Chapter 9 The Labor Market and Wage Rates

INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL CHAPTER 9 / THE LABOR MARKET AND WAGE RATES 2005, South-Western/Thomson Learning

Slides by John F. Hall

Animations by Anthony Zambelli

Labor Markets In Perspective

Labor Markets differ in an important way from the other markets weve considered so far in this book Firms need resources to make goods and services We can identify three general categories of resource markets Markets for capital Markets for land Markets for labor Labor is different from other things that are traded Sellers of labor care about factors in the work place Another feature of labor is the meaning of the price in this market Wage rate

Lieberman & Hall; Introduction to Economics, 2005

Figure 1: Product and Factor Markets

Product Markets Demand for Goods and Services
S D

Supply of Goods and Services

Households

Firms

Supply of Resources

Demand for Resources

Factor Markets
Lieberman & Hall; Introduction to Economics, 2005

Defining a Labor Market

How broadly or narrowly we define a market depends on the specific questions we wish to answer Broadly defined markets may look at markets
that draw on labor from all over the world Narrowly defined markets may look at markets that draw on labor on a very localized level

Lieberman & Hall; Introduction to Economics, 2005

Competitive Labor Markets

Market with many indistinguishable sellers of labor and many buyers

Involves no barriers to entry or exit Perfectly competitive labor markets must

satisfy three conditions Great many buyers (firms) and sellers (households) of

labor in market All workers in market appear the same to firms No barriers to entering or leaving labor market

Lieberman & Hall; Introduction to Economics, 2005

Competitive Labor Markets and The Equilibrium Wage

Wage rate determined like the price of other competitive markets:

Supply and demand

The labor demand curve in any labor market slopes downward because a rise in the wage rate

1) increases firms costs, causing them to decrease production and employ

fewer workers 2) increases the relative cost of labor from that market, causing firms to substitute other inputs, such as capital or other types of labor

The labor supply curve in any labor market slopes upward because a rise in the wage rate

1) induces some of those not currently working to seek work 2) attracts some of those who are currently working in other labor markets

The forces of supply and demand will drive a competitive labor market to its equilibrium pointthe point where the labor supply and labor demand curves intersect

Lieberman & Hall; Introduction to Economics, 2005

Figure 2: A Competitive Labor Market

Hourly Wage LS

$12

LD

10,000

Number of Workers

Lieberman & Hall; Introduction to Economics, 2005

Why Do Wages Differ?

Significant

inequality exists in wage

rates

Among different occupations Among and within occupations in U.S.

labor market

Wage

inequality is persistent Both highest and lowest paid occupations have been so for decades

Lieberman & Hall; Introduction to Economics, 2005

An Imaginary World

To understand why wages differ in the real world, lets start by imagining an unreal world Except for differences in wages, all jobs are
equally attractive to all workers All workers are equally able to do any job All labor markets are perfectly competitive

In such a world, we would expect every worker to earn an identical wage in long-run
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An Imaginary World

Figure 3 shows two different labor markets that initially have different wage rates In our imaginary world, could this diagram
describe long-run equilibrium in these markets? No

As these shifts occur, market wage rate of elementary school teachers will rise and that of systems analysts will fall

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Figure 3: Disappearing Wage Differentials

(a) Hourly Wage (b)

LS 2
S L1

Hourly Wage B $30 25

S L1

LS 2

A' $25 20

B'
LD

A
LD

Number of Elementary School Teachers

Number of Computer Systems Analysts

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An Imaginary World

When will the entry and exit stop? When there is no reason for an elementary school teacher to want to
be a systems analyst

When both labor markets are paying same wage rate

Long-run adjustments will occur even if no one actually switches jobs Changes will continue untilat points A and Bthe longrun wage rate is equal in both markets Take any one of these assumptions away, and equal-wage result disappears Tells us where to look for sources of wage inequality in real world
A violation of one or more of our assumptions

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Compensating Differentials

In our imaginary world, all jobs were equally attractive to all workers In real world, jobs differ in hundreds of ways that matter to workers When one job is intrinsically more or less attractive than another Can expect wages to differ by a compensating wage
differential Difference in wage rates that makes two jobs equally attractive to
workers

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Nonmonetary Job Characteristics

When evaluating a career, whether you are aware of it or not, you are evaluating hundreds of nonmonetary job characteristics, including Risk of death or injury Cleanliness of work environment Prestige you can expect in your community Amount of physical exertion required Degree of intellectual stimulation Potential of advancement
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Nonmonetary Job Characteristics

You will also think about geographic location of job and characteristics of the community in which you would live and work Weather Crime rates Pollution levels Transportation system Cultural amenities Nonmonetary characteristics of different jobs give rise to compensating wage differentials Jobs considered intrinsically less attractive will tend to pay higher
wages, other things being equal

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Nonmonetary Job Characteristics

What about unusually attractive jobs? These jobs will generally pay negative compensating
differentials

Different people have different tastes for working and living conditions Cannot use our own preferences to declare a job as less attractive or more attractive Or to decide which jobs should pay a positive or negative
compensating differential Rather, when labor markets are perfectly competitive

Entry and exit of workers automatically determines compensating wage differential in each labor market

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Nonmonetary Job Characteristics

Compensating wage differentials are one reason most economists are skeptical about idea of comparable worth Holds that a government agency should determine skills
required to perform different jobs and mandate wage differences needed between them

Economists generally prefer policies to increase competition and eliminate discrimination So that the market itself can determine comparable worth

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Cost of Living Differences

Differences in living costs can cause compensating wage differentials Areas where living costs are higher than average
will tend to have higher than average wages To compensate for the higher cost of living

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Differences in Human Capital Requirements

All else equal, jobs that require more education and training will be less attractive

In order to attract workers, these jobs must offer higher pay than other jobs
that are similar in other ways, but require less training

Differences in human capital requirements can give rise to compensating wage differentials

Jobs that require more costly training will tend to pay higher wages, other
things equal

Compensating differentials explain much of the wage differential between jobs requiring college degrees and requiring only a high school diploma The idea of compensating wage differentials dates back to Adam Smith

First observed that unpleasant jobs seem to pay more than other jobs that
require similar skills and qualifications

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Differences In Ability

Not everyone has the intelligence needed to perform well at any job Scientific discoveries and technological advances have increased not only skill requirements of many jobs But also abilities needed to acquire those skills In general, those with greater ability to do a job wellbased on their talent, intelligence, motivation, or perseverance will be more valuable to firms Firms will be willing to pay them a higher wage rate
Beyond any compensating differential for their human capital investment

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The Economics of Superstars

Why was owner of Texas Rangers willing to pay $25 million per year to have Alex Rodriguez play for his team?

Immediate answer

Because Rodriguez is so good When we try to explain extremely high wage rates of these superstars based on their exceptional abilities alone, we confront a puzzle

The very top writers, rock stars, comedians, talk-show hosts, and movie directors all earn wage premiums that seem vastly out of proportion to their additional abilities

Why?

Explanation in all these cases is based on ability

And also by exaggerated rewards market bestows on those deemed the

best or one of the best in a field

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The Economics of Superstars

If most people rank recent mystery novels in the same order, then the best will sell millions of copies, second best will sell hundreds of thousands, and third best might sell only thousands Even though all three novels might be very close in quality A publisher will earn ten times more revenue selling the best novel (compared to the second best), and ten times more revenue selling the second best (compared to the third best), and so on Same thing happens in markets for athletes, rock concerts, action movies, and news broadcasters But phenomenon is not limited to media markets or media stars

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Barriers to Entry

In some labor markets, barriers keep out would-be entrants Resulting in higher wages in those markets Since barriers to entry help maintain high wages for those protected by the barriersthose who already have jobs in the protected market Should not be surprised to find that in almost all cases, it
is those already employed who are responsible for erecting barriers

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Occupational Licensing

In many labor markets, occupational licensing laws keep out potential entrants American Medical Association (AMA) is perhaps the strongest example of occupational licensing as a barrier to entry

Professional organization to which almost half of American physicians

belong Much of AMAs activity has been designed to decrease supply of doctors AMA has also increased demand for physicians services by preventing nonphysicians from competing In late 1980s, rising health care costs led to increased public scrutiny of AMA, and its anticompetitive practices came under heavy attack

Economists see AMA primarily as an instrument to maintain high incomes for doctors

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Figure 4: The Market for Physicians

Physicians' Salaries 2. AMA restrictions on the supply of physicians move the market here.

LS 2
S L1

C W3 W2 W1 B

LD 2
D L1

3. Other policies to increase demand for physicians move the market here, at final wage rate W3.

1. Without AMA activities to increase salaries, equilibrium is here, at wage rate W1.

Number of Physicians

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Union Wage Setting

A labor union represents collective interests of its members Major objective of a union is to raise its members pay Higher union wage is contrary to interests of employer
so why does employer agree? Because union has power to strike

In a competitive labor market, a unionby raising the wage firms must paydecreases total employment in the union sector This, in turn, causes wages in non-union sector to drop Result is a wage differential between union and nonunion wages

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Figure 5(a): Union Wage Differentials

(a) Wage 2. A union wage of for long-haul truckers of W2 creates an excess supply of workers. LS

W2 W1

A' A

1. With no labor union, both longand short-haul truckers earn the same wage rate, W1.
250,000 350,000 300,000

LD

Number of Long-haul Truckers

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Figure 5(b): Union Wage Differentials

(b) Wage 3. Unemployed long-haul truckers move to the nonunion short-haul market, and the labor supply curve shifts rightward . . .
S L1

LS 2

B W1 W3 B' 4. pushing the short-haul wage rate down to W3. Number of Shorthaul Truckers

LD 200,000 225,000

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Union Wage Setting

Unions still maintain a significant, though declining, presence in many industries Such as automobiles, steel, coal, construction, mining, and trucking Certainly responsible for at least some of the higher wages earned in
those industries

Full effect of unions on labor markets is much more complex Many of the features of modern work that we take for granted today originated in union struggles with management Such as paid vacations and overtime pay Unions can raise workers morale and reduce labor turnover Through grievance procedures and other forms of communications
with management

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Discrimination and Wages

Discrimination occurs when members of a group of people have different opportunities because of characteristics that have nothing to do with their abilities First step in understanding economics of discrimination is to distinguish two words that are often confused Prejudice

Emotional dislike for members of a certain group Discrimination Restricted opportunities offered to such a group

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Employer Prejudice

When you think of job discrimination, your first image might be a manager who refuses to hire members of some group because of pure prejudice Such as African-Americans or women May surprise you to learn that economists generally consider employer prejudice one of the least important sources of labor market discrimination When prejudice originates with employers, market forces
work to discourage discrimination and reduce or eliminate any wage gap between favored and unfavored group

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Employee and Customer Prejudice

What if workersrather than employersare prejudiced? In a competitive output market, non-discriminating firm will be forced
out of business

Cannot count on the market to solve the problem

Same argument applies if the prejudice originates with firms customers When prejudice originates with firms employees or its customers Market forces may encourage, rather than discourage, discrimination
Can lead to a permanent wage gap between favored and unfavored
groups

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Figure 6: Employer Discrimination and Wage Rates

Sector A (Discriminating)
Wage Wage Sector B (Nondiscriminating)

LS 2
W3 W1 E'
S L1

S L1

F E LD W1 W2 F' LD

LS 2

Number of Workers

Number of Workers

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Statistical Discrimination

Suppose you are in charge of hiring 10 new employees at your firm Young married women in your industry are twice as likely to quit their
jobs within two years than men and those that quit are very costly to your firm 20 people apply for 10 positionshalf men and half women

Whom will you hire?

If your sole goal is to maximize the firms profit You will hire men Even if there isnt a trace of prejudice in you, in the firms employees, or in its customers, profit maximization may still dictate hiring the men

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Statistical Discrimination

When individuals are excluded from an activity based on the statistical probability of behavior in their group Rather than their personal characteristics Some observers have suggested that statistical discrimination is often a cover for prejudice According to critics of the statistical discrimination theory, the negative behavior of a favored group is rarely considered by employers

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Dealing With Discrimination

Discrimination due to pure employer prejudice is unlikely to have much of an impact on labor markets For other types of discrimination market incentives work in the opposite way, leading to a permanent and stubborn problem Such as statistical discrimination or discrimination due to worker or
consumer prejudice

In these cases, many economists and other policy makers believe that
government action is needed

Some favor affirmative action programs Others favor stricter enforcement of existing antidiscrimination laws and stiffer penalties when discriminatory hiring occurs Both approaches to policy force all firms to bear costs of nondiscriminatory hiring

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Discrimination and Wage Differentials

Consider the black-white differential for men Several studies suggest that if we limit comparisons to whites and blacks with same educational background, geographic location, and, in some cases, same ability (measured by a variety of different tests), 50% or more of the earnings difference disappears In addition to job-market discrimination, there is pre-market discrimination
Such as unequal treatment in education and housing For women, as well as blacks and other minorities, differences in skills and experience can be the result of lower wages

Occurs before an individual enters labor market

Since women know they will earn less than men and will have more trouble
advancing on the job

They have less incentive to invest in human capital and to stay in labor force

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Discrimination and Wage Differentials

In the end, we do not know nearly as much about the impact of discrimination on wages as we would like to know But research is proceeding at a rapid pace As weve seen, data must always be interpreted with care In measuring impact of job market discrimination on earnings
Wage gap between two groups gives an overestimate

Since it fails to account for differences in skills and experience

However, comparing only workers with similar skills and experience

leads to an underestimate

Since some of the differences are themselves caused by

discriminationboth in the job market and outside of it

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Figure 7: Vicious Cycle of Discrimination

Current Job Discrimination

Lower Wage

Pre-market Discrimination

Lower Human Capital Investment

Unemployment

Lower Skill Level

Less Job Experience

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Using The Theory: The Minimum Wage

Minimum wage lawmakes it illegal to hire a worker for less than a specified wage In any labor market covered by the law Most people think about the minimum wage as a means to increase living standards for the lowest paid workers, and their analysis stops there But minimum wage creates a wage differential among the least-skilled workers, depending on the industry in which they work By raising wages rates in covered industries, and
lowering them in uncovered industries

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Figure 8(a/b): The Minimum Wage

(a) Unskilled Labor Covered by Law Hourly Hourly A minimum wage raises Wage Wage pay, but decreases jobs in the covered sector. (b) Unskilled Labor Not Covered by Law

S L1

LS 2
Some who can't find work go to the uncovered sector, lowering wages there.

$5.15 4.00

A' A N2 N1 N3 LD

LS $4.00 3.00 B B' LD

Number of Workers

Number of Workers

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Figure 8(c): The Minimum Wage

(c) Hourly Wage Skilled Labor LS C'

$24.00 20.00

LD 2
As capital is substituted for unskilled labor, demand for skilled workers goes up, raising the skilled wage rate.
D L1

Number of Workers
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Using The Theory: The Minimum Wage

Only one group of workers in which everyone benefits: skilled workers Should come as no surprise that for many decades the
most vocal advocates of raising the minimum wage have been labor unions Membership is disproportionately made up of skilled workers

What do economists think about the minimum wage? Most regard it as an inefficient policy for helping poor
working families

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Using The Theory: The Minimum Wage

You might think that economists would overwhelmingly oppose any increase in minimum wage But that is not the case
Those who favored an increase in minimum wage tended to
believe the effect on unemployment was much smaller than those who opposed an increase Others may believe that higher unemployment is more likely to influence policy in a direction they favor

The minimum wage, like most issues of public policy, is not as simple as it appears
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Lieberman & Hall; Introduction to Economics, 2005