PART FOUR

Resource Markets

Chapter 10: Wage Determination

A Focus on Labor

Resources include land, labor, and capital. Since labor accounts for about 72 percent of all income in the U.S., we will focus on the pricing and employment of labor. In a purely competitive labor market, a large number of similarly qualified workers independently offer their labor services to a large number of employers, none of whom can set the wage rate.
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Labor Demand

The demand for labor is an inverse relationship between the price of labor (hourly wage) and the quantity of labor demanded. The demand for labor is a derived demand: it results from the products that labor helps produce.

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Marginal Revenue Product

When more labor is employed, total product (or output) increases. The marginal product of labor (MP) is the additional output that results from the use of one more unit of labor.

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Marginal Revenue Product

Multiplying total product by price yields total revenue. In a competitive product market, product price equals marginal revenue (MR). Marginal revenue product (MRP) is the change in a firms total revenue when it employs one more unit of labor. change in total revenue MRP = unit change in labor
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Rule for Employing Labor: MRP = MRC

A profit maximizing firm will hire additional units of labor as long as each successive unit adds more to the firms total revenue than to its total costs. Marginal revenue cost (MRC) is the change in a firms total cost when it employs one more unit of labor. change in total (labor) cost MRC = unit change in labor
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Rule for Employing Labor: MRP = MRC

The MRP = MRC rule is the principle that to maximize profit, a firm should expand employment until the marginal revenue product (MRP) of labor equals the marginal resource cost (MRC) of labor.

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MRP as Labor Demand Schedule

Because each firm hires only a small portion of the market supply of labor, it cannot influence the market wage rate.

For each additional unit of labor hired, total labor costs increases by exactly the amount of the constant market wage rate. The market wage rate (its MRC) is equal to its MRP.

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MRP as Labor Demand Schedule

An MRP schedule (or curve) constitutes a firms demand for labor because each point on the schedule or curve indicates the quantity of labor units the firm would hire at each possible wage rate.

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Market Demand for Labor

The market demand for labor is the horizontal summation of all the individual firm demand curves for labor.

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Changes in Labor Demand

The labor demand curve can shift if there are:

Changes in product demand Changes in productivity Changes in the prices of other resources

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Changes in Product Demand

Because labor is a derived demand, when the demand for a product increases, the demand for a resource used in its production increases, other things equal. When the product demand decreases, the demand for resources will fall.

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Changes in Productivity

Other things equal, an increase in the productivity of a resource will increase the demand for the resource and a decrease in productivity will reduce the resource demand. Factors that affect the productivity of resources include (1) quantities of other resources, (2) technological advance, and (3) quality of labor.
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Changes in the Price of Other Resources

Changes in the price of other resources may change the demand for labor. Resources that are used in place of each other are called substitute resources.

Labor and capital are substitutable in certain production processes.

Resources that are used together are called complementary resources.

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Changes in the Price of Other Resources

When two resources are substitutes, a firm will purchase more of the resource whose relative price has declined and, conversely, use less of the resource whose relative price has increased. This is called the substitution effect. An increase in the use of one resource when the price of the other falls and the firm increases its output because of the lower production costs is called the output effect.

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Changes in the Price of Other Resources

When two resources are complements, an increase in the use of one resource requires an increase in the use of the complement resource, and vice versa. Furthermore, an increase in the price of one resource decreases the demand for the other resource, and vice versa.

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Elasticity of Labor Demand

A measure of the responsiveness of employers to a change in the wage rate is called the elasticity of labor demand (or wage elasticity of demand). percentage change in labor quantity EW = percentage change in wage rate

When EW < 1, labor demand is inelastic; when EW > 1, it is elastic; and when EW = 1, labor demand is unit-elastic.
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Elasticity of Labor Demand

Several factors interact to determine wage elasticity of demand:

Ease of Resource Substitutability Elasticity of Product Demand Ratio of Labor Cost to Total Cost

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Market Supply of Labor

The supply curve for each type of labor slopes upward, indicating that firms must pay a higher wage rate in order to attract workers away from the alternative job opportunities available to them and workers not in the labor force.

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Wage and Employment Determination

The intersection of labor supply and labor demand determine the equilibrium wage rate and level of employment in a given labor market. The market wage rate is given to the individual firm since each of the many firms employs such a small fraction of the total available supply of labor.
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Wage and Employment Determination

The supply of labor is therefore perfectly elastic at the market wage rate and firms will apply the MRP = MRC rule to determine its profit maximizing level of employment.

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Wage and Employment Determination

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Monopsony

Monopsony is a market structure in which there is only a single buyer of a good, service, or resource. Characteristics of a labor market monopsony include:

A single buyer of a particular type of labor This type of labor is relatively immobile The firm is a wage maker
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Monopsony

There are varying degrees of monopsony. In an extreme case called a pure monopsony, there is only one employer in the labor market.

In this situation, the labor supply curve for the firm is identical to the total labor supply curve.

The supply curve is the average-cost-oflabor curve for the firm.

To attract more workers, the firm must pay a higher wage rate; thus the upward-sloping supply curve.
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MRC Higher than the Wage Rate

To avoid wage differentials in the same job, monopsonists must pay a uniform wage to all workers.

This means that the cost of an extra worker the marginal resource (labor) cost (MRC)is the sum of that workers wage rate and the amount necessary to bring the wage rate of all current workers up to the new wage level. The MRC curve lies above the labor supply curve and MRC exceeds the wage rate.
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Equilibrium Wage and Employment

The monopsonist will hire a quantity of labor where the MRC equals the MRP. Using the labor supply curve, the monopsonist will pay a wage rate based on this quantity of labor.

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Monopsony

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Union Models

In some labor markets, workers sell their labor services collectively through labor unions. Unions work to raise wage rates for its members. The two union models are:
Exclusive or Craft Union Inclusive or Industrial Union

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Exclusive or Craft Union Model

Exclusive unionism is the practice of restricting the supply of skilled labor to increase the wage rate received by union members. A reduction in supply raises the equilibrium wage rate but reduces the number of workers employed.

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Exclusive or Craft Union Model

Policies that restrict labor supply include:

restrict immigration reduce child labor encourage compulsory retirement enforce a shorter workweek enforce occupational licensing

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Inclusive or Industrial Union Model

Inclusive unionism is the practice of including as members all workers employed in an industry, regardless of their skill level. These unions can put great pressure on firms to agree to its wage demands through the threat of a strike, which could eliminate the entire labor supply in a given industry.
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Inclusive or Industrial Union Model

High wage demands cause a portion of the labor supply curve to becomes perfectly elastic at the higher wage rate. Firms are wage takers; in paying the higher above-equilibrium wage rate, they cut back on the quantity of workers demanded.

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Inclusive or Industrial Union Model

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Wage Differentials

Wage differentials are the differences between the wage received by one worker or group of workers and that received by another worker or group of workers. These differences can arise either on the demand or the supply side of labor markets.

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Wage Differentials
When labor supply is fixed, a weak labor demand will result in a low equilibrium wage but a strong labor demand will result in a high equilibrium wage.
W

S Weak Demand D
Q Q

W W

Strong Demand

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Wage Differentials
When labor demand is fixed, a low labor supply will result in a high equilibrium wage while a higher abundant labor supply results in a low equilibrium wage.
W W

Low Supply D

S
W

High Supply

D
Q Q

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Non Competing Groups

The labor force is composed of many noncompeting groups of workers, each representing several occupations for which members of that particular group qualify. Members of noncompeting groups differ in their mental and physical abilities and in their level of education and training.

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Compensating Differences

Wage differentials received by workers to compensate them for nonmonetary disparities in their jobs are called compensating differences. Compensating differences help allocate societys scare labor resources.

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