Wage Determination

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.

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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

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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.

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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. ✦

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Equilibrium

Wage Rate

S

W*

D Q* Lesson Nine part 1

Quantity (Labor) 7

Demand Shift

Wage Rate

S W’ W* D’ D Q*

Q’

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Quantity (Labor) 8

Supply Shift

Wage Rate

S

S’

W* W’’

D Q* Q’’ Lesson Nine part 1

Quantity (Labor) 9

Monopoly S

wage rate

W** W*

D Q** Q* Quantity of labor Lesson Nine part 1

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Monopsony

Wage rate (dollars)

MRC

S

W*

W** D Q** Q* Quantity of labor Lesson Nine part 1

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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.

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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. ✦

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For Example ✦

Households do want to consume the food and fiber products these resources help produce.

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Similarly ✦

The demands for such services as income tax preparation, haircuts, and child-care create derived demands for accountants, barbers, and childcare workers.

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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

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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.

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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. ✦

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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.

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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. ✦

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A Tough Question ✦

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

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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.

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Resource price (wage rate)

P

✦Under pure competition, product

price is constant. 14

✦Therefore, diminishing marginal

productivity is the only reason why the resource demand curve is downward sloping.

12 10 8 6 4

D

2 0

1

2

3

4

5

6

7

8

Quantity of resource demanded Lesson Nine part 1

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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. ✦

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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. ✦

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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

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More Is Better ✦

From this list of productivityboosters, 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. ✦

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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. ✦

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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.

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Labor Force Participation One of the most dramatic developments in labor force participation over the last halfcentury 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. ✦

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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

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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. ✦

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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. ✦

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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. ✦

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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.

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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. ✦