The Labor Market and Wage

Determination
 Introduction

✦ What do Michael Eisner and Michael

Jordan have in common, besides of
course their first names?
✦ Well, both earn over $50 million a year,
Eisner as the head of Walt Disney and
Jordan as an athletic superstar.
 Meanwhile

✦ $12,000 a year is still ten times more than

a factory worker in the Philippines or a
seamstress in Bangladesh makes.

Lesson Nine part 1 3

 Why Do Some Earn More?
✦ Why do doctors earn
15 to 20 times more
than lifeguards even
though both are
saving lives?

✦ And why does a

college graduate
likewise earn
substantially more
than a high school
dropout? Lesson Nine part 1 4
 These Are Important Questions

✦ The wages you will earn in your

lifetime will likely be the single most
important determinant of your own
economic welfare.

Lesson Nine part 1 5

What Determines the Wage Rate?
✦ Why might the wage rate rise or fall?
✦ And let’s try to answer that question with
the help of our old friends, supply,
demand, and equilibrium.

Lesson Nine part 1 6

 Equilibrium
S
Wage Rate

W*

Q*
Quantity (Labor)
Lesson Nine part 1 7
 Demand Shift
S

W’
Wage Rate

W*

D’

Q* Q’
Quantity (Labor)
Lesson Nine part 1 8
 Supply Shift
S S’
Wage Rate

W*
W’’

Q* Q’’
Quantity (Labor)
Lesson Nine part 1 9
 Monopoly
S

W**
wage rate

W*

Q** Q*
Quantity of labor
Lesson Nine part 1 10
 Monopsony
MRC
S
Wage rate (dollars)

W*

W**

Q** Q* Q
Quantity of labor
Lesson Nine part 1 11
 That’s The Overview

✦ Our job now is to come to better

understand each of the key elements of
the labor market that I have outlined.

Lesson Nine part 1 12

 A Derived Demand

✦ Demand for factors in general and for

labor in particular is a derived demand.
✦ Factor resources usually do not directly
satisfy consumer wants, but do so
indirectly by producing goods and
services.

Lesson Nine part 1 13

 For Example

✦ Households do want to consume the food

and fiber products these resources help
produce.

Lesson Nine part 1 14

 Similarly

✦ The demands for such services as

income tax preparation, haircuts, and
child-care create derived demands
for accountants, barbers, and child-
care workers.

Lesson Nine part 1 15

 An Important Insight
✦ The derived nature of resource demand
implies that the strength of the demand
for a factor such as labor will depend on
two things:
(1) the productivity of the factor helping
to create the product, and
(2) the market price of the product that
the factor is helping to produce.

Lesson Nine part 1 16

 The Marginal Productivity
Theory of Resource Demand
✦ To maximize profits, the firm should
hire additional units of a given
resource – labor, land, and capital --
so long as each successive unit
adds more to the firm's total
revenues than it does to total costs.

Lesson Nine part 1 17

 Hiring An Extra Worker
✦ When a firm decides to hire, say, an
additional worker, it must evaluate how
much that worker will increase the firm's
profits.
✦ It will do so by comparing the extra
revenue generated by the extra output
produced by the additional worker to the
costs of employing that worker.
✦ Now, we already know what the firm’s
addition to total revenues is.
✦ What is it?
 Marginal Resource Cost
✦ That’s right: it’s the marginal revenue
product.
✦ But what about the addition to cost?
✦ Here, we can define the marginal
resource cost simply as the amount that
each additional unit of a factor resource
adds to the firm's total resource cost.

Lesson Nine part 1 19

 The Profit-Maximizing Rule
✦ It will be profitable for a firm to hire
additional units of a factor resource such
as labor up to the point at which that
resource's MRP is equal to its MRC.

Lesson Nine part 1 20

 If MRP≠ MRC
✦ If the number of workers currently
employed by the firm is such that the
MRC of the last worker is less than the
MRP, the firm can clearly profit by
hiring more workers.
✦ If the number of workers already hired is
such that the MRC of the last worker
exceeds the MRP, a firm can increase its
profits by laying off some workers.

Lesson Nine part 1 21

 A Tough Question
✦ Under the assumption that the labor
market is perfectly competitive, what
do you think that the MRC will be
equal to?

Lesson Nine part 1 22

 MRC=Wage Rate
✦ Therefore, the complete rule for profit
maximization under perfect competition
is this: The MRP will equal the MRC will
equal the wage rate.

Lesson Nine part 1 23

 P ✦Under pure competition, product
price is constant.
Resource price (wage rate)

14 ✦Therefore, diminishing marginal

productivity is the only reason why
12
the resource demand curve is
10 downward sloping.
8
6
4
D
2
0
1 2 3 4 5 6 7 8 Q
Quantity of resource demanded
Lesson Nine part 1 24
Productivity and Product Prices
✦ It should be clear from this discussion,
then, that if your productivity increases,
so, too, should your wage.
✦ By the same token, if the price of the
product that you are helping to produce
falls, you are likely to see your wages fall
as well.

Lesson Nine part 1 25

 Product Prices and Wages
✦ From our earlier lessons on supply and
demand, we know how prices might
change in the product market.
✦ The demand curve for both eggs and
bacon might shift inward after an article
in the Journal of Medicine links their
consumption to increased heart disease.
✦ This would drive down prices and wages
in the egg and bacon industries.
Lesson Nine part 1 26
 Productivity and Wages
✦ How might a worker’s productivity or
marginal productivity change and
thereby change his/her wages?
✦ The most important influences on
productivity are:
– the amount of capital and natural
resources that a person has to work
with,
– the state of the technology,
– and the quality of the labor itself.
Lesson Nine part 1 27
 More Is Better
✦ From this list of productivity-
boosters, we can see why American
workers are so much more
productive – and earn higher wages
-- than workers from many other
nations.
 For Example
✦ The United States is richly endowed with
natural resources ranging from fertile
farmland and mineral resources such as
oil, coal, and uranium to sources of
industrial power such as hydroelectric
dams.
✦ At the same time, American workers
have large amounts of capital to work
with – on average, over $50,000 of plant
and equipment per person.
Lesson Nine part 1 29
 Other Factors
✦ It’s not just that Americans have more
capital equipment to work with than
many of their counterparts.
✦ They also have more technologically
superior machinery as well as more
advanced management and work
methods.

Lesson Nine part 1 30

 Finally
✦ The health, vigor, education, training
and work attitudes of American
workers are generally better than
most other nations.
✦ This means that, even if other
nations had the same equipment,
technology, and natural resources,
American workers would still be
more productive.
 Labor Supply
✦ As we saw earlier, if the labor supply
curve shifts, then wages can rise or fall.
✦ The three major determinants of labor
supply are
– labor force participation,
– hours worked,
– and the rate of immigration.

Lesson Nine part 1 32

 Labor Force Participation
✦ One of the most dramatic
developments in labor force
participation over the last half-
century has been the sharp influx of
women into the work force.
✦ In fact, that participation has roughly
doubled since 1950, from 34% to
about 60% today.

Lesson Nine part 1 33

 At The Same Time
✦ Labor force participation by older
men has fallen sharply, particularly
for men over 65 – a change probably
due in large part to changes in
programs such as Medicare and
Social Security which offer far more
generous health and retirement
benefits.

Lesson Nine part 1 34

 Hours Worked
✦ The typical American works between 35
and 40 hours a week.
✦ Nonetheless, many workers work as
much as 50 to 60 hours a week at the
same, or a second, job.
✦ In fact, there are a variety of incentives
such as over-time pay that can greatly
affect hours worked.

Lesson Nine part 1 35

Backward Bending Curve
Backward Bending Curve
 The Reason
✦ At higher wages, workers can afford
more leisure even though each extra hour
of leisure costs more in wages foregone.
✦ To see this, put yourself in the shoes of a
worker who is offered higher hourly
rates and the freedom to choose the
number of hours worked.

Lesson Nine part 1 38

 The Substitution Effect
✦ The more you work, the more you will
earn so each hour of leisure becomes
more expensive to you as the wage rate
rises.
✦ Your incentive, then, is to substitute
work for leisure.

Lesson Nine part 1 39

 The Income Effect
✦ The higher the wage, the higher your
income so you will be able to take that
extra week of vacation to ski in Colorado
or sun yourself in Miami.

Lesson Nine part 1 40

At what point
in this graph do
you think the
income effect
dominates?
 Income
Effect
Dominates

Substitution
Effect
Dominates
 Immigration
✦ A final important determinant of
labor supply is immigration.
✦ In recent years, this has become a
potent political issue for many
reasons, not perhaps the least of
which is that as immigration
increases, every thing else being
equal, wages tend to decline.