C hapter 15 Wage Rates in Competitive Labor Markets © 2002 South-Western.

CChapter 15hapter 15

Wage Rates in Competitive Labor Markets

© 2002 South-Western

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Economic PrinciplesEconomic Principles• Marginal physical product of labor

• Marginal revenue product

• The law of diminishing returns

• Marginal labor cost

• The profit-maximizing level of employment

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Economic PrinciplesEconomic Principles• Firm and industry demand for labor

• The supply of labor

• The backward-bending supply curve of labor

• Wage differentials

• Minimum wage laws

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You Load Sixteen You Load Sixteen Tons and What Do Tons and What Do

You Get?You Get?Marginal physical product (MPP)

The change in output that results from adding one more unit of a resource, such as labor, to production. MPP is expressed in physical units, such as tons of coal, bushels of wheat, or number of automobiles.

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MPP = change in output (Q) divided by change in the number of people employed (L).

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Any change in MPP is attributed to the hiring of one additional employee.

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EXHIBIT 1A OUTPUT AND MARGINAL PHYSICAL PRODUCT CURVES

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EXHIBIT 1B OUTPUT AND MARGINAL PHYSICAL PRODUCT CURVES

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Exhibit 1: Output and Exhibit 1: Output and Marginal Physical Marginal Physical

Product CurvesProduct Curves1. How can the shape of the total output curve in panel a of Exhibit 1 be described? • The total output curve is upward sloping, increasing by large amounts until three miners are employed, then increasing by smaller and smaller amounts when more than three miners are employed.

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Exhibit 1: Output and Exhibit 1: Output and Marginal Physical Marginal Physical

Product CurvesProduct Curves2. Why does the MPP curve in panel b climb to a peak and then fall? • The MPP curve maps the increases noted in the total output curve. The MPP increases for the first three miners, then falls as more miners are added to production.

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You Get?You Get?Law of diminishing returns

As more and more units of one factor of production are added to the production process while other factors remain unchanged, output will increase, but by smaller and smaller increments.

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Adding more labor to a given stock of physical capital must eventually create a less-than-efficient match of labor to capital.

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The law is demonstrated in the eventual flattening of the total output curve and the negative slope of the MPP curve.

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You Get?You Get?Marginal revenue product (MRP)

The change in total revenue that results from adding one more unit of a resource, such as labor, to production. MRP, which is expressed in dollars, is equal to MPP multiplied by the price of the good.

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You Get?You Get?Marginal revenue product

MRP = MPP x price

Or

MRP = change in total revenue (TR) divided by change in labor (L).

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Deriving the Firm’s Deriving the Firm’s Demand for LaborDemand for Labor

The quantity of labor demanded depends on price. If the price of labor falls, the quantity demanded of labor increases.

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Wage rate

The price of labor. Typically, the wage rate is calculated in dollars per hour.

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Total labor cost (TLC)

Quantity of labor employed (L) multiplied by the wage rate (W).

TLC = L x W

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Marginal labor cost (MLC)

The change in a firm’s total cost that results from adding one more worker to production.

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Marginal labor cost (MLC)

MLC = change in TLC divided by change in L.

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EXHIBIT 2A DERIVING THE MARGINAL LABOR COST CURVE

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EXHIBIT 2B DERIVING THE MARGINAL LABOR COST CURVE

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Exhibit 2: Deriving the Exhibit 2: Deriving the Marginal Labor Cost Marginal Labor Cost

CurveCurveWhat causes the MLC curve to be horizontal in panel b of Exhibit 2?• The labor market is perfectly competitive. Individual firms cannot influence the wage rate. The firm can hire as many workers as it wants at the prevailing wage rate. MLC is equal to the wage rate.

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The hiring rule for firms:

• Compare marginal revenue product and wage rate and hire laborers until MRP = W.

• If MRP > W, hire more laborers.

• If MRP < W, don’t hire.

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EXHIBIT 3 THE DEMAND FOR LABOR

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Exhibit 3: The Exhibit 3: The Demand Demand for Laborfor Labor

Why is a firm’s demand for labor equal to marginal revenue product (MRP)?

• MRP reflects the maximum a firm is willing to pay for an additional unit of labor.

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Exhibit 3: The Exhibit 3: The Demand Demand for Laborfor Labor

Why is a firm’s demand for labor equal to marginal revenue product (MRP)?

• When the price of labor falls, firms can afford to hire more labor, even though MRP declines.

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Changes in the price of a good and improvements in technology shift the demand curve for labor to the right.

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EXHIBIT 4 SHIFT IN THEA DEMAND CURVE FOR LABOR CAUSED BY AN INCREASE IN THE PRICE OF THE GOOD

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Exhibit 4: Shift in the Exhibit 4: Shift in the Demand Curve for Labor Demand Curve for Labor Caused by an Increase in Caused by an Increase in

the Price of the Goodthe Price of the GoodHow does an increase in the price of coal affect the number of miners hired at a wage rate of $24?

• When the price of coal is $2, seven miners are hired at a wage rate of $24.

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• When the price of coal increases to $3, the demand curve for miners shifts to the right.

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• At the new coal price, nine miners are demanded at the wage rate of $24.

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EXHIBIT 5 THE DERIVATION OF MRP USING OLD AND NEW TECHNOLOGY (PRICE OF COAL = $2)

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Exhibit 5: The Derivation Exhibit 5: The Derivation of MRP Using Old and of MRP Using Old and

New Technology (Price of New Technology (Price of Coal = $2)Coal = $2)

How does a change from old technology to new technology affect the MPP and MRP in Exhibit 5?

• With new technology the same miner is able to produce twice as much coal.

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Exhibit 5: The Derivation Exhibit 5: The Derivation of MRP Using Old and of MRP Using Old and

New Technology (Price of New Technology (Price of Coal = $2)Coal = $2)

How does a change from old technology to new technology affect the MPP and MRP in Exhibit 5?

• The new technology doubles both MPP and MRP.

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Industry Demand Industry Demand for Laborfor Labor

If all of the firms in an industry have essentially the same quality resources, use the same technology, and compete for the same laborers in the same labor market, then the industry’s demand curve for labor is the same as the individual firm’s demand curve for labor, magnified by the number of firms in the industry.

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EXHIBIT 6 INDUSTRY DEMAND FOR LABOR

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Exhibit 6: Industry Exhibit 6: Industry Demand for LaborDemand for Labor

What is the firm’s demand for labor at a wage rate of $20 compared to the industry’s demand for labor at the same wage rate?

• The firm’s demand for labor is 8 at a wage rate of $20.

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Exhibit 6: Industry Exhibit 6: Industry Demand for LaborDemand for Labor

What is the firm’s demand for labor at a wage rate of $20 compared to the industry’s demand for labor at the same wage rate?

• With 1,000 firms in the industry, the industry’s demand for labor at $20 = (8*1,000) = 8,000 laborers.

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The Supply of LaborThe Supply of Labor

The opportunity cost of working -- the value a laborer places on the next best alternative to working -- is different for different people.

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Opportunity cost determines how many people are willing to work at differing wage rates.

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EXHIBIT 7 THE SUPPLY CURVE OF LABOR

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Exhibit 7: The Supply Exhibit 7: The Supply Curve of LaborCurve of Labor

Why does the labor supply curve slope up in Exhibit 7?

• The curve is upward sloping because the higher the wage rate, the more willing are workers to supply greater quantities of labor. Their opportunity costs are met at higher wage rates.

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Three factors affect workers’ willingness to supply their labor at different wage rates: changes in alternative employment opportunities, changes in population size, and changes in wealth.

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The Supply of Labor: The Supply of Labor: Changes in Alternative Changes in Alternative

Employment Employment OpportunitiesOpportunities

• When new industries willing to pay higher wage rates enter a market, fewer laborers are willing to work for the older industry at the lower wage rate.

• The supply curve for labor in the older industry shifts to the left.

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The Supply of Labor: The Supply of Labor: Changes in Population Changes in Population

SizeSize• When the population of a region declines, the number of workers willing to work at any wage rate declines.

• The supply curve for labor shifts to the left.

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The Supply of Labor: The Supply of Labor: Changes in WealthChanges in Wealth

• When people have more wealth, they choose more leisure time and less work.

• The supply curve for labor shifts to the left.

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EXHIBIT 8 CHANGES IN THE SUPPLY CURVE OF LABOR

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Exhibit 8: Changes in Exhibit 8: Changes in the Supply Curve of the Supply Curve of

LaborLaborWhat happens to the quantity of labor supplied at a wage rate of $20 when the supply curve shifts from S to S1?

• The quantity of labor supplied drops from 8,000 to 6,000.

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An increase in the wage rate typically induces workers to increase the quantity of labor supplied, but only up to a certain point.

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After that point, an increase in the wage rate results in less, not more, labor supplied.

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EXHIBIT 9 THE BACKWARD-BENDING SUPPLY CURVE OF LABOR

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Exhibit 9: The Backward-Exhibit 9: The Backward-Bending Supply Curve of Bending Supply Curve of

LaborLaborWhat is the wage rate at which the laborer in Exhibit 9 decides to cut back on the quantity of labor he is willing to supply?

• The laborer is willing to increase the quantity of labor supplied up to a wage rate of $40.

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• Above $40, the laborer cuts back on hours worked per week and gains more leisure time.

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• To the laborer, the value of the leisure time is greater than the extra income he could have earned by working more hours.

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Deriving Equilibrium Deriving Equilibrium Wage RatesWage Rates

Combining the industry demand curve for labor and the industry supply curve for labor allows the industry equilibrium wage rate to be derived.

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Deriving Equilibrium Deriving Equilibrium Wage RatesWage Rates

• Individual firms within the industry have no influence on the market wage rate.

• Firms must accept the market wage rate and face a horizontal supply curve for labor.

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EXHIBIT 10 THE LABOR MARKET

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Exhibit 10: The Labor Exhibit 10: The Labor MarketMarket

How is the level of the horizontal labor supply curve for the firm in panel b of Exhibit 10 determined?

• The level of the labor supply curve is equal to the equilibrium wage rate of the industry (W = $20).

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Explaining Wage Rate Explaining Wage Rate DifferentialsDifferentials

How different opportunity costs of laborers affect the supply curve of labor and how differences in technology and the price of goods produced by labor affect MRP help explain why different wage rates exist in different labor markets.

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EXHIBIT 11 NORTH-SOUTH WAGE RATE DIFFERENTIALS

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Exhibit 11: North-Exhibit 11: North-South Wage Rate South Wage Rate

DifferentialsDifferentialsWhat are the factors that caused the wage rate to decline in the North in Exhibit 11?

• Immigration from the South to the North increased the pool of laborers and thus shifted the North’s labor supply curve to the right.

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• At the same time, relocation of factories from the North to the South shifted the North’s demand curve for labor to the left.

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• An increase in the supply of labor and a decrease in the demand for labor caused the wage rate to decline in the North.

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EXHIBIT 12 NET DOMESTIC MIGRATION AND IMMIGRATION FOR THE NORTHEAST, MIDWEST, SOUTH, AND WEST: 1985–94 (1,000s OF POPULATION)

Source: Bureau of the Census, Statistical Abstract of the United States, 1996 (Washington, D.C.: U.S. Department of Commerce, 1996), p. 32.

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Exhibit 12: Net Domestic Exhibit 12: Net Domestic Migration and Immigration Migration and Immigration for the Northeast, Midwest, for the Northeast, Midwest, South, and West: 1985-94South, and West: 1985-94

Based on Exhibit 12, which region of the country experienced the greatest net total migration?

• The South experienced the greatest net total migration, followed closely by the West.

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Explaining Wage Rate Explaining Wage Rate DifferentialsDifferentials

The supply curve of labor is affected not only by the supply conditions in the labor market, but also by the government’s immigration policy.

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Persisting Wage Persisting Wage DifferentialsDifferentials

Noncompeting labor markets

Markets whose requirement for specific skills necessarily excludes workers who do not have the required skills.

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Persisting Wage Persisting Wage DifferentialsDifferentials

Specific talents, limited to small numbers of people, create unique labor markets that allow relatively high wage rates and protect wage rates against erosion.

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The Economics of The Economics of Minimum Wage RatesMinimum Wage Rates

The problem with persistent wage differentials is not so much that a few people make millions, but that some people are unable to compete successfully in any occupation that provides an adequate standard of living.

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In an effort to remedy the problem, government can outlaw low wage rates by implementing a minimum wage law.

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The Economics of The Economics of Minimum Wage RatesMinimum Wage Rates• The problem with mandated minimum wage rates is that employers cannot be expected to hire workers whose MRP is below the legislated minimum wage rate.

• Thus some workers are left with no job at all.

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The impact of minimum-wage legislation on low-wage-rate-earning people depends on the price elasticities of demand and supply for labor.

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EXHIBIT 13 THE EFFECTS OF MINIMUM WAGE RATES

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Exhibit 13: The Effects Exhibit 13: The Effects of Minimum Wage of Minimum Wage

RatesRates1. How many people lose their job when minimum wage rates are implemented under the price elasticities of supply and demand for labor in panel a?• 1,000 workers were employed at $3 per hour.

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RatesRates1. How many people lose their job when minimum wage rates are implemented under the price elasticities of supply and demand for labor in panel a?• Only 300 workers are employed at $5.15. Thus 700 workers lose their jobs.

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RatesRates2. How many people lose their job when minimum wage rates are implemented under the price elasticities of supply and demand for labor in panel b?• 1,000 laborers were employed at $3 per hour.

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RatesRates2. How many people lose their job when minimum wage rates are implemented under the price elasticities of supply and demand for labor in panel b?• 9000 laborers are employed at $5.15 per hour. Thus only 100 lose their job.

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The Ethics of w = MRPThe Ethics of w = MRP

• Most economists accept market-determined wage rates as ethically defensible.

• The ethic is expressed as “From each according to his or her contribution, to each according to his or her contribution.”

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The Efficiency The Efficiency Wages TheoryWages Theory

Efficiency wages

A wage higher than the market’s equilibrium rate; a firm will pay this wage in the expectation that the higher wage will reduce the firm’s labor turnover and increase labor productivity.

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The Efficiency Wages The Efficiency Wages TheoryTheory

There are several reasons why a firm may choose to pay efficiency wages:

• Efficiency wages allow the firm to select more qualified workers.

• Efficiency wages increase workers’ morale and motivation on the job.

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The Efficiency Wages The Efficiency Wages TheoryTheory

There are several reasons why a firm may choose to pay efficiency wages:

• Reduce labor turnover.

• Deter workers from joining unions.

• Fairness -- if the firm is making a profit, it should share some with its workforce.

C hapter 15 Wage Rates in Competitive Labor Markets © 2002 South-Western.

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