains
  accruing to workers are given by the area of the
  triangle Q called worker surplus.
 The total gains from trade accruing to the national
  economy are the sum of producer surplus and
  worker surplus, or the area P + Q.
 Thus, the competitive market maximises the total
  gains from trade therefore generates an efficient
  allocation of labor resources.

       Competitive Equilibrium
        Across Labor Markets
 If workers were mobile and entry and exit of
  workers to the labor market was free, then there
  would be a single wage paid to all workers
 The allocation of workers to firms equating the
  wage to the value of marginal product is also the
  allocation that maximizes national income (this
  is known as allocative efficiency)

 Competitive Equilibrium Across
         Labor Markets

 Dollars                                            Dollars

                   SN        s                                           SS      SS

 wN                A

  w*                     B                          w*

               C                                    wS
                                       DN                                              DS

                                       Employment                                      Employment

       (a) The Northern Labor Market                     (b) The Southern Labor Market

Suppose the wage in the northern region (wN) exceeds the wage in the southern region
(wS). Southern workers want to move North, shifting the southern supply curve to the left
and the northern supply curve to the right. In the end, wages are equated across regions
(at w*).
          Compensating Wage
 These differentials consist of the extra pay that
  an employer must provide to compensate a
  worker for some undesirable job characteristics
  that does not exist in an alternative
 Jobs have differing non-wage attributes; require
  different types and degree of skills and differ in
  the amenities they offer.
 Compensating wage differentials are thus
  equilibrium wage differentials since they do not
  cause workers to shift to the higher paying jobs
  and thereby cause wage rates to move toward

Compensating Wage Differentials
The types of nonwage aspects of jobs that cause differing
  labor supply curves and therefore compensating
  payments are:
 1) risk of job injury or death;
 2) fringe benefits;
 3) job status;
 4) job location;
 5) Job security: regularity of earnings; and
 6) the prospect of wage advancement.

        Policy Applications

1. The Employment Effects of Minimum
   Government legislation affecting the cost of
   Tends to affect employers’ hiring decisions
    and, therefore, the level of employment.

The Impact of the Minimum Wage
        on Employment

                                          A minimum wage set at
                                          w forces employers to
                                          cut employment (from E*
                                          to E). The higher wage
w*                                        also encourages (ES - E*)
                                          additional workers to
                                          enter the market. The
                                          minimum wage,
                                          therefore, creates
          E   E*   ES       Employment   unemployment.

The Impact of Minimum Wages on
  the Covered and Uncovered
           Sectors                                        Dollars
                                                                                           (If workers migrate to
                                                                                           covered sector)

                                                                                               (If workers migrate to
w*                                                        w*                                   uncovered sector)

                                     DC                                                        DU

           E         EC                   Employment                  EU   EU   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 sector to the left and
     raising the uncovered sector’s wage.

     Application: Payroll Taxes and

 Payroll taxes assessed on employers lead to a
  downward parallel shift in the labor demand curve
   The new demand curve shows a wedge between
    the amount the firm must pay to hire a worker and
    the amount that workers actually receive
   Payroll taxes increase the total costs of employing
    labor, so these taxes reduce employment in the


 Firms and workers share the cost or the
  burden of payroll taxes, since as the cost of
  hiring a worker rises, it implies that the wage
  received by workers declines
 The payroll tax has the same impact on the
  equilibrium wage and employment regardless of
  who it is assessed on.

   The Impact of a Payroll Tax
        Assessed on Firms

                                           S           A payroll tax of $1
                                                       assessed on employers
w1 + 1                                                 shifts down the demand
         w0                      A
                                                       curve (from D0 to D1).
                                                       The payroll tax cuts the
         w1             B
                                                       wage that workers
w0  1                                                 receive from w0 to w1,
                                               D0      and increases the cost
                                                       of hiring a worker from
                   E1       E0            Employment   w0 to w1 + 1.

 The Impact of a Payroll Tax
     Assessed on Workers

w0 + 1
                                                   A payroll tax assessed on
    w1              B                              workers shifts the supply
                                                   curve to the left (from S0
                                                   to S1).
w1  1
                                                   Workers take home w1-1
                                                   Firm’s total cost of hiring a
                                            D0     worker would be w1

               E1       E0            Employment

      The Impact of a Payroll Tax
   Assessed on Firms with Inelastic
                                         A payroll tax assessed on
               S                         the firm is shifted
                                         completely to workers
                                         when the labor supply
    w0                                   curve is perfectly
                                         inelastic. The wage is
                                         initially w0. The $1
w0 – 1
                              D0         payroll tax shifts the
                       D1                demand curve to D1, and
              E0            Employment   the wage falls to w0 – 1.

Deadweight loss of a Payroll
 Creates inefficiency – the number of workers
  employed and the wage actually received by
  workers are not the levels that maximise the
  total gains from trade
 Figure 5.7 b – Gains are lost –payroll tax
  reduces employment and raises the cost of
  hiring labor-hour
 Deadweight loss

           Payroll Subsidies

 An employment subsidy lowers the cost of hiring
  for firms, increase labor demand
 This means payroll subsidies shift the demand
  curve for labor to the right (down)

The Impact of an Employment

                                                 An employment subsidy
w0 + 1                                           of $1 per worker hired
    w1                 B
                                                 shifts up the demand
                                                 curve, increasing
    w0        A
                                                 employment. The wage
w1 – 1                                           that workers receive rises
                                                 from w0 to w1. The wage
                                                 that firms actually pay
         E0       E1                Employment
                                                 falls from w0 to w1 – 1.

          The Cobweb Model
Two assumptions of the cobweb model:
   Time is needed to produce skilled workers
   Persons decide to become engineers by
    looking at conditions in the engineering
    labor market at the time they enter school
 A “cobweb” pattern forms around the

The Cobweb Model in the Market
for New Engineers
                                               The initial equilibrium wage in
                              S                the engineering market is w0.
                                               The demand for engineers shifts
w1                                             to D, and the wage will
w3                                             eventually increase to w*.
                                               Because new engineers are not
                                               produced instantaneously and
                                               because students might
                                               misforecast future opportunities
                                               in the market, a cobweb is
                                               created as the labor market
                              D                adjusts to the increase in
          E0   E2   E*   E1       Employment

Cobweb Model (continued)

1. The cobweb pattern arises when people are
2. The model implies naïve workers who do not
   form rational expectations
3. Rational expectations are formed if workers
   correctly perceive the future and understand
   the economic forces at work

     Non-competitive labor markets:

 Monopsony market exists when a firm is a lone
  buyer of labor (acting as a sole employer of labor in
  the market)
 Such a firm must increase wages to attract more
 Two types of monopsonist firms:
   Perfectly discriminating
   Non-discriminating

Discriminating Monopsonist

 Able to hire different workers at different wages
 When “perfectly discriminating” each worker is
  paid his or her reservation wage

The Hiring Decision of a
Perfectly Discriminating
Dollars          A perfectly discriminating
                                          monopsonist faces an upward-
                                          sloping supply curve and can hire
                                          different workers at different wages.
                                          The labor supply curve gives the
w*                       A
                                          marginal cost of hiring. Profit
w30                                       maximization occurs at point A. The
                                 VMPE     monopsonist hires the same number
w10                                       of workers as a competitive market,
                                          but each worker gets paid his
               30   E*       Employment
                                          reservation wage.

Non-disriminating 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

 The Hiring Decision of a
 Nondiscriminating Monopsonist
  Dollars                                   A nondiscriminating
                      MCE    S              monopsonist pays the same
                                            wage to all workers. The
                                            marginal cost of hiring
VMPM                                        exceeds the wage, and the
                                            marginal cost curve lies above
                                            the supply curve. Profit
  wM                                        maximization occurs at point
                                            A; the monopsonist hires EM
                                            workers and pays them a wage
                            VMPE            of wM.
            EM   E*

     The Impact of the Minimum Wage
        on a Non-discriminating
                                               The minimum wage
                                               may increase both
                                               wages and employment
            A                                  when imposed on a
                                               monopsonist. A
w*                                             minimum wage set at

                                               w increases
                                               employment to E.

           EM   E                Employment

         Noncompetitive labor
           markets: Monopoly
 Firms that have monopoly power can influence
  the price of the product that they sell
 Monopolist faces a downward sloped market
  demand curve for its output

The Output Decision of a
                                          A monopolist faces a downward-
                            MC            sloping demand curve for his
                                          output. The marginal revenue
pM                                        from selling an additional unit of
                                          output is less than the price of the
                                          product. Profit maximization
          A                               occurs at point A; a monopolist
                                          produces qM units of output and
                                          sells them at a price of pM
                       MR    D            dollars.
              q M q*

    The Labor Demand Curve of a
Dollars                                    The marginal revenue product
                                           gives the worker’s contribution
                                           to a monopolist’s revenues (or
                                           the worker’s marginal product
                                           times marginal revenue), and is
          A                                less than the worker’s value of
                                           marginal product. Profit
                                           maximization occurs at point A;
                                           the monopolist hires fewer
                                           workers (EM) than would be
                    MRPE   VMPE            hired in a competitive market.
          EM   E*



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